Unforeseen developments ultimately made it a raw deal for LPs, but the RJR Nabisco buyout created nearly $23bn in value for other transaction participants, not least KKR, writes Cezary Podkul

Looking at a recent Kohlberg Kravis Roberts investor presentation, one figure quickly jumps off the page. The buyout giant's worst performing fund, vintage 1987, returned an internal rate of return of just 12 percent – well below the gross IRR of 26 percent across all its funds and all-time best of 48 percent from its 1982 fund.

A footnote chimes in: “The 1987 fund includes KKR's investment in RJR Nabisco/Borden. Excluding this investment, the fund would have returned 25.2 percent.”

To most observers, this alone would seem to vindicate popular accounts that KKR's buyout of the food and tobacco conglomerate was a flop. Indeed, KKR co-founder George Roberts seemed to suggest as much himself at a July 1995 meeting with the Oregon Public Employees Retirement System- at $800 million, one of the biggest investors in the 1987 fund and, at $478million, one of the biggest investors in the RJR deal as well.

“We don't consider that a successful deal by any stretch of the imagination”, Roberts told OPERS, as reported by The Oregonian that day.

For 1987 fund LPs like OPERS, the deal's lacklustre performance is rooted in post-LBO events that dramatically altered the assumptions on which KKR inked the transaction, which, due to KKR's aggressive bid, had little room for error. But the nearly $22 billion in returns to banks, junk bond investors and preferred shareholders, not to mention close to $1 billion of fees earned by KKR, its financial advisors and loan syndicates is a silver lining worthy of its own footnote.

KKR's offer for RJR stood out not just for its size but also for the epic bidding war with management that it helped fuel. At its conclusion, KKR emerged victorious, paying $31.4 billion for RJR, including assumed debt.

Its 1987 fund contributed $2 billion in equity and bridge financing toward that price tag, which, excluding preferred shares, left the company with a debt burden of about $25 billion – nearly five times RJR's pre-LBO debt obligations.

KKR wasn't nervous. It had a three pronged strategy for servicing the debt: refinance its high-yield debt at more attractive rates, improve cash flows and sell assets.

An implicit assumption in this strategy: that everything would go according to plan, since KKR's premium of nearly 95 percent to RJR's stock price before the first bid left it with little room for error.

Cirumstances proved otherwise. “There were a series of events, three of them, that in hindsight made the difference between a successful deal and one in which investors got their money back, “Roberts told OPERS. First, within a year of the buyout, the junk bond market which KKR had relied on to sell much of its debt, began to dry up. This forced it to refinance its high-yield securities much earlier than it had anticipated.

To make matters worse, Moody's downgraded RJR's debt in December 1989, making refinancing more difficult and raising its borrowing costs. Coupled with $7 billion of pay-in-kind bonds awaiting steep interest resets to bring them up to par, the company was heading toward default.

In July 1990, KKR had to diffuse the situation by making an emergency $1.7 billion equity infusion into RJR, also from its 1987 fund, and securing $2.25 billion in new bank loans. Rather than selling down its interest in an already troubled investment, this drove KKR's ownership from 58 percent on a diluted basis to 83 percent.

Second, tobacco giant Philip Morris threw a wrench into KKR's cash flow projections.

Up until his departure in 1993, Lou Gerstner, KKR's hand-picked successor to former RJR chief executive Ross Johnson, had largely delivered on his promise to make the company more profitable. Within the first two years alone, operating profits were up 31 percent.

But on 2 April 1993, faced with stiff competition from low-cost brands, Philip Morris slashed the price of its flagship Marlboro cigarettes. The move lit a cigarette price war that burned two percent off RJR's cigarette market share by the end of 1994 and, as Roberts explained to OPERS, cost the firm $900 million in profits.

Third, the sale of RJR's tobacco businesses didn't pan out.

KKR's plan to sell assets in order to pare down debt was initially a bright spot in the deal. It had expected to get $5 billion from various asset sales and instead got $6 billion, KKR partner Perry Golkin said at a 2002 lecture in Philadelphia. By the end of 1993, RJR had managed to slice its debt obligations from $29 billion down to $9 billion, thanks in large part to this strategy.

But in 1994, Congress called in all the heads of US tobacco companies for high-profile hearings on the impact of cigarettes on smokers' health. Class action lawsuits followed en masse. The resulting threat of billions of dollars in potential lawsuit settlements made it impossible for KKR to sell the tobacco business, which continued to lose market share to Philip Morris.

By late 1994, KKR's LPs were still essentially flat on their investment in RJR, as were KKR's partners, who had $126 million on the line alongside them. In order to avoid exiting the investment at a disappointing return, KKR had to find a way to get out of RJR without closing the books on the transaction.

KKR found the answer in cash strapped food and consumer goods conglomerate Borden. Between December 1994 and March 2005, KKR swapped its remaining 40 percent stake in RJR for full control of the Ohio-based manufacturer of well known brands such as Elmer's Glue and Krazy Glue. The $1.9 billion transaction gave Borden the money it needed to pay down its debt and reinvest in its business while enabling KKR to make a live exit from RJR and try to make its LPs money anew by successfully executing a turnaround play.

The Borden swap was such a win win that even former KKR partner Jerry Kohlberg, who left the firm in 1987 amid differences with Roberts and Kravis about the size of the firm's deals, celebrated it as “very clever” and “brilliantly done”, according to George Baker's and George Smith's account of the RJR deal in their 1998 book, The New Financial Capitalists.

Eventually KKR exited Borden by selling its remaining assets to Apollo Management for $1.2 billion in 2005. KKR's LP's realised an IRR of less than one percent on their RJR investment.


Nov 1988: KKR buys RJR Nabisco, paying $31.4 billion, with only $2 billion of equity on the line in the deal.
Jul 1990: Approaching default, KKR makes an additional $1.7 billion equity infusion into RJR and secures $2.25 billion in new bank loans as part of a $6.9 billion refinancing package.
Apr 1993: RJR competitor Philip Morris cuts the price of its Marlboro cigarettes by 40 cents, forcing competitors to follow suit. Tobacco stocks plunge.
Sept 1994: KKR offers to purchase 100 percent of Borden with $1.9 billion of RJR stock representing its remaining 40 percent interest in the company. By March 1995, it exits its last holdings in RJR Nabisco.
Apr 2005: KKR exits Borden by selling its remaining assets to Apollo Management for $1.2 billion.
Source: BusinessWeek, 3 April 1995. Factiva searche