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Leveraged management buy-outs at KKR: Historical perspectives on private equity, debt disciplines, and LBO governance

As with all forms of private equity investing, leveraged buy-outs require close evaluation, sophisticated financing, diligent oversight and patience. What makes the LBO distinctive is that it employs high leverage in the initial financing, and that it is normally a rehabilitative acquisition strategy undertaken in mature sectors of industry where under-performing companies are ripe for rejuvenation. It was in its formative stages, and remains, a highly specialised technique for acquiring assets and improving their value. What makes it historically important is that its impact - the lessons it has to teach about incentives for management and corporate governance - have spread to the wider corporate world. George Baker, Harvard Business School and George Smith, Stern School of Business discuss.

This article is extracted from Private Equity and Venture Capital with the kind permission of Euromoneny Books (a division of Euromoney) Email books@euromoneyplc.com for further information about this title.

Antecedents to the modem LBO can be traced back to the 19th century, if not before, but the modem LBO was developed gradually after World War II in arcane corners of small business finance. More often than not, the LBO was intended as a 'friendly' takeover strategy, in which a target company's key executives stayed on to run the companies that had been acquired and financially restructured. Kohlberg Kravis Roberts & Co. (KKR), whose founders helped pioneer the LBO at Bear, Stearns & Co. as early as 1968, was the first to apply the technique both systematically and successfully over a series of transactions. From 1976 to 1989, after which the long-sustained activity in M&A during the 1980s subsided, KKR completed 38 transactions, or ‘deals', for their limited equity partners in five different LBO funds 97 pools of equity capital that KKR as general partner had discretion to invest in limited partnerships organised for discrete acquisitions.

In the early years, KKR's target companies were neither sick companies nor turnaround candidates - they were reasonably healthy concerns that could be improved through more aggressive management and better operating disciplines. From the beginning, Messrs. Kohlberg, Kravis and Roberts understood that the feasibility of any LBO had to be measured not by conventional measures of profitability, but rather by its cash flows, which would have to be sufficient to pay down debt without debilitating operations.

Such deals were radical and daring by then conservative M&A financing standards; it was no easy business to find backers. High leverage offered prospects for high upside gains for lenders and equity investors alike, but left little margin for error. Bankers demanded their interest and principal on strict time schedules, and had to have faith in that they would get their due. On the other hand, it would normally take years to improve performance to the point where the market value of the equity would yield a high enough return to compensate equity investors for the risk of their investment. Hence, equity holders had to be patient, just as lenders had to have faith. The LBO was not some sort of get-rich-quick scheme. Over time, KKR would hold equity interests in the majority of its companies for an average of more than six years.

The combination of high risk and the need for patience was familiar in the small world of small company venturing, where KKR found some of its first allies. The firm92s first equity fund was formed with less than US$35 million contributed by a few individuals along with a handful of banks where venture specialists could be persuaded to participate, and a few insurance companies.

Of course LBOs were quite different from cash-poor new ventures that could ill afford debt. Although modest in scale, the early LBOs were limited to closely held or small, cash-rich manufacturing companies in mature markets. Scepticism was hard to overcome, despite the success that Kohlberg Kravis and Roberts had with several small transactions at Bear, Steams. KKR's first deal as a firm, in early 1977, was the buyout of A.J. Industries, a small conglomerate manufacturing company. It was impossible to persuade anyone to provide subordinated debt for the US$94 million transaction, and so the deal92s 66 per cent leverage rested entirely on senior bank debt. In 1979, the US$380 buyout of the publicly traded stock of Houdaille Industries with 86 per cent leverage financed by a multi-layered array of senior and subordinated securities sent shock waves through Wall Street and the Securities and Exchange Commission. Prior to the deal being closed, the Houdaille stock had never been traded as high as KKR's offering price. That would never happen again. Post-Houdaille, KKR was able to attract a widening circle of institutional lenders, as well as equity investors. Five more funds with ever-increasing pools of equity capital were formed in the 1980s; the 1987 Fund invested more than US$6 billion in equity before it was finished

