Authors: Qitong Sun and Massimiliano Marchisio

Date 30 November 1988
Type of transaction Leveraged Buyout
Valuation 7.5-8.0x FY 1988 EBITDA of c. $3.1bn
Bidder KKR
Target company (sector)

Financials

RJR Nabisco (Tobacco & Food)

FY1988 Rev./EBITDA $16.9bn/$3.1bn (margin c.18.3%)

Rationale

RJR Nabisco’s operations exhibited moderate and consistent growth, required little capital investment and carried low debt levels.  All these features made it a particularly attractive LBO candidate. Though it had problems of declining ROA and falling inventory turnover, they appeared fixable.

On November 24th, 1988, the board of RJR Nabisco finally announced its acceptance of a revised proposal from KKR, with $25bn ($109 per share). KKR won the competitive process for the ownership and control of RJR Nabisco, a victory that resulted in the largest corporate control transaction in the US, opening the road for large corporate buyouts.

History of the RJR Nabisco takeover

  • 1985 – RJR Nabisco was formed in 1985 when Nabisco merged with RJ Reynolds tobacco. The CEO F.Ross Johnson, originally from Canada, was known for a risky, bold decision making process inside the boardroom.
  • 20th October 1988 – Johnson decided to take the company private and proposed a $17bn LBO. Company shares rose sharply on the news. Sherson Lehman Hutton announced they would take the company private at $75/share.
  • 26th October 1988 – KKR & Co. made an offer $20.4bn, but the deal was rejected. Salomon Brothers, Forstmann Little, Shearson Lehman Hutton, Goldman Sachs, First Boston, Merrill Lynch, Morgan Stanley, and more are all trying to get in on the action. A few days later, RJR Nabisco gave KKR confidential financial data about its operations.
  • 2nd November 1988 – KKR and RJR Nabisco tentatively agreed to join forces, but just after one day, the agreement failed. After that, RJR Nabisco upped the ante by making a $92/share offer (i.e. $20.9bn).
  • 18th November 1988 – Fist Boston put together a deal. Working with the Pritzker family in Chicago, offering between $23.8bn and $26.bn.
  • 29th November 1988 – Management offered $22.9bn, KKR offered $24bn and First Boston offered $23.38 to $26.1bn. The stock price jumped to $90.88.

30th November 1988 – Finally, the company went to KKR for $24.9bn or $109 a share. Mr Johnson received $53m from the buyout, $23m after taxes.

kkr pic1

The RJR Nabisco transaction warrants particular attention. Not only is it the largest LBO on record, but it also features a particularly wide range of sophisticated players, a complex set of innovative financial instruments, and a challenging valuation process.

Successful LBOs are generally characterized by both low business risk and moderate growth. RJR’s unlevered beta was 0.69, which means the firm was relatively insensitive to market-wide fluctuations. Although the growth rates of tobacco and food were 9.8% and 3.5% respectively, most analysts had forecast a slower long-term growth rate in both units. Together with the firm’s little capital investment requirement and low debt levels, RJR Nabisco was a particularly attractive LBO candidate.

ESCP PE-Team View

How did KKR win if its offer was low?

By traditional standards, RJR management should have won the bidding war. Its offer, $112 a share, was higher than KKR’s by nearly $700m, its cash portion of the offer (i.e. $84) was higher than KKR’s ($81), its members were all industry experts with an intimate knowledge of the company and management was on good terms with the board members. Nevertheless, when the bidding ended, traditional factors did not determine the winner. The management group lost.

Why?

Here the following factors had led to the success of KKR’s lower bid:

  • The break-up factor – KKR promised to keep the tobacco and most of the food business intact, which matched the board’s will to keep the company as intact as possible. While KKR promised to keep the tobacco and most of the food business intact, the management group planned to keep only the tobacco business. Indeed, KKR specified that it would sell only $5bn-$6bn of RJR assets in the near future, while the management group planned to sell the whole food business (estimated at $13bn).

To sum up: Better negotiations carried out by Henry Kravis and George Roberts (co-founders of KKR). The reality is the KKR kept its options open, not disclosing its long-term pans.

  • The equity factor: The board’s five person committee wanted to provide existing share-holders with an option to participate in the buyout and thus share in any future KKR profits from the transaction. The desire was to leave some portion of the company’s stock in public hands. While KKR proposed to distribute 25% of the equity in the future company to existing shareholders, the management grup offer included only 15%.

To sum up: Better terms and proposal deriving from a higher expertise in meeting boards’ requests.

  • Financing structure: Based on an analysis performed by the advisors to the board’s committee, KKR was offering $500m more equity than the management group, which again accommodated the board’s objective of maximizing current shareholders’ participation in future profits.

To sum up: Better understanding of businesses’ capital structures and again higher expertise in meeting boards’ requests.

  • Post-LBO leadership: The intensive bidding war affected all parties involved (including management, employees, communities and the bidders themselves). During the bidding period, the uncertainty was high and business was affected. In the interest of restoring stability, the board’s special committee assessed each offer in terms of its effects on RJR’s identity and culture. KKR quickly read the board’s mind and announced its plan to install J. Paul Sticht as the new CEO (vs. management which proposed Johnson to continue as CEO). For various reasons (i.e. most expensive fleet of corporate jets and poor public relation) the board associated MR. Johnson’s group with greed, lavish spending and insensitivity to employee and community needs.

To sum up: Again KKR demonstrated higher expertise vs management in meeting boards’ requests.

The board assessed each offer in terms of its effects on RJR’s identity and culture, and finally placed more preference on KKR. KKR was able to recognise that financial factors, as well as the acquiring group’s goodwill, would play a decisive role in the game.

About RJR Nabisco – was an American conglomerate, selling tobacco and food products, headquartered in the Calyon Building in Midtown Manhattan, New York City. RJR Nabisco stopped operating as a single entity in 1999; however, both RJR (as R.J. Reynolds Tobacco Company) and Nabisco (now part of Mondelēz International) still exist.

 About KKR & Co. – is a global investment firm that manages multiple alternative asset classes, including private equity (corporate buyouts, infrastructure and real estate), credit, and through its strategic partners, hedge funds. As of September 30, 2018, Assets under Management were $195 billion.

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