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What is the book Barbarians at the Gate about? What was the biggest leveraged buyout in history?
In their book Barbarians at the Gate, Bryan Burrough and John Helyar detail the 1988 leveraged buyout of RJR Nabisco, which is the biggest business transaction of the 20th century. The high value of the transaction, as well as the unusually competitive bidding in the LBO process, caught the attention of the press.
Read below for a brief Barbarians at the Gate book overview.
Barbarians at the Gate by Bryan Burrough and John Helyar
The buyout of RJR Nabisco represented a turning point in the use of LBOs. The press coverage revealed how LBOs can generate tremendous income for CEOs and finance companies, but they also can incur tremendous corporate debt that weakens the company. Increased public awareness of these issues caused LBOs to fall out of favor in the business community.
Wall Street Journal reporters Bryan Burrough and John Helyar covered the story of the RJR Nabisco buyout as it was unfolding and dug into the background of the various parties who were involved. In their book Barbarians at the Gate, they present a detailed chronology of the LBO with colorful depictions and inside information on many of the people and companies involved.
The Basics: Leveraged Buy-Outs
Burrough and Helyar focus more on the drama of the RJR Nabisco buyout than on the mechanics of it, but they do explain LBOs in passing. In a typical leveraged buyout, a team of executives takes the company private, usually in order to gain a greater share of company profits, as we’ll elaborate on shortly.
The LBO Process
In an LBO, the management team arranges to buy all the company’s stock at a price agreed upon by the company’s board of directors. They purchase the stock using primarily borrowed money and use the company (and its assets) as collateral for the loan.
Thus, an LBO removes a company’s stock from the stock market and replaces its board of directors with a new board representing the company’s new owners. In principle, the new board could just be the management team, who would then be their own bosses. But in practice, the management team almost always partners with a financial consulting company, which usually acquires a controlling share of ownership in the company.
In addition to coordinating the transaction, the consulting company brings its own financial resources to the table. In most cases, partnering with a financial company is the only way the management team can acquire sufficient credit to borrow enough money for the LBO.
Finally, as the authors point out, LBOs are not a hostile business maneuver: The management team and its financial partners make an offer to the company’s board of directors. The LBO only happens if the board of directors agrees to sell the company to them on behalf of the shareholders.
Motives for LBOs
Why would a company’s executives prefer to share ownership of the company with a financial consulting firm and have a huge loan to pay off instead of having publicly traded stock? Burrough and Helyar give two reasons, both of which revolve around making more money.
First and foremost, they say LBOs became popular in the 1980s because they allowed executives to dramatically increase their own income from corporate dividends—the share of corporate profits that a company pays to its shareholders.
Second, interest payments on bank loans are deductible from corporate taxes, while dividends paid to stockholders are not. Depending on interest rates and tax rates, this sometimes produces substantial savings for the company after the LBO, increasing profits.
Burrough and Helyar also recount how the financial consulting firms that facilitate LBOs actively try to sell CEOs on these advantages. They do this because they profit from up-front fees for their financial services, as well as dividends on their share of ownership in the company once the LBO is completed.
Junk Bonds
Burrough and Helyar go on to explain how finance companies that facilitate LBOs often raise large amounts of money by selling what the authors call “junk bonds,” or pay-in-kind (PIK) securities. These are high-interest bonds that pay the interest on the bonds in the form of more of the same kind of bonds, rather than in cash.
The Background: Ross Johnson and RJR Nabisco
Now that you understand how leveraged buyouts work, you’re in a position to understand the buyout of RJR Nabisco. But to help you see the whole picture and understand what made the RJR Nabisco buyout special, we’ll now discuss the background of the RJR Nabisco CEO who initiated the LBO, Ross Johnson.
Ross Johnson’s Philosophy
The authors recount that from practically the beginning of his career, Johnson’s philosophy revolved around two principles. First, he believed anything that wasn’t changing was stagnating and decaying. He would frequently change the organizational structure of his company, making sure that the company was always adapting and not becoming stagnant.