By the mid-1980s, KKR was acquiring ever-larger companies across a wide spectrum of US industry: perishable consumer products, broadcast and cable television, food and speciality retailing, packaging, printing, real estate and natural resources. It was acquiring sick as well as healthy companies; the horribly mismanaged Beatrice Companies, acquired for more than US$8 billion, was one of KKR's more notable successes. After 1984, when the burgeoning market for high-yield securities suddenly made highly leveraged transactions feasible for multibillion-dollar companies, KKR deftly exploited junk bond financing and moved to the centre of the 1980s market for corporate control. In 1989, after its memorable acquisition of RJR Nabisco, had KKR been an industrial holding company, it would have ranked in sales fifth in the United States behind General Motors, Ford, Exxon and IBM.

Ranging in transaction value (equity investment plus financing costs) from the US$12.7 million Eagle/FB Truck Line deal in 1979 to the US$31.4 billion RJR Nabisco buyout in 1989, KKR applied the same basic, tripartite principle to virtually all 38 buyouts we studied in detail between 1977 and 1989. The principle was elegantly simple: (1) acquire under managed companies with high levels of debt financing; (2) make their managers owners; (3) monitor post-deal managerial performance rigorously - all for the sake of improving the long-term value of the assets. Virtually all the buyouts we studied have either been completely sold off or have had at least ample time to demonstrate how the initial investments actually turned out in the long run. What we found were some common patterns of success, even as we discovered a high degree of variation among acquired companies, potential sources of value creation and post-deal strategies for realising value.

Financing leveraged acquisitions

Acquiring a company with high levels of debt - KKR's leverage (total debt-to-asset) ratios ranged from 58 to 93 per cent in our sample 97 had three key advantages for making LBOs work. In the first place, high levels of debt financing enabled equity investors with limited capital to realise huge gains as the debt was paid down. From management's standpoint, the high debt ratio shrank the equity portion of the financing of the deal to levels at which top executives could afford to buy into the deal with a significant portion of the equity, 10 to 20 per cent of it in many cases. From KKR's standpoint, the debt also served as a useful tool, as the need to make timely debt repayments compelled managers to improve performance. Indeed, the leverage in LBO financing served a paradoxical function. On the one hand it liberated managers, enabling them to become entrepreneurial owners of their businesses; on the other it shackled them to strict operating budgets, locked in, as they were, by external debt covenants.

There was no formula, strictly speaking, in the financing of a KKR buyout. Each company KKR decided to pursue (out of scores that were screened by its growing staff of professionals) presented a different set of opportunities and problems. Each financing was crafted to fit the perceived situation. Each took into account the preferences of lenders as well as the needs and capabilities of the companies involved. Each was designed to maximise operating cash flows through creative approaches to layered debt structuring and the minimisation of tax liabilities: Each was unique in its combination of senior and subordinated debt and in the kinds of securities employed. Such flexibility was key to assuring success. It was never enough to ascertain that the company's stock was undervalued; it was important to form a clear picture of where and how value could be unlocked. James Greene, who joined the firm in 1986, learned just how specific each
Buy-out transaction was, and just how much had to be settled in the minds of everyone concerned before the financing took place:

It was a matter of understanding at the outset, before we bought anything, what the company's objectives were, how its management thought it was going to attain those objectives, what kind of capital they needed to spend, what kind of investment in R&D, people, equipment, software, and so on. Then we structured the balance sheet and leveraged the company appropriately.

