PDF Summary:Barbarians at the Gate, by Bryan Burrough and John Helyar

The leveraged buyout of RJR Nabisco in 1988 garnered the attention of the press, not only because at $25 billion it was the largest buyout in history up to that point, but the transaction was also surrounded by an unusual amount of drama and intrigue. In Barbarians at the Gate, Wall Street Journal reporters Bryan Burrough and John Helyar present a detailed history of the buyout proceedings, with inside information on many of the people and companies involved.

In this guide, we’ve distilled the narrative into a concise chronology and covered the authors’ discussion of the mechanics of leveraged buyouts and junk bonds. Along the way, we’ll show how the events that Burrough and Helyar recount illustrate principles found in other books, ranging from The 22 Immutable Laws of Marketing by Al Ries and Jack Trout to The Art of War by Sun Tzu.

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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.

Positioning

Shearson’s motive for working with Ross Johnson on unusually generous terms illustrates the concept of “positioning,” which marketing consultants Al Ries and Jack Trout discuss in The 22 Immutable Laws of Marketing. As they explain, a company’s “position” in the market is simply how prospective customers perceive the company. For example, is it the market leader? Is it the alternative to the market leader? Is it an option that caters to a specific niche?

They assert that as markets mature, eventually every sector becomes a two-rung ladder, with one clear market leader and one clear rival to the leader, while the rest of the companies in that sector are relatively obscure and compete for just a tiny fraction of the overall market share.

Based on Burrough and Helyar’s account, it appears that at the time of the RJR Nabisco LBO, Shearson wanted to be one of the top two in the LBO consulting market, but they weren’t, and they knew it. They believed that handling the largest LBO in history would provide a step-change in their market position, raising them from relative obscurity to one of the top few LBO companies in the minds of prospective customers. If they could establish a position on one of the top two rungs of the two-rung ladder, then in the long run, their increased market share would likely more than make up for lower profits on the RJR Nabisco LBO itself.

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.

Loss Aversion Bias

In Thinking Fast and Slow, Nobel laureate Daniel Kahneman discusses biases in human thinking and how these natural biases can lead us to make irrational business decisions. Ross Johnson’s approach to the RJR Nabisco LBO appears to have been influenced by loss-aversion bias, which Kahneman explains as part of the “prospect theory” of how humans evaluate possible gain and loss.

According to prospect theory, you tend to focus on changes to your situation, not on expected end states, and you tend to see losses as more significant than gains. So, if you start with $1 million and end up with $2 million after a business venture, you’ll be elated because you gained $1 million, but if you start out with $4 million and end up with $2 million after a business venture, you’ll feel terrible because you lost $2 million, even though your net worth after the venture is the same in both cases.

Loss aversion bias arguably influenced Ross Johnson in three ways:

• He may have been driven to pursue the LBO because he viewed stagnation (of the stock price, the corporate structure, and so on) as a type of loss, and thus felt he had to do something to avoid the loss.

• He accepted the idea of an LBO only in an unusually generous partnership with the financial firm that would handle it because he didn’t want to lose influence and perks in the company.

• He approached the board unusually early in the LBO process because he didn’t want to lose his influence with the board in the event they disapproved of the LBO.

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.

(Shortform note: Lower-than-usual prices naturally attract attention from prospective customers. Sam Walton used this principle strategically to build Walmart into a retail empire, by selling some items at cost in order to draw in customers, and making a profit on other things they bought while they were there. But, in hindsight, Johnson and Shearson’s $75 bid was a strategic blunder: If they had offered a little more, the price might have not lured in other bidders and started a bidding war.)

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.

The Strategic Importance of Information

In The Art of War, Sun Tzu argues that espionage and intelligence-gathering are among the most important elements of fighting a war because understanding your opponent is crucial for strategic planning. Kravis’s situation illustrates how this principle can be applicable to business strategy as well as military strategy:

• First an intelligence leak forced Kravis’s hand in making a competitive offer to buy RJR Nabisco.

• Then, lack of inside information handicapped them when it came to determining how much was really safe to bid.

• As we’ll discuss later, when Kravis finally did find an insider who was willing to discuss RJR Nabisco’s operations with them, that new information was what enabled them to place the winning bid.

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.

Strategic Partnerships

In Crossing the Chasm, Geoffrey Moore discusses the importance of partnering with other companies so you can take advantage of each other’s capabilities. If you’re trying to bring an innovative product to market (which is the focus of Moore’s book), your corporate partners may be able to deliver supporting services or just establish your credibility in the marketplace in ways that you couldn’t on your own.

In the case of the Shearson-Salomon partnership, the primary capability that each company contributed was their credit, since one of the biggest challenges of pulling off an LBO is raising enough borrowed money for the buyout.

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.

The Wisdom of Doing Nothing

The way Forstmann handled the RJR Nabisco LBO, or rather declined to handle it, demonstrates an important business principle that can be easy to overlook: Sometimes the best strategy is to do nothing.

Books about building up your business often focus on the necessity of taking risks in order to reap rewards. They offer advice on overcoming your aversion to risk because excessive risk aversion can cause you to miss important opportunities. But it’s also possible to make the opposite mistake. In any given situation, you need to evaluate whether the opportunity is actually good enough to be worth the risk.

Furthermore, in the highly dynamic world of business and finance, you often encounter situations that seem to demand immediate action, whether it’s a natural disaster that disrupts shipping and causes certain stocks in your portfolio to plummet, or a chance to get in on a huge business deal (as in Forstmann’s case), or something else. The adrenaline rush that these situations elicit makes you feel like you need to do something, but in many cases the best thing you can do is actually to do nothing, riding out market fluctuations and passing up business deals that would be exciting and glamorous but not actually profitable.

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.

Moving on and Thinking Big

First Boston’s entry into the RJR Nabisco LBO could be seen as an application of David Schwartz’s advice on dealing with setbacks. In The Magic of Thinking Big, he asserts that to overcome a setback you should experiment boldly with new approaches until you find a path to success, instead of beating yourself up over it or assigning blame to factors beyond your control.

First Boston’s staff certainly demonstrated boldness and perseverance when they decided to tackle the biggest LBO in history at a time when their company was in turmoil. And in spite of the upheaval, they found a creative way to save money (the tax deferrals) on the LBO that would enable them to bid higher. As Burrough and Helyar remark later in the book, the way First Boston tackled the RJR Nabisco LBO did help them to restore their reputation and shape up their company after the split, even though their bid ultimately didn’t win.

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.

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.

LBOs made a comeback in the early 2000s, and Kravis remained a leading finance consultant in the field, despite the less-than-stellar profits they made on RJR Nabisco. In 2006, for example, Kravis handled an LBO for Hospital Corporation of America that totaled $33 billion, making it 32% larger than the RJR Nabisco buyout. This trend of more and larger LBOs in the early 2000s continued until the economic downturn of 2008. Since 2008, LBOs have made another comeback, with the volume of LBOs in the 2020s exceeding all previous peaks.