Asked how to respond to a rival company's most recent gambit, the well-dressed man looks out of the window of his lavish New York office and says simply, "Napalm."
Thus was Henry Kravis, co-founder of the leveraged-buyout firm Kohlberg Kravis Roberts, introduced to the viewing public in the HBO film version of the 1980s business classic Barbarians at the Gate. The story of KKR's successful but ill-fated LBO of RJR Nabisco, Barbarians offered an indelible portrayal of KKR (and its competitors and allies) as made up of insatiable deal makers and game players. They flourished on brinkmanship, buying companies only to dismember them and caring only for the chance to crush their opponents.
What a long, strange trip it's been. Just last week, KKR announced that it would partner with upstart LBO firm Hicks, Muse, Tate & Furst to buy Regal Cinemas, the country's second-largest owner of movie theaters, for $1.2 billion. The Regal theaters will be combined with those owned by Act III, which KKR bought just a month ago, and those owned by the United Artists Theatre Group, which Hicks, Muse is in the process of acquiring, to create the world's largest chain of movie theaters. (Got all that? There will be a pop quiz at the end of the story.) The new company will control 17 percent of all the theaters in the United States and has plans to build many of those giant multiplexes we've been hearing so much about, the ones with 20 or 30 theaters apiece.
One can be forgiven for wondering if what America really needs is more movie theaters, especially at a time when movie attendance is flat and the number of screens has risen by a third in the last decade. (For more on that question, click.) But, setting that aside, what's really interesting about the Regal acquisition is that it is a bona fide long-term investment. In other words, KKR isn't buying it to sell off its assets and pocket the proceeds. On the contrary, by combining Regal with Act III, KKR is actually using one acquisition as a platform for another, much in the way any corporation looking to expand into a new field of business does.
I t may seem improbable that KKR is interested in actually building up businesses. After all, in popular mythology, KKR is thought of as the firm that pioneered the leveraged buyout and left America's once-proud corporations either struggling under mountains of junk-bond-financed debt or stripped of their most valuable jewels. But in fact the Regal deal, far from being anomalous, is typical of what KKR has done in the years since the LBO craze came to a screeching halt at the end of the 1980s. More than that, the firm's performance in this decade sheds a new light on its performance in the last one and makes it worth asking, once again, what the real impact of LBOs and junk bonds on U.S. corporations was. (If you've forgotten what a junk bond is, click.)
KKR is a private partnership rather than a corporation. In essence, what the firm does is raise money from investors--primarily pension funds, closed-end mutual funds, and banks--and then put that money to use in the hope of getting those investors better returns than they could have found in the stock or bond markets. KKR does so by buying and selling companies, which is to say that the firm never makes a deal to buy a company without plans to sell it eventually or to take it public or both. The investors reap their rewards not by taking out profits from the companies during the time KKR owns them but through the capital gains they reap when the companies are sold or taken public.
The obvious conclusion to draw from this is that KKR must be hurting these companies' long-term prospects by trying to maximize their short-term value. If you're buying a company knowing that somewhere down the line you'll want to sell it, the argument goes, you'll shortchange research and development, cut back on long-term investment and sell off slow-performing parts of the business in an effort to make the company look better in the present. As a result, KKR gets richer while the country as a whole ends up poorer.
The problem with this analysis is that it assumes that KKR is smart while everyone else is dumb. After all, when deciding whether or not to buy a company from KKR--as Gillette recently did with Duracell--presumably you'll want to kick the tires and look under the hood a little bit. And unless Henry Kravis has magical powers no one knows about, it's unlikely that buyers are going to make a long-term investment in a company that's had all the value stripped out of it. In other words, if you think that markets are even relatively good at determining a fair price for assets, then KKR can't hurt its companies' long-term prospects without hurting itself.
What about the question of debt, though? In part, what KKR did when it purchased companies in the 1980s was replace those companies' dividend payments to shareholders with debt payments to creditors. In principle, one is no better or worse for a company's health than the other. But there is one big difference between dividends and debts, which is that if you fail to pay the first, your stock price gets punished, but the company stays in business--while if you fail to pay the second, the company goes under. And there's no question that the LBO craze led to the destruction of a series of companies that took on more debt, often in the form of junk bonds, than they could handle. Southland (home of 7-Eleven), Westpoint-Pepperell, Federated Department Stores: They all collapsed because their debt loads were too high. It's interesting that the one thing those companies had in common was that KKR had passed on acquiring them. But even KKR overreached itself when it spent $26 billion to acquire RJR Nabisco. The near-collapse of that deal almost sent the firm out of business, in addition to making Kravis a poster boy for unrestrained greed.
In retrospect, though, two things seem clear. First, the RJR deal was atypical of KKR's broader strategy. Second, the whole fiasco was the best thing that could have happened to the firm. The death of LBO fervor, which in practical terms meant the death of banks' willingness to lend freely to almost anyone, forced KKR to refocus its business around the strongest deals possible. It also meant that future buyouts would be less heavily leveraged. (In 1996, only 30 percent of all junk bonds went to finance LBOs.) And the continued bull market meant that you had to look harder to find companies that investors were undervaluing and that there was a greater incentive to improve those companies' bottom-line performance.
The results have been striking. Duracell, bought by KKR in 1988 for $350 million, was sold to Gillette for $3.7 billion in 1996. In that same year, it sold American Re, a reinsurer, to a German company for a profit of $1.8 billion, and Stop & Shop to a Dutch company for a profit of $1.4 billion. All these were companies that KKR had owned for an extended period of time during which all had expanded, improved productivity, and--in the case of Duracell--benefited from increases in R & D spending. The firm's one great flop of recent years has been Flagstar, which owns Denny's. The Grand Slam Breakfast just never took off.
One familiar interpretation of KKR's success is that it illustrates the disciplining power of debt. Becoming highly leveraged has forced managers to think seriously about costs, trim overhead, and improve productivity. The broader lesson we're supposed to learn, then, is that it was precisely the takeover mania of the 1980s that created the lean, efficient profit machines of the 1990s. But the truth is that KKR's success illustrates a more mundane--but even more important--point, which is that managers of a company perform better when they're held accountable by the owners of that company. KKR has not succeeded because of the discipline of debt or even the promise of untold riches. Rather, it has succeeded because it brought a relentless focus on the bottom line to the corporations it has owned, and established standards its managers have had to live up to. For most of this century, U.S. corporations featured rubber-stamp boards of directors handpicked by management and uninterested in rocking the boat. What these boards have allowed managers to do is, simply, play with other people's money. And in some very basic sense, what KKR has done best is get managers to take other people's seriously.