Nevertheless, some rules of thumb were worked out in the early years. There was an overarching financial framework within which the large majority of KKR's deals fit. In its pro forma plans, KKR would propose to acquire companies with about 10-20 per cent equity and 80-90 per cent debt. Of that, senior bank debt was to have fairly short (five-year) repayment requirements, while subordinated debt typically had somewhat longer terms. A typical plan for a KKR buyout would show an acquired company repaying the debt within five to seven years. By then significant gains in the operating performance of the assets would, one hoped, yield high enough returns to compensate for both the perceived risks of highly leveraged transactions and the premium over prevailing market values that had to be paid to buy out the departing equity holders.

KKR and other early LBO practitioners recognised that the key to ‘super-normal' equity returns was the then rather unconventional idea that asset growth was not necessarily the path to value creation. The leverage in the deal was there to force changes in performance in some cases radical downsizing and cost cutting; in others just incremental operating improvements; in still others aggressive expansion that could be converted into long-term capital gains. The role that debt played as a tool is worth emphasising, if only because it shows just how wrong prevailing abstract economic theories regarding capital structure could be in the real world. The way a company is financed not only affects its cash flows but also the way it is managed. Debt was not only a financing technique, but also a tool to force change in behaviour.

A good example is Fred Meyer, Inc., a West Coast retailing chain that KKR acquired in 1981. Realising that Fred Meyer's real estate holdings were seriously undervalued, KKR acquired them through a limited partnership separate from the one it set up to buy out the stores. This enabled KKR to borrow more for the deal, of course, but more important, by renegotiating the real estate leases with the operating company to reflect prevailing market rates, Fred Meyer managers were forced to change their priorities. They curtailed store expansion, which had been their wont, and focused instead on improving the profitability of existing properties.

Governance and the LBO association

In its communications to its limited partners KKR always described the leverage in its buyouts simply as a ‘financial technique'. It was more than that. The leverage was inextricably linked to management performance in the post-buyout environment. If the price paid for a company were too high, the demands for debt repayment could undermine the best efforts of management to achieve long-term strategic and operating efficiencies. At the same time, the debt imposed an ironclad discipline on budgets, compelling management to take the actions necessary to fix short-term problems. The ability of managers to operate under the discipline of debt demanded competencies that were often untested in normal corporate environments.

To ensure that everything was working in timely fashion, the buyout firm exercised continuous oversight of the board. Indeed, as KKR's explained to its fund investors, -the ongoing monitoring role [was] equally as important as the initial structuring and consummation of the transaction. When the LBO deal closed, everyone - KKR and its equity partners, senior and subordinated lenders, and corporate management alike ‘bought in' to a strategy and operating objectives that would be constrained by high debt service for at least two to three years. Debt covenants and projections for meeting them became imperatives for improvements in economic efficiency. Nonetheless, the results were never predetermined. The ultimate success of a buyout was contingent on human factors, chief among them the relationship between the KKR-led board of directors and the company's top management.

In monitoring bought-out companies, KKR and other LBO firms developed a distinctively new form of business organisation, which in the jargon of institutional economics is called the LBO association. Although it looks a bit like a conglomerate in that it is diversified and acquisitive, the LBO association is not a corporation and does not function like a holding company; it is a set of limited partnerships organised as discrete equity funds the LBO association allows its constituent companies to float on their own bottoms. There is no consolidation of accounts, inter company transfers of cash, or cross-subsidisation. There are no forced inter firm sales, commonly imposed information systems, or any other attempts to achieve either uniformity in practice or operating, financial and technical synergies.

There is no ‘black book', KKR's Henry Kravis explained. ‘We try to work with whatever structures and systems a company has used historically and go from there.' Nor is the LBO association a mere portfolio of investments, since each company is actively overseen and influenced by the general equity partners. As it evolved, the LBO association became a means for imposing a common oversight regime through a commonly experienced group of LBO-seasoned hoard directors. Through its long-standing relationship with law firms, accountants and consultants, KKR could bring legal, financial and management expertise to meet specific organisational needs and could apply its experience in high-level financings, including public offerings and balance sheet restructurings. Most of all, KKR, whose professionals dominated each constituent company's board, could watch its investments closely and knowledgeably to a degree uncommon in the world of corporate governance.