Second, Johnson believed in spending money liberally. He saw restrictive budgets as a cause of stagnation, which he went out of his way to avoid. Not only did he pay his executives higher wages than competing companies, but he also provided them (and himself) with extensive perks such as company cars and apartments, company-paid membership in exclusive social and recreational clubs, and personal use of corporate jets. Johnson was particularly adept at spending company money in ways that would build his network of social connections or endear him to board members or other important contacts.
Ross Johnson’s History of Mergers
According to Burrough and Helyar, Ross Johnson grew up in a lower-middle-class family in Canada. He worked his way up the ladder at a food company called Standard Brands, where he eventually became CEO.
After Johnson became CEO of Standard Brands, he arranged a merger in which Nabisco acquired Standard Brands. Nabisco (originally an abbreviation of National Biscuit Company) was a leading food company, whose product lines included Oreo cookies and Ritz crackers. After the merger, Johnson again worked his way up to CEO and helped many of his executives from Standard Brands climb the Nabisco corporate ladder as well.
A few years later, as CEO of Nabisco, Johnson arranged a similar merger in which the RJ Reynolds tobacco company acquired Nabisco, creating the RJR Nabisco company. Once again, Ross Johnson worked his way up to CEO.
As CEO of RJR Nabisco, Johnson deployed his usual regimen of restructuring, among other things moving the corporate headquarters from Winston-Salem, North Carolina, to Atlanta, Georgia. Sales and profits increased while he was running the company, and Johnson had a good working relationship with his board of directors. He and his fellow executives had a fleet of corporate jets at their disposal and all the other perks to which Johnson was accustomed.
How and Why Ross Johnson Initiated an LBO
According to Burrough and Helyar, LBO consultants repeatedly contacted Johnson, asking him to consider a leveraged buyout and offering their services. Initially, Johnson was resistant to the idea because he feared that an LBO would force him to adopt a restrictive budget in order to pay off bank loans. Also, he didn’t want to trade his amicable board of directors for a group of finance-consultant partners who might be less inclined to let him run the company as he saw fit.
However, Burrough and Helyar speculate that Johnson grew restless, not finding enough avenues for continued change and improvement. He also became obsessed with the company’s stock price, which dropped to around $45 per share in an economic downturn and failed to come back up. In the end, Johnson agreed to try an LBO, seeing it as the only way to address the low stock price: If Johnson and his partners bought the company, the stockholders would get a big payout and then there would be no more publicly traded stock to worry about.
According to Burrough and Helyar, Johnson partnered with the finance firm Shearson Lehman because Shearson was willing to give his executive team more generous terms for their partnership than other consulting firms. Specifically, the new board of directors would be structured such that Johnson’s team had veto power. And Johnson’s team would get 18.5% of the company’s dividends (almost twice the going rate), even though Shearson would put up all the money for the LBO (most of which they would borrow from banks or raise by selling junk bonds).
Burrough and Helyar explain that Shearson Lehman was willing to accommodate Johnson’s terms because they felt they needed the LBO to establish themselves in the LBO consulting business. They were a relatively new company that had started out facilitating wire transfers, bought out the Lehman Brothers investment bank, and was now trying to get started in the LBO consulting business. Because of the size and value of RJR Nabisco, doing an LBO for Johnson would have propelled Shearson immediately to the top of the LBO-services market.
The Bidding Contest for RJR-Nabisco
Understanding Ross Johnson’s background and philosophy makes it easier to understand why he managed the RJR Nabisco LBO the way he did, since competitive bidding is unusual in LBOs.
As Burrough and Helyar explain, usually people doing an LBO will carefully determine what the company is worth, estimate how much debt it can pay down, and secure funding commitments from banks before proposing the LBO to the board of directors. This makes it almost impossible for anyone else who might be interested in buying the company to come up with a viable counteroffer before the board reaches a decision.
