Oct 28th 2008
From The Economist print edition
Will private equity behave any better in this downturn?
It is now 20 years since the mother of all corporate-takeover battles ended, when the private-equity firm, Kohlberg Kravis Roberts (KKR), acquired RJR Nabisco for $25 billion. A new edition of the best-seller about the battle, “Barbarians at the Gate”, by Bryan Burrough and John Helyar, has been published to mark the anniversary. Already widely regarded as one of the best business books of all time, the 2008 edition includes a fascinating extra chapter, updating the story.
Ross Johnson, the former chief executive of RJR Nabisco, is reportedly living a happy semi-retirement in Florida, bearing no ill will to anyone from back then, though it seems he doth protest a little too much that he secured a fantastic deal for the firm’s shareholders. Ted Forstmann, another private-equity legend, who fought hard to block KKR, is “still a little angry”, and the “one thing he wants readers to know” is that “it was he, Ted Forstmann himself, who coined the title of this book”.
Henry Kravis, meanwhile, is “just where we left him, in a conference room in KKR’s 42nd-floor offices at Nine West.” As the authors note, in the past 20 years KKR has enjoyed spectacular growth, with (at the time the book went to press—a couple of important months ago) $52 billion in assets under management, having grown from 32 employees in two offices to 400 professionals in a dozen offices around the world. KKR led a consortium that paid a record $45 billion for TXU, a Texas utility, in 2007—just before the credit crunch brought private-equity deal-making to an abrupt halt.
Of course, the industry’s big change since 1988 is that it has rebranded itself as “private equity”. KKR et al used to be known as leveraged buyout (LBO) firms, before they concluded that advertising their enthusiasm for borrowing was bad for their reputations, getting them called Barbarians and worse. Private-equity firms were supposed to be different from LBO firms. They try to use the best LBO techniques for improving the performance of the firms they buy, but without saddling those firms with the massive debt burdens that were to prove so disastrous for RJR Nabisco and many other acquisitions made after the 1980s’ LBO boom turned to bust. A study by Steven Kaplan and Jeremy Stein of the buy-outs executed at the boom’s peak (1987-88) found that around one-third went bust or needed restructuring by 1991. As Messrs Burrough and Helyar recount, firms such as RJR Nabisco suffered long-term damage to their brand and market share due to aggressive cost-cutting that was driven by the need to pay off debt and interest.
This time was supposed to be different. Yet, as Mr Forstmann tells the two authors, “the so-called junk-bond excesses of the 1980s were minor league compared to what’s been going on in credit markets in the last five years or so.” Already there are signs that the easy credit available until the summer of 2007 proved too tempting to some private-equity firms. So far this year, at least 32 significant private-equity-backed firms have gone bust, according to Ed Altman of New York University’s Stern School.
The main saving grace is the “covenant lite” debt that private-equity firms used this time to make their acquisitions, which has made it much harder for lenders to force firms into bankruptcy when they fail to meet their payments. As Hamilton James, the chief executive of Blackstone Group, a firm that has arguably surpassed KKR in the private-equity firmament, argued earlier this year, “covenant-lite debt structures are not only in private equity’s interest, they’re in everyone’s interest. The only one you might argue is not better off is the senior secured. By keeping the company intact, the private-equity owners are able to fix the problems, and by preserving the employees, the customers and the business, society at large benefits.”
True enough. On the other hand, covenants-lite will mean bigger losses for lenders, which may ultimately hit the private-equity-owned firms, as they will lead to tighter lending conditions and thus to slower economic growth.
Still, the head of one big private-equity firm was bullish this week, telling The Economist that “losses by private-equity this time around will disappoint the prophets of doom.” Indeed, he points out that many big private-equity firms have plenty of equity—raised before the credit crunch—and unused lines of credit from banks. Thus, they are well placed to make huge returns by buying assets at the bottom of the cycle, just as they have done in past downturns.
The new chapter ends with two thoughts. First, given how today’s private-equity industry seems “eerily reminiscent” of the early 1990s, post-RJR Nabisco hangover: “Does anyone on Wall Street ever really learn anything?” Well, we shall see. Second, asserted with more certainty: “Be assured, however, that the Barbarians are out there just beyond the gate, licking their wounds, biding their time, waiting for their next chance to storm the gates.” Indeed, while all eyes are on the financial market meltdown, the gates may already be opening.