The mission of the buyout board, from the first day of its control over a company to the last, was to ensure the creation of long-term value. This objective had to be managed carefully, as KKR often found itself acting as a buffer between managers with visionary goals and somewhat impatient institutional fund investors. Managers had to watch their costs, but they also needed support for their business-building strategies: funds for capital investment, for research and development, for marketing. ‘We are long-term
players,' KKR partner Perry Golkin explained:

'We can't manage quarter to quarter with respect to our fund investors. We often get pressured to issue monthly reports when we don't even want to do quarterly reports, because it misses the point philosophically. We still won't value the privately held companies more than annually. If the plan is to build value over time you think about things differently; you have to be patient.'

Patience was evidenced by the holding periods for most KKR investments. The mean number of years KKR held equity in (and hence influence over) its companies was 7.6 years; the median was 6.2 years. In only four cases was KKR able to sell off a company's equity for a satisfactory gain in less than four years. Such quick tumarounds occurred only when the market for a certain class of assets, such as cable television in the mid-1980s, was so robust that KKR seized the opportunity to realise the windfall for itself and its equity partners. Usually, value had to be created by long and sustained hard work, not by fortuitous circumstances.

Board governance at KKR was characterised by frequent contact between corporate executives and leading directors, who were most heavily engaged during the first three years or so after a buyout. Detailed written monthly reports sent to KKR formed the basis for ongoing discussions between CEOs and chief financial officers on the one hand, and KKR on the other. Formal board meetings were less important. Monthly and quarterly meetings were less important than the frequent conversations, sometimes daily, between director and manager.

Management decisions were to be listened to, questioned, and even debated, but rarely overruled. KKR exercised a board's authority to review and help implement strategic financial decisions. It provided advice on accounting and control systems. It insisted on continuous and interactive discussions with management. It did, in short, what corporate board directors are supposed to do, but it did not dictate corporate strategic or operating decisions or meddle with their implementation. And, as we show in more detail below, KKR boards proved to be willing investors in management strategies. Capital expenditures, Investments in research and development, and employment were generally sustained or increased over pre-buyout levels in KKR companies. Charitable contributions and community involvement were encouraged.

Continuous communication - candid, informal and fluid enabled KKR to better grasp the changing realities of its holdings while providing managers opportunities to get their ideas heard, their plans reviewed, and ultimately their strategies represented and defended to KKR's limited partners. As one manager put it, the KKR board process served not only as a monitoring device but also as a useful consultancy. ‘I like to bounce ideas off of
smart people,' he said, and KKR has an extremely dense population of smart people. It doesn't matter who you talk to, you get ... well-thought out answers, almost on any subject, but most certainly on those subjects where their strengths lie.' Those strengths, he noted, were precisely in those financial areas that KKR reserved to itself - in the buying and selling of businesses, in the arranging of financial market transactions.

Therefore, serious tensions in the boardroom were rare. Our interviews with KKR partners and company CEOs alike revealed little conflict. Chief executive Donald Boyce of Idex, for example, said that while it was natural enough for financiers and managers to see the world differently, KKR never interfered with his management of Idex. And although Charles Perrin, the CEO of Duracell, recalled a couple of boardroom conflicts, one over a stock buy-back proposal (management favoured it, KKR did not) and a plan to construct a new headquarters (KKR acceded after finding a less expensive way to finance it), such conflicts rarely arose. KKR partner Scott Stuart noted that directors tended to be more conservative than managers in post-buyout M&A activity, and that disagreements might surface over changes in capital structure that could alter management's stockholdings, but he could recall no systematic biases that divided managerial from investor interests in KKR firms. ‘The fact that managers are so heavily invested financially in their businesses takes care of more than 90 per cent of the problems,' he noted. ‘The rest, we simply work through.'

George Baker, Harvard Business School
George David Smith, Stern School of Business

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