The Deal That Burst the Bubble for KKR : Buyouts: The bankruptcy filing of Hillsborough Holdings, formerly Jim Walter Corp., was the end of an era for an investment giant of the ‘80s.
Four days before the start of the new decade, a court clerk in Tampa, Fla., stamped and filed a foot-thick batch of bankruptcy petitions from a local building materials and resources company, and a chapter in business history quietly ended.
The company was Hillsborough Holdings, and its bankruptcy pleading Dec. 27 signaled the end of the era in which its owners, the great buyout firm of Kohlberg Kravis Roberts & Co., stood as a symbol of invincibility for all the financial world.
Signs of trouble for Kohlberg Kravis Roberts had been appearing for some months. Since late summer, two other KKR-organized buyouts--Seaman Furniture and SCI Television--had struggled to pay debts and avoid bankruptcy. And in August, the firm’s apostate founder, Jerome Kohlberg, had sued former partners Henry Kravis and George Roberts for allegedly cheating him out of some earnings from earlier deals.
But the bankruptcy of Hillsborough, formerly called Jim Walter Corp., was different. At $2.4 billion, this 2-year-old deal was far bigger than the others. And although the Tampa concern was forced into bankruptcy court by an improbable mix of circumstances--an asbestos health-damages suit and turmoil in the high-yield junk bond market--it suggested that KKR, like everybody else, could goof up royally.
In this high-priced deal, “they just hadn’t left enough margin for error, by definition,” said Wilbur Ross, a Rothschild Inc. investment banker who represents many of the big bondholders in the Hillsborough proceeding. And while most of KKR’s deals are still solid, the episode has raised questions about the returns that the firm will be able to offer its investors and, indeed, how easily it will be able to find investors when it next looks for them.
KKR’s specialty, the leveraged buyout, is a deal in which the firm, often with the support of top management, typically borrows heavily to buy out public shareholders. The acquirers then repay debts through asset sales and operating profits.
Since 1979, the firm has done 35 of the deals, with a value of more than $62 billion, giving it sway over an industrial commonwealth nearly as large as International Business Machines Corp.
The capper on KKR’s career was 1988’s $25-billion conquest of RJR Nabisco, in which the partners overcame the competition of a management-led buyout group and a third bidder to seal the biggest deal of all time.
But since rising to prominence in the mid-’80s, Kohlberg Kravis Roberts had become more than a symbol of financial success. Traveling in New York’s beau monde, Kravis, 45, and his wife, fashion designer Carolyne Roehm, 38, had become symbols of ‘80s accomplishment, glamour and self-indulgence.
Roehm, the daughter of schoolteachers from tiny Titusville, Mo., had emerged from the shadow of her mentor, Oscar de la Renta, as a leading designer. The preeminence of Kravis, son of a Tulsa oil and gas executive, was now unchallenged in the buyout world.
With Susan and John Gutfreund, chairman of the Salomon Bros. investment bank, and Gayfryd and Saul Steinberg, the corporate raider, Kravis and Roehm became part of a social whirl that the society watchers called Nouvelle Society. The photo spreads in the papers and celebrity magazines showed a 5-foot, 6-inch man with the self-confidence to marry a woman who was an imperially slim 5-foot-10.
Kravis’ net worth was now about $330 million, and the couple bought a $5-million, four-bedroom homestead on Park Avenue, furnishing it with Renoir paintings and French antiques. They accumulated residences in Connecticut; Southampton, N.Y., and Vail, Colo.
The couple gave millions to charity, including a $10-million gift to memorialize the deal maker in a new Henry R. Kravis Wing of New York’s Metropolitan Museum of Art.
When Fortune magazine did a cover story on the successful “trophy wives” top businessmen marry in their mature years, Roehm was picked for the cover photo. In late 1988, Kravis gazed from the cover of Business Week magazine under a headline that proclaimed him “King Henry.” The man in this portrait seemed to be less a modern businessman than a noble Roman posing to have his likeness engraved on a coin.
But if KKR’s principals were seeming more than mortal, Hillsborough “brought them back to life size,” said Samuel L. Hayes III, a Harvard Business School professor.
Hillsborough suggested that, after years of crafting deals it seemed nobody could complete, KKR was falling victim to mistakes anybody could make.
When KKR began the Hillsborough buyout, about 80,000 people had already joined lawsuits claiming that their health had been damaged by asbestos sold by a Walter subsidiary called Celotex. Far from being frightened by the suits, KKR figured they could prove an advantage: They would scare away other potential bidders and allow KKR to do the deal at an advantageous price.
The blue-chip Latham & Watkins law firm, based in Los Angeles, had given KKR an opinion that the plaintiffs weren’t legally entitled to claims against Hillsborough or the buyout firm.
This conclusion may still be proven correct in court. But the deal makers didn’t foresee that in the meantime, the plaintiffs’ attorneys would open a new front in the legal battle, in the Texas state courts, where they could tie up any sales of assets.
Such sales were needed to raise cash to pay bondholders, and some of those bondholders grew exceedingly nervous.
Under the terms of Hillsborough’s $624 million in junk bonds, the interest rates on the securities are to be reset each year so that the bonds trade at 101% of their face value. But in November, when the firm’s bond advisers tried to calculate what the rates had to be, they discovered that they would have to set the figures so high as to be beyond the company’s ability to pay.
When Hillsborough offered to swap the bonds for new ones with lower rates, some of the bondholders balked. The company then felt compelled to file for reorganization under Chapter 11 of the U.S. Bankruptcy Code, which may force KKR and its investors to give up a big slice of their $150-million investment in the firm.
