The Taming of the Barbarians
Asked how to respond to a
rival company's most recent gambit, the well-dressed man looks out of the
window of his lavish New York office and says simply, "Napalm."
Thus
was Henry Kravis, co-founder of the leveraged-buyout firm Kohlberg Kravis
Roberts, introduced to the viewing public in the HBO film version of the 1980s
business classic Barbarians at the Gate . The story of KKR's successful
but ill-fated LBO of RJR Nabisco, Barbarians offered an indelible
portrayal of KKR (and its competitors and allies) as made up of insatiable deal
makers and game players. They flourished on brinkmanship, buying companies only
to dismember them and caring only for the chance to crush their opponents.
What a long, strange trip it's been. Just last
week, KKR announced that it would partner with upstart LBO firm Hicks, Muse,
Tate & Furst to buy Regal Cinemas, the country's second-largest owner of
movie theaters, for $1.2 billion. The Regal theaters will be combined with
those owned by Act III, which KKR bought just a month ago, and those owned by
the United Artists Theatre Group, which Hicks, Muse is in the process of
acquiring, to create the world's largest chain of movie theaters. (Got all
that? There will be a pop quiz at the end of the story.) The new company will
control 17 percent of all the theaters in the United States and has plans to
build many of those giant multiplexes we've been hearing so much about, the
ones with 20 or 30 theaters apiece.
One can
be forgiven for wondering if what America really needs is more movie theaters,
especially at a time when movie attendance is flat and the number of screens
has risen by a third in the last decade. (For more on that question, click .)
But, setting that aside, what's really interesting about the Regal acquisition
is that it is a bona fide long-term investment. In other words, KKR isn't
buying it to sell off its assets and pocket the proceeds. On the contrary, by
combining Regal with Act III, KKR is actually using one acquisition as a
platform for another, much in the way any corporation looking to expand into a
new field of business does.
It may seem improbable that KKR is interested
in actually building up businesses. After all, in popular mythology, KKR is
thought of as the firm that pioneered the leveraged buyout and left America's
once-proud corporations either struggling under mountains of junk-bond-financed
debt or stripped of their most valuable jewels. But in fact the Regal deal, far
from being anomalous, is typical of what KKR has done in the years since the
LBO craze came to a screeching halt at the end of the 1980s. More than that,
the firm's performance in this decade sheds a new light on its performance in
the last one and makes it worth asking, once again, what the real impact of
LBOs and junk bonds on U.S. corporations was. (If you've forgotten what a junk
bond is, click .)
KKR is
a private partnership rather than a corporation. In essence, what the firm does
is raise money from investors--primarily pension funds, closed-end mutual
funds, and banks--and then put that money to use in the hope of getting those
investors better returns than they could have found in the stock or bond
markets. KKR does so by buying and selling companies, which is to say that the
firm never makes a deal to buy a company without plans to sell it eventually or
to take it public or both. The investors reap their rewards not by taking out
profits from the companies during the time KKR owns them but through the
capital gains they reap when the companies are sold or taken public.
The obvious conclusion to draw from this is
that KKR must be hurting these companies' long-term prospects by trying to
maximize their short-term value. If you're buying a company knowing that
somewhere down the line you'll want to sell it, the argument goes, you'll
shortchange research and development, cut back on long-term investment and sell
off slow-performing parts of the business in an effort to make the company look
better in the present. As a result, KKR gets richer while the country as a
whole ends up poorer.
The
problem with this analysis is that it assumes that KKR is smart while everyone
else is dumb. After all, when deciding whether or not to buy a company from
KKR--as Gillette recently did with Duracell--presumably you'll want to kick the
tires and look under the hood a little bit. And unless Henry Kravis has magical
powers no one knows about, it's unlikely that buyers are going to make a
long-term investment in a company that's had all the value stripped out of it.
In other words, if you think that markets are even relatively good at
determining a fair price for assets, then KKR can't hurt its companies'
long-term prospects without hurting itself.
What about the question of debt, though? In
part, what KKR did when it purchased companies in the 1980s was replace those
companies' dividend payments to shareholders with debt payments to creditors.
In principle, one is no better or worse for a company's health than the other.
But there is one big difference between dividends and debts, which is that if
you fail to pay the first, your stock price gets punished, but the company
stays in business--while if you fail to pay the second, the company goes under.
And there's no question that the LBO craze led to the destruction of a series
of companies that took on more debt, often in the form of junk bonds, than they
could handle. Southland (home of 7-Eleven), Westpoint-Pepperell, Federated
Department Stores: They all collapsed because their debt loads were too high.
It's interesting that the one thing those companies had in common was that KKR
had passed on acquiring them. But even KKR overreached itself when it spent $26
billion to acquire RJR Nabisco. The near-collapse of that deal almost sent the
firm out of business, in addition to making Kravis a poster boy for
unrestrained greed.
In
retrospect, though, two things seem clear. First, the RJR deal was atypical of
KKR's broader strategy. Second, the whole fiasco was the best thing that could
have happened to the firm. The death of LBO fervor, which in practical terms
meant the death of banks' willingness to lend freely to almost anyone, forced
KKR to refocus its business around the strongest deals possible. It also meant
that future buyouts would be less heavily leveraged. (In 1996, only 30 percent
of all junk bonds went to finance LBOs.) And the continued bull market meant
that you had to look harder to find companies that investors were undervaluing
and that there was a greater incentive to improve those companies' bottom-line
performance.
The results have been striking. Duracell,
bought by KKR in 1988 for $350 million, was sold to Gillette for $3.7 billion
in 1996. In that same year, it sold American Re, a reinsurer, to a German
company for a profit of $1.8 billion, and Stop & Shop to a Dutch company
for a profit of $1.4 billion. All these were companies that KKR had owned for
an extended period of time during which all had expanded, improved
productivity, and--in the case of Duracell--benefited from increases in R &
D spending. The firm's one great flop of recent years has been Flagstar, which
owns Denny's. The Grand Slam Breakfast just never took off.
One familiar interpretation
of KKR's success is that it illustrates the disciplining power of debt.
Becoming highly leveraged has forced managers to think seriously about costs,
trim overhead, and improve productivity. The broader lesson we're supposed to
learn, then, is that it was precisely the takeover mania of the 1980s that
created the lean, efficient profit machines of the 1990s. But the truth is that
KKR's success illustrates a more mundane--but even more important--point, which
is that managers of a company perform better when they're held accountable by
the owners of that company. KKR has not succeeded because of the discipline of
debt or even the promise of untold riches. Rather, it has succeeded because it
brought a relentless focus on the bottom line to the corporations it has owned,
and established standards its managers have had to live up to. For most of this
century, U.S. corporations featured rubber-stamp boards of directors handpicked
by management and uninterested in rocking the boat. What these boards have
allowed managers to do is, simply, play with other people's money. And in some
very basic sense, what KKR has done best is get managers to take other people's
seriously.