However, Ross Johnson’s team didn’t do that. Instead, Johnson pitched the idea of an LBO to the board very early in the process, presenting it as a solution to the problem of their low stock price, and asking for their approval to move forward. He did this because he wanted to maintain his good relationship with the board, whether they approved the LBO or not. Besides this, Shearson didn’t think anyone else would be interested in buying the company anyway, given the lagging stock price and the public sentiment against tobacco companies.
Competitors Emerge
Burrough and Helyar recount how the assumption that no one else would try to buy RJR Nabisco proved to be horribly wrong. When the board gave Johnson the go-ahead to pursue an LBO, he and Shearson proposed to pay $75 per share based on their initial analysis. This was published in a press release. A number of financial companies saw the press release and thought RJR Nabisco was worth a lot more than $75 per share.
Kravis
The Kohlberg Kravis company was a financial consulting firm that, according to Burrough and Helyar, had arguably invented LBOs and was unarguably the market leader in LBO consulting. They were among the first to react to the press release. After meeting with banks to discuss the value of RJR Nabisco and the availability of funding, they considered offering the board $90 per share.
Burrough and Helyar note that before Kravis reached a decision on how much to offer per share, someone leaked their meeting minutes to the press, and a newspaper ran a story announcing that they were offering $90 per share for RJR Nabisco. Upon seeing the story, Kravis felt obligated to make the offer official in order to avoid confusion or bad press.
Kravis was at a severe disadvantage when it came to determining how much RJR Nabisco was worth because no one at Kravis had inside knowledge of RJR Nabisco’s operations. This was in contrast to practically all the other LBOs they had done, where they worked closely with the company’s executives. Shearson and Kravis considered partnering up instead of bidding against each other but were unable to agree on the terms of the partnership.
Salomon
Burrough and Helyar report that a finance company called Salomon Brothers also prepared to make an offer to buy RJR-Nabisco when they saw the press release stating that Shearson had offered $75 per share. When they saw Kravis’s competing bid of $90 per share, they backed off.
After the partnership negotiations between Kravis and Shearson broke down, Shearson started looking for other partners to augment their financial resources for competitive bidding. At that point, Salomon entered into a partnership with Shearson. With Salomon’s backing, Shearson increased their offer from $75 per share to $92 per share.
Forstmann
Forstmann Little, the second-leading LBO company after Kravis, was also interested in owning RJR Nabisco. Shearson and Salomon offered to partner with Forstmann, but after reviewing their financial analysis and proposal in detail, Forstmann declined.
According to Burrough and Helyar, Forstmann thought Shearson’s fees were excessive and their analysis wasn’t very good. Also, unlike most other LBO consultants, Forstmann eschewed junk bonds and thus objected to taking on partners who would sell junk bonds to raise money for the LBO.
Forstmann later partnered with Goldman Sachs, and they prepared to put in their own bid. But after doing their financial analysis, they decided they couldn’t safely bid more than $85 to $90 per share without resorting to junk bonds. Since they couldn’t top the highest bid that had already been placed, they withdrew from the contest without making a formal bid.
First Boston
As Burrough and Helyar recount, the final interested party was the First Boston financial consulting firm. First Boston had been a market leader in mergers and hostile takeovers, until two of their executives and a number of their employees left to form a competing company.
They were still struggling to recover from the split when the RJR Nabisco LBO was announced, and they wanted to participate in the LBO mostly to save face: Since the RJR LBO was the largest LBO in history, and since it seemed like every other major financial firm on Wall Street was getting involved in one way or another, sitting on the sidelines would have made it look like the corporate schism had completely ruined them.
Burrough and Helyar note that First Boston got a late start assessing RJR Nabisco’s value, but found a clever way to save about $4 billion by taking advantage of an obscure financial mechanism to defer some taxes.
