The Largest LBO in History: The RJR Nabisco Controversy

This article is an excerpt from the Shortform book guide to "Barbarians at the Gate" by Bryan Burrough and John Helyar. Shortform has the world's best summaries and analyses of books you should be reading.

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What was the largest LBO in history? What did Ross Johnson do after selling RJR Nabisco?

In 1986, the financial company Kravis bought RJR Nabisco for an astounding $25 billion. This makes the acquisition the largest LBO to date and sent CEO Ross Johnson into full retirement.

Continue reading to learn more about Kravis’s final offer for RJR Nabisco.

Formal Bidding for RJR Nabisco

According to Bryan Burrough and John Helyar’s book Barbarians at the Gate, 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. But little did Kravis know that it would soon hold the record for the largest LBO in history.

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.

Deadlines in Business Deals

The bidding for RJR Nabisco illustrates a couple of principles of negotiation that Chris Voss and Tahl Raz explain in Never Split the Difference. Voss and Raz assert that deadlines are one of the cornerstones of high-pressure sales and negotiation tactics. A looming deadline puts pressure on you to suspend your rational judgment and complete a transaction, make an offer, or accept the terms of an agreement. Deadlines work because of humans’ natural bias for loss aversion, which we discussed earlier: The deadline creates the impression that if you don’t act now, you’ll lose the opportunity.
However, Voss and Raz go on to advise that you should never let a deadline compel you to accept unfavorable terms in a negotiation or make a frivolous purchase. They assure you that in business and negotiations, deadlines are almost always arbitrary and negotiable.

Although the board of directors may not have intentionally been using high-pressure sales tactics, the bidding deadline did incentivize all the bidders to put in the highest bid they thought they could afford before the deadline arrived. And when the most attractive bid was incomplete, they readily extended the deadline.

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.

Strategic Misinformation

We previously discussed how information and intelligence-gathering play a central role in strategy development, both for the military and in business. As a corollary to this principle, misinformation can also be used strategically, as Kravis exemplified in the second round of bidding for RJR Nabisco.
When Sun Tzu discusses espionage in The Art of War, he describes five types of spies, two of which are specifically used for misinforming the enemy, illustrating the relative importance that he placed on strategic misinformation.

“Dead spies” are people loyal to you who gain your enemy’s trust and feed him false or misleading information at your behest. Tzu calls them “dead spies” because as soon as the enemy discovered he’d been deceived, he would typically have the false informants put to death.

“Reverse spies” are enemy spies that you’ve recognized as such. Tzu points out that you can leak false information to them in hopes they’ll believe it and pass it on, misinforming your enemy.

Kravis, however, illustrates how the misinformation game in business is a bit subtler and less risky than it is in war. Burrough and Helyar note that Wall Street executives and their families all tended to run in the same social circles, so it was easy for Kravis executives to spread rumors just by dropping a few seemingly casual comments at social functions. And the RJR Nabisco executive who revealed the company’s avoidable expenses to Kravis didn’t have to worry about being beheaded for it, as Sun Tzu’s spies did.

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.

Why Johnson Lost RJR Nabisco

Earlier, we discussed loss-aversion bias, and how Johnson exemplified it in demanding unusually generous terms from his financial partner (so that he wouldn’t lose any of his existing corporate perks if the LBO went through) and presenting the LBO to the board of directors early in the process (so that he wouldn’t lose his standing with them if they disapproved it). We could also infer that Shearson reworking their bid to increase it first to $108 and then to $112 and demanding another round of bidding was also motivated by loss-aversion bias, as they saw the LBO slipping through their fingers.

But as we’ve now seen, approaching the board early opened the door to competitive bids, and the generous terms of Johnson’s arrangement with Shearson generated so much bad press that it turned the board against him, prompting them to favor Kravis over Shearson. Thus, measures that Johnson took to mitigate the risk of loss ended up contributing to the very loss he was trying to avoid.
Of course, the board was obligated to do what was best for shareholders, so they couldn’t arbitrarily sell the company to Kravis if Johnson and Shearson’s bid was higher.

Both bids included a fraction of cash and a fraction of bonds in the price. Bonds carry a certain amount of risk that they may not pay out as much as their face value, so the board (or their financial advisers) had to estimate the probability of the bonds paying what Johnson said they would. They could then calculate the expected value of the bonds by multiplying the face value by the probability of actually getting it. This is why the higher risk associated with Shearson’s bonds made the board consider the two bids equal, even though Shearson’s had a higher face value.

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.

After the Aftermath

Ross Johnson’s retirement continued until 2016 when he passed away at the age of 85. As recounted in his obituary, he never regretted the RJR Nabisco LBO, despite losing the bidding contest and sinking his executive career. This seems to imply that his alleged convictions about doing the right thing for the stockholders were genuine—even if some of the stockholders disagreed with his perspective.

Moreover, throughout his retirement, Johnson enjoyed the fame that the LBO brought him, even though the publicity didn’t cast him in a particularly positive light. Not only did he become famous from the media coverage of the LBO itself, but the publication of Barbarians at the Gate and the release of a movie based on the book further spread his fame.

As Burrough and Helyar report, the popularity of leveraged buyouts fell off after the RJR Nabisco buyout. They became relatively uncommon throughout the 1990s. However, that wasn’t the end of the story after all.

The Largest LBO in History: The RJR Nabisco Controversy