Thayer Watkins
Silicon Valley
& Tornado Alley

The New Financial Capitalists:
Kohlberg Kravis Roberts and
the Creation of Corporate Value

George P. Baker and George David Smith have written the best book on leveraged buyouts and KKR. It is not likely that any better book will ever be written on this topic. Baker and Smith, who are economists, were commissioned by George Roberts of KKR to write the history of the firm's investments. They were given access to private records and were able to interview the principal participants in those investment projects. Separate from the reports written for KKR, Baker and Smith were allowed by KKR to publish a book on the topic utilizing the information they acquired while serving as consultants on KKR's history project.

Since the authors are economists they were primarily interested in how the phenomenon of leveraged buyouts affects matters of economic efficiency on the industrial and commercial system. Their conclusions are very positive on the benefits of leveraged buyouts for economic efficiency. Thus contrary to the view of the general press that leveraged buyouts were merely pecuniary manipulations that hurt the long run functioning of the enterprises Baker and Smith found that the discipline of debt forced the reduction of wasted resources in enterprises in which there was a divorce between management and ownership.

The general press tends to treat any deviation from the status quo as detrimental. Milton Friedman entitled one of his popular works The Tyranny of the Status Quo. Sometimes the status quo needs to be changed for the long term health of the system. In the 1980's most people thought that American industry was decidedly inferior in efficiency to corresponding Japanese industries. American industry went through some painful adjustments in the 1980's and became leaner and stronger and in the 1990's went on to international dominance while Japan's industries suffered from a malaise in the 1990's that still has not abated. With hindsight we now realize that much of Japan's seeming economic success was based upon an artificial financial structure that could not be sustained indefinitely, a house of cards so to speak.

Baker and Smith's book gives not only new information obtained from KKR's files but also more in depth research about familiar cases such as the leveraged buyout of Safeway. They also give the history of RJR Nabisco after its acquisition. There could be an interesting sequel to the movie Barbarians At the Gates.

There is a particularly interesting and valuable chapter in Baker and Smith's book on the failed cases of leveraged buyouts. It is recognized that high leverages entail risks and it is not surprising that in some cases an unanticipated chain of events brought financial distress and failure. Only about three of the thirty seven LBO's executed by KKR came to default on interest payments. In those cases it is notable how difficult it would have been to have foreseen the events responsible for the failure. It is also interesting and enlightening to compare some of the LBO's handled by firms other than KKR with the ones handled by KKR.

Take the case of the hostile LBO of Federated Department Stores by Robert Campeau, a Canadian financier. Federated Department Stores were relatively high end retailers. The company had lots of stores but did not have a mass marketing strategy. Robert Campeau believed he could realize a major gain in value for the corporation with a change in management. He acquired Federated at a price that was nearly double its preacquisition market value. This was risky enough, but he amplified the risk by using debt to cover about 97 percent of the acquisition costs. This was a leverage ratio (debt/equity) of about 32 to 1. Leverage ratios in excess of 9 to 1 have a notably higher rate of failure. The safe levels of the leverage ratio depends upon the nature of the business, the stability of the rate of return on capital. American banks typically operate with leverage ratios of 15 to 1 but this is acceptable because of the predictability and stability of their earnings. Manufacturing corporations in the U.S. operate with leverage ratios which are typically in the range of 0.5 to 1 or 1 to 1.

Robert Campeau acquired Federated in 1989. In 1990 Federated filed for bankruptcy. While financially the LBO of Federated was a failure Campeau was able to bring about some adjustments before the collapse that improved the performance of the company. The improvements were just not enough and not soon enough to cope with the financial burden of high interest payments required to cover the high acquisition price.

Baker and Smith cite some very interesting results of Steven Kaplan of the University of Chicago whose research indicated that the reforms carried out did increase the value of the company even though financial distress drove the company into bankruptcy.

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