Sunday, October 26, 2014

Book review: "Merchants of Debt" by George Anders

Merchants of Debt is a history of Kohlberg, Kravis & Roberts, the leveraged-buyout firm. KKR was founded in 1976 and Merchants was was published in 1992, so it covers the first fifteen years of KKR's existence.

The three partners who founded KKR and gave it its name met at Bear Stearns. Jerome Kohlberg was a Bear partner, while Henry Kravis and George Roberts were new hires. Bear had already completed several several LBOs under Kohlberg's direction when Kravis and Roberts joined, but together they pushed the firm to do more and larger buyouts.

Bear's focus at the time was lower-risk short-term trading, but Kohlberg had enough influence that the firm let him, Kravis, and Roberts commit more of its capital to LBOs. Unfortunately, the trio's deals weren't very successful. One early acquisition, a for-profit technical school in San Francisco, went bankrupt. Another, a shoe company named Cobblers, met the same fate after its president committed suicide. Eagle Motor Lines, a trucking company, was a loser. Boren Clay suffered during the early-'80s recession, and while it was eventually a profitable investment, the returns were much lower than expected.

Kolhberg, Kravis, and Roberts also had several winners, but their overall record was mediocre. That, along with philosophical differences, led to an acrimonious departure from Bear and their decision to found their own company. Their timing was perfect: KKR began life in 1976, just a few years before interest rates peaked and the stock market began an unprecedented surge.

Apart from good timing, KKR was successful because it pioneered a new way of financing LBOs. Traditionally, the sponsor of an LBO financed the transaction by investing a small amount of its own money in the LBO and borrowing the rest from an insurance company at high rates. KKR changed how both the debt and equity were funded.

Instead of borrowing exclusively from insurance companies, KKR convinced banks to lend it money as well, and it began issuing junk bonds once they gained acceptance in the early '80s. KKR also didn't invest any of its own money in its buyouts: instead it created limited partnerships, which it earned large fees for managing, that purchased the buyouts' equity.

The biggest investors in these partnerships were public pension funds. KKR won the funds' investments through a mixture of client hand-holding and legal bribery. The book describes it as follows:

Investing pension money with KKR also provided civil servants with a ticket into a glamorous new world. They didn't need to be mere spectators in Wall Street's biggest, most exciting takeover battles. By allying themselves with KKR, the Walter Mitty types who ran big state pension funds could feel that they were players, too. Roberts, Kravis, and Kohlberg shrewdly cultivated this "fan club," playing tennis with their pension fund backers, sending them confidential briefing books, and inviting them to private two-day conferences at elegant hotels. At those sessions, modestly paid civil servants got the chance to rub shoulders with KKR's founders, and to address them as "Jerry" and "Henry" and "George."

Drawn closest to KKR was Roger Meier, the long-time chairman of the Oregon Investment Council. In conversations about the buyout firm, Meier sometimes would say "we," then pause, correct himself, and say: "I mean, KKR." In 1983, Meier joined the board of a KKR-controlled company, Norris Industries, based in Los Angeles. Several times a year, right before or after board meetings, Roberts and Meier played doubles tennis matches at the plush Beverly Hills Hotel, pairing up with the hotel pro, former Wimbledon champion Alex Olmedo. "It was delightful," Meier later recalled. "Here was a little yokel from Portland, Oregon, operating with really some pretty fantastic high fliers. I was pretty impressed."

Meier had even more reason to be impressed after he retired from OIC in 1986 and KKR let him buy stock in one of its portfolio companies at a below-market price.

So how did KKR's others investors-- the ones who weren't allowed to make below-market purchases-- do? Merchants of Debt has an appendix that lists all the KKR deals that had been completed by time the book was published, along with their internal rates of return. The appendix suggests that KKR's record was very similar to its founders' record at Bear Stearns: many winners, but also a number of investments that went to zero. Two late-'70s deal went bankrupt. KKR's first big deal, the buyout of Fortune 500 constituent Houdalille Industries, returned only 22% per year even though KKR had borrowed 97% of purchase price. The buyout firm had to shut down one of Houdalille's two divisions a few years after the acquisition because Japanese competition had made it structurally unprofitable.

Some later deals earned 50-60% annualized returns, but even that's not as impressive as it may seem:

As a mischievous exercise, Goldman, Sachs partner Leon Cooperman at one point devised on paper a crude variation on the principle of the leveraged buyout, involving taking out big loans to buy stocks. Cooperman's method: Buy a cross-section of the stock market, paying nine-tenths of the purchase price with borrowed money at a 15 percent interest rate. Then wait a few years, see how much the stock price has climbed, and tally up the profits on the one-tenth "equity" portion of the purchase price. For a few years, Cooperman pointed out, his method would have yielded annual profits of 74 percent, an even better showing that the returns that KKR's passive investors were collecting. 

The largest deal that Merchants covers-- and the all-time largest LBO when the book was published-- was KKR's purchase of RJR Nabisco, which nearly went bankrupt a year after KKR bought it. The reason for the near-bankruptcy is that RJR had issued toxic securities called reset bonds-- if the bonds traded down from their issue price, the interest rate would reset higher to compensate for the fall in price. Essentially, the yield to maturity at time of adjustment would become the new coupon yield.

The reset bonds plummeted when the junk-bond market seized up in 1989. KKR averted bankruptcy by injecting new equity into RJR, but it reportedly lost a billion dollars when it sold RJR years later. KKR had gotten into a bidding war for RJR, dramatically overpaid for the company, and financed the purchase recklessly.

KKR's experience during the last economic cycle was similar: it made a string of successful deals during the housing bubble, culminating in its acquisition of TXU, which replaced RJR as the largest LBO ever. TXU, which changed its name to Energy Future Holdings, declared bankruptcy earlier this year as low natural gas prices crippled its profitability. KKR and its partners lost $8 billion on the buyout.

KKR's unlevered returns during the 1980s seem to have been similar to the stock market's, so KKR was collecting large fees for providing beta. And some of those fees were egregious: In addition to earning carried interest and a 1.5% management fee on the partnerships it set up, KKR gave itself a transaction fee equal to 1% of purchase price on every company it bought. This was a source of controversy during its negotiations to purchase Houdaille and later RJR. KKR also took a large fee for selling RJR, even though its investors had lost money on the deal.

Merchants of Debt has an impressive level of detail about KKR's strategy and its investments, and its treatment of the company and its principals seems very balanced. Unfortunately, the book suffers somewhat from a lack of context. For example, while it implies that reset bonds were common among junk issuers, it doesn't quantify this or give any examples other than RJR. (In retrospect, it's amazing that anyone issued them.)

The book also doesn't compare KKR with its rivals. Although KKR became the most prominent buyout firm during the 1980s, Merchants mentions that the single most prominent deal was Wesray's 1982 acquisition of Gibson Greetings. Wesray sold Gibson less than eighteen months later for a $200mm profit on a $1mm equity investment, demonstrating the enormous potential rewards of LBOs. But the book doesn't describe any of Wesray's other deals or compare their record to KKR's.

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