Formal Bidding
According to Burrough and Helyar, when RJR Nabisco’s board began receiving competitive offers for the company, they announced a formal bidding deadline of 5 p.m., November 18, 1988. By this deadline, Ross Johnson’s management team, supported by Shearson and Salomon, submitted a final bid of $100 per share. Kravis, still without access to inside information about the company, bid a more cautious $94 per share.
First Boston was unable to finish their analysis, much less secure financial backing of major banks by the deadline, but they submitted a preliminary proposal outlining how they hoped to offer between $105 and $118 per share. Since First Boston’s bid appeared to be the highest but was incomplete, the board voted to reject all the bids and announced a new deadline that would give First Boston a little over a week to finish their analysis and secure financial backing.
The Second Round
Burrough and Helyar describe how Kravis spread a rumor that they might not bid in the second round, or wouldn’t raise their bid much if they did. But during this time, Kravis also finally found an RJR Nabisco executive who was willing to discuss its operations, especially avoidable expenses that the company could eliminate to improve profitability. Based on this new information, Kravis ended up bidding $106 per share in the second round.
Meanwhile, Johnson’s team bid $101 per share, not expecting much competition: They didn’t think First Boston would be able to pull off what they had proposed, and they more or less believed the rumor that Kravis wouldn’t bid again. They were wrong about Kravis, but they were right about First Boston. Although First Boston finished much of their analysis, they were unable to secure enough financial backing to convince the board that their bid was a viable option.
The Third Round
According to Burrough and Helyar, Johnson’s financial consultants were surprised and outraged by Kravis’s high bid. Furthermore, upon analyzing Kravis’s bid, they realized that it employed less cash and more junk bonds than their own bid. Reworking their bid along the same lines, they determined that they could bid at least $108 per share. They demanded that the board extend the bidding again.
When the board ignored them because they were already working with Kravis to finalize details of the buyout, Shearson and Salomon issued a press release stating that they had increased their bid to $108. Once Shearson’s bid was published, the board felt they couldn’t ignore it. They paid Kravis $45 million in consulting fees for the work they’d already done on the details and reopened bidding.
Johnson, backed by Shearson and Salomon, made a final bid of $112 per share, while Kravis made a final bid of $109 per share. However, the board’s financial advisers determined that the real value of both bids was about the same because Shearson’s junk bonds carried a higher risk than Kravis’s junk bonds. Regarding the two bids as equal, the board voted to sell the company to Kravis.
Burrough and Helyar conjecture that the board chose Kravis partly because they had already started working with them after the previous bid, and partly because their sentiments had shifted against Johnson during the LBO process. Both LBOs in general and Ross Johnson’s proposed LBO in particular had drawn a lot of negative press. Many commentators argued that LBOs were motivated by executives’ greed and resulted in irresponsible levels of corporate debt. In particular, when the press found out about the exceptionally generous terms of Johnson’s partnership with Shearson, they portrayed Johnson as the epitome of corporate greed.
The Aftermath
Burrough and Helyar report that Ross Johnson accepted the loss of the bidding contest graciously and went into retirement. He asserted that both his actions in initiating the LBO and the ultimate outcome had been best for the company’s stockholders. Some of the stockholders, though, disagreed: RJR Nabisco stock had paid dividends, and the company was so profitable that stockholders were making money even when the stock price was low. So they were sorry to lose their stock even though they got a big payout when the company sold.
Kravis hired a new management team to run RJR Nabisco, restructured the company, and eventually sold it again. In the end, Kravis made only a small profit on the LBO, despite streamlining RJR Nabisco’s operations to increase the company’s profitability by almost 50%.
After the RJR Nabisco LBO, leveraged buyouts became much less popular. Burrough and Helyar believe this was due in large part to the negative publicity that LBOs and especially junk bonds received, which reached a peak during the RJR Nabisco buyout. Of the few LBOs that did happen after 1988, most were handled by Forstmann Little without using junk bonds.
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