KKR officials insist that Hillsborough is in good operating condition and maintain they’re the victims of unforeseeable misfortune. They couldn’t have predicted the turmoil in the junk bond market, they say, and note that it was just bad luck that the case was moved to the unpredictable Texas court system, which, they recall, tried to award Pennzoil $11 billion for losing Getty Oil to Texaco.
Other assessments are different. Stephen Susman, the Houston plaintiff’s attorney who brought the battle to the Texas courts, said KKR overlooked the suits’ threat “out of sheer negligence.”
Hayes, of Harvard, wonders if the firm, in its eagerness to close a big deal, wasn’t sufficiently circumspect.
Another Wall Street takeover specialist said the episode points up the hazards of the so-called reset notes, a financing technique that KKR has used in other deals as well. As Hillsborough showed, if the bond prices are seriously slumping, a reset won’t help, this investment banker believes.
“They don’t work when you need them most,” he said.
KKR’s mistakes in its other two troubled deals seem, if anything, more basic. In Seaman Furniture, the buyout firm was taking private a Long Island, N.Y., furniture retailer whose prosperity was directly tied to the strength of the local housing market.
Seaman had been growing at 20% a year. But just after the deal, Long Island sank into a sort of regional recession, the housing market tumbled and Seaman’s revenues flattened. KKR restructured the deal in late November, agreeing to invest another $35 million in the company and letting its stake drop to 33% from 80%.
In the $1.2-billion SCI Television deal, KKR was selling the six television stations of the old Storer Communications chain. It had a choice of two buyers: Westinghouse Electric, which offered cash, and entrepreneur George N. Gillett Jr., who was offering a higher price, but in a joint venture that would give KKR an initial equity stake of 49%.
The firm chose to go with Gillett, and, as the television market declined, regretted it, according to a person close to KKR.
Under a proposed restructuring of SCI’s debt, KKR and Gillett would give up about $200 million of their investment in the company. KKR’s stake would drop to 15% from 46%, while Gillett’s would fall to 41% from 54%. (The creditors would get the balance.)
How much damage have the three deals done to KKR? Not too much in the short term. In the years ahead, the goofs will make life a little tougher for the firm, in an LBO environment that will probably never be what it was in the ‘80s.
Seaman was a $360-million deal--not large, by this firm’s standards.
Kohlberg Kravis Roberts had already taken out $1 billion from the SCI Television deal. KKR points out that if the value of its stake in SCI were to dwindle to zero, its investors would still have earned 60% on their money.
“So they’ve had a couple bad deals out of 60--some terrible record!” said Martin Dubilier, founding partner in the Clayton & Dubilier leveraged buyout firm. Soured transactions, he said, are “part of the business.”
Far more important in Kohlberg Kravis Roberts’ future will be the success of its RJR Nabisco investment, which dwarfs all others. RJR’s returns to investors won’t be clear for at least a couple of years. Meanwhile, three other KKR buyouts--Stop & Shop, Duracell and Safeway--appear to be working out well.
Kohlberg Kravis Roberts has gone out of its way to maintain happiness among the few dozen institutional bondholders who are the backbone of the junk market. Bondholders in SCI “very much appreciated that KKR was willing to bring in new money,” said Ross, the Rothschild investment banker. “LBO sponsors don’t all do that, believe me.”
Yet Kohlberg Kravis Roberts and all other leveraged buyout firms face a more difficult environment. In recent years, growing competition has increased the price that LBO firms must pay for companies, cutting once-astronomical returns. Junk bond financing, which was the underpinning of so many deals since the mid-’80s, is difficult to come by, for the moment at least.
Bank lenders are also much more nervous, because of failed deals and because the Federal Reserve is growing more concerned about debt-heavy transactions.
KKR took part in only one small deal last year, largely because high stock prices made LBOs unattractive. But even when the LBO business revives, many analysts expect that deals will require more of the buyout firm’s own money and less debt, thus offering lower returns to investors.
It is not yet clear whether KKR’s recent troubles will cool the enthusiasm of investors the next time the buyout firm seeks to raise an investment pool, as it last did two years ago.
The majority of KKR’s limited partners are state pension funds, which give the buyout firm roughly 5% to 15% of their assets that have been earmarked for venture capital or other higher-risk deals. The trustees of these funds know that KKR made an eye-popping 59% annual return for investors in its 1982-87 fund, and some have declared that they’ll be satisfied even if future returns are half that.
But some aren’t so sure it will be such a cinch. Scott Sperling, a partner in Harvard Management Co., which handles Harvard University’s $5-billion endowment and is an investor in several KKR deals, believes that the firm may have a tougher time raising its next pool for several reasons.
Not only will returns inevitably be lower than last time, but investors will be considering KKR’s first troubled deals, as well as the publicity and controversy that has surrounded RJR Nabisco and other transactions.
Managers of public pension funds must be sensitive to controversy, and KKR’s public profile “has been a lot higher than they’d like,” Sperling said.
KKR’S BIGGEST DEALS
Year Company Price 1988 RJR Nabisco $25.0 billion 1985 Beatrice 6.2 billion 1986 Safeway 4.1 billion 1986 Owens-Illinois 3.7 billion 1988 MacMillan 2.5 billion 1987 Jim Walter Corp. 2.4 billion 1985 Storer Communications 2.4 billion 1985 United Texas Petroleum 2.2 billion 1988 Duracell 1.8 billion 1984 Pace Industries 1.6 billion 1988 Stop & Shop 1.2 billion 1984 Wometco Enterprises 1.0 billion
Source: Business Week, IDD Information Services
