Barbarians at the Gate

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Outline: RJR Nabisco Leveraged Buyout (LBO) and Its Implications

Outline

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Introduction

  • Subject: The 1988 RJR Nabisco leveraged buyout (LBO) for $25 billion.
  • Significance: Largest business transaction of the 20th century; pivotal moment for LBOs.
  • Themes:
    • LBO mechanics and controversy.
    • Profile of RJR Nabisco CEO Ross Johnson.
    • Detailed chronology of the buyout.
    • Aftermath and legacy of LBOs.

Part 1: The Basics of Leveraged Buyouts (LBOs)

What is an LBO?

  • Definition: A company is taken private using mostly borrowed funds, with company assets as collateral.
  • Process:
    • Management team buys all company stock.
    • Removes company from the stock market.
    • Replaces the board with representatives of new owners.
  • Key Players: Management team, financial consulting firm (often acquires a controlling share).
  • Funding Mechanism: Junk bonds (high-risk, high-interest securities).

Motives for LBOs

  • Executives can increase income through dividends.
  • Tax advantages: Interest on loans is deductible, unlike stockholder dividends.
  • Financial firms profit from fees and ownership dividends.

Part 2: Ross Johnson and RJR Nabisco

Johnson’s Philosophy

  1. Change is Vital: Frequent restructuring to prevent stagnation.
  2. Liberal Spending: High executive wages, lavish perks, and networking-focused expenditures.

Johnson’s History of Mergers

  • Career Highlights:
    • Rose from modest beginnings in Canada.
    • CEO roles at Standard Brands and Nabisco.
    • Orchestrated mergers leading to the creation of RJR Nabisco.
  • Impact at RJR Nabisco:
    • Moved headquarters to Atlanta, boosting sales and profits.
    • Maintained strong relations with the board.

Why Johnson Initiated the LBO

  • Motivations:
    • Frustration with stagnant stock price.
    • LBO as a solution to deliver shareholder value.
  • Partnership with Shearson Lehman:
    • Secured generous terms: veto power, high dividends.
    • Shearson’s aim: gain market leadership in LBO consulting.

Part 3: The Bidding Contest for RJR Nabisco

Unusual Competitive Bidding

  • Johnson proposed the LBO early to maintain board relations.
  • Press release about $75/share bid attracted other financial firms.

Major Competitors

  1. Kravis (Kohlberg Kravis Roberts):
    • Market leader in LBOs.
    • Disadvantaged due to lack of inside knowledge.
    • Bid $90/share, later raised to $106/share.
  2. Salomon Brothers:
    • Partnered with Shearson Lehman, raising the bid to $92/share.
  3. Forstmann Little:
    • Avoided junk bonds, withdrew after determining $85–$90/share was viable.
  4. First Boston:
    • Late entry, proposed $105–$118/share but failed to secure funding.

Formal and Second-Round Bidding

  • Final bids:
    • Johnson’s team (Shearson-Salomon): $101/share.
    • Kravis: $106/share, backed by insider information on expenses.

Part 4: The Third Round and Outcome

Final Bids

  • Johnson’s team: $112/share (higher risk junk bonds).
  • Kravis: $109/share (lower risk junk bonds).
  • Board’s Decision:
    • Considered bids equal due to risk-adjusted valuations.
    • Chose Kravis due to:
      • Advanced preparations with Kravis.
      • Negative press about Johnson’s greed and lavish partnership terms.

Why Johnson Lost

  • Early board proposal invited competition.
  • Publicized partnership terms alienated the board and public opinion.
  • Loss-aversion bias drove decisions that backfired.

Part 5: Aftermath

Impact on Key Players

  • Ross Johnson:
    • Retired gracefully in 1988.
    • Maintained his stance that the LBO was best for shareholders.
  • Kravis:
    • Restructured RJR Nabisco, increased profits by 50%.
    • Made a modest profit after selling the company.

Legacy of the RJR Nabisco LBO

  • LBOs declined in popularity after the negative publicity.
  • Junk bonds became controversial.
  • Forstmann Little gained prominence as a junk bond-free LBO firm.

Part 6: Long-Term Trends and Lessons

LBO Trends Post-RJR Nabisco

  • 1990s: Decline in LBO activity.
  • 2000s: Resurgence until the 2008 financial downturn.
  • 2020s: LBO volume surpasses previous peaks.

Key Takeaways

  • Economic Impact: Highlighted risks of excessive corporate debt.
  • Behavioral Insights: Loss-aversion bias shaped key decisions.
  • Cultural Legacy: Barbarians at the Gate book and movie immortalized the drama.

Conclusion

  • Significance: RJR Nabisco LBO was a watershed moment in corporate finance, reshaping perceptions of LBOs and influencing financial strategies for decades.
  • Final Reflection: Johnson’s legacy is a blend of controversy and lasting fame, underscoring the complex ethics and economics of high-stakes business deals.