Barbarians at the Gate (23 page)

Kohlberg saw the LBO as “the missing link,” a way for aging executives “to have their cake and eat it, too.” His first deal, in 1965, was the $9.5 million acquisition of a Mount Vernon, New York, dental products maker named Stern Metals. It remained his blueprint for years. Kohlberg formed a shell company, backed by a group of investors he assembled, to buy Stern from its seventy-two-year-old family patriarch, using mostly borrowed money. The Sterns retained a stake in the business and continued to run it. Eight months later Kohlberg sold some of his stock—which he had bought for $1.25 a share—to the public for $8 a share, using the proceeds to retire debt. Kohlberg then took the company on a buying spree, snapping up a California dental supply company, an Ohio X-ray firm, and a European maker of dental chairs. When the original investors sold off their $500,000 investment in the transformed company to the public two years later, it was worth $4 million.

The approach was refined in subsequent deals. As the vast conglomerates of the 1960s shed businesses in the face of a declining stock market in the early 1970s, Kohlberg branched out to buy their cast-off divisions. He liked basic industry, companies that made things like bricks and wires and valves, whose management, products, and earnings were solid and reliable. Because he borrowed heavily to buy companies, getting a fix on future earnings and cash flows was crucial if Kohlberg was to avoid having his loans called. Balance sheets were his tarot cards, cash flow projections his crystal ball. Once Kohlberg got his hands on a company, he ruthlessly cut costs and sold unwanted businesses, freeing up every extra dollar to pay debts. In most cases he gave management stock incentives, which he found did wonders for their ability to run the business more efficiently. When he was done, the leaner, meaner result was usually worth more than when he bought it. In their most basic guise, LBOs have worked the same way ever since.

This was grimy, street-level work, and as “Jerry’s boy,” Kravis pursued it with abandon. For the buyout of a Rockwell International division named Incom, Kravis compiled a seventy-five-page prospectus, crammed with balance sheets, operation summaries, and debt projections, and sent it to major insurance companies. One spring morning a handful of potential investors assembled in Quincy, Massachusetts, where Kravis escorted them through Incom’s Boston Gear plant. Piling into three limousines,
the group continued on to Holyoke to tour Acme Chain, then to Fairfield, Connecticut, to see Helm Bearing. Finally they caught a plane to Cleveland to visit Incom’s Air Maze and Morse Control divisions. It wasn’t glamorous, but it worked.

By 1973, after three years of tutelage, Kravis was ready to call the shots on his first deal. Like Stern Metals and other Kohlberg targets, Boren Clay Products, a small North Carolina brick maker, was owned by a strong-willed, elderly founder looking to cash out before his death. Orten Boren, then in his early seventies, didn’t have much use for Yankees or, for that matter, Jews.

“Boy,” Boren said at one of his first meetings with Kravis. “What faith are you?”

Kravis clinched. “Well, I’m Jewish.”

“I thought so.” A pause. “You Jewish boys are pretty smart, aren’t you?”

Kravis gritted his teeth. If anti-Semitism was the price of success, it was the price he would pay. Over the course of a six-month courtship, Kravis would pay plenty more. At one point, Boren showed Kravis through one of the company’s brick factories.

“Henry, see those kilns?” Boren asked, pointing to the giant containers where bricks were baked. “Those are just like the ovens the Germans used.” He repeated the remark for emphasis.

Kravis forced a smile.

“Boy,” Boren urged, “come on over here, a little closer, and see ’em.”

“Oh, no,” Kravis replied. “I can see them fine from here.”

After buying Boren Clay, Kravis moved on to Providence, Rhode Island, where he began negotiations to buy a tiny, family-owned jewelry maker, Barrows Industries. “I always had the impression Henry just wanted to show he was doing better than his father,” recalled its retired chairman, Fred Barrows, Jr. “He always set very strenuous goals for himself…. Even then you got the sense Henry was getting too big for Jerry Kohlberg to stomach. Henry was just so aggressive. Jerry was much more conservative.”

The Barrows buyout, Kravis’s second deal, ended three years later after a series of rancorous disputes. Kravis charged that company executives were “playing games with the figures” to enable them to obtain incentive bonuses. Fred Barrows remembered the falling out differently. “Very frankly, I thought they were milking the company,” he says. “They
wanted directors’ fees, but they weren’t directing. And then they had what they called maintenance fees. I said, ‘Look, why do we need all this expense?’…It just went against my Yankee grain.”

In the end, Barrows bought out Kravis and his investors, giving Kravis a 16.5 percent annual return on his money, little better than a certificate of deposit. Kravis was disappointed, but ultimately better off: Gold prices shot up shortly after, and Barrows eventually went out of business.

In fact, Kravis and Kohlberg’s experience with Barrows wasn’t all that unusual. After three successful buyouts in the mid-sixties, Kohlberg had yet to discover the Midas touch that would later bring Kohlberg Kravis to prominence. A graph of the returns from the fourteen buyouts he completed between 1965 and 1975 would start high on the left, then plunge straight down, ending in a series of low hummocks.

When stock prices turned down in the early 1970s, Kohlberg’s returns turned dismal, at least by later standards. Eagle Motors Line, an Alabama trucking outfit acquired in 1973, was a disappointment and had to be merged with another trucker. Boren Clay, Kravis’s first deal, hit a long slump before rebounding nearly a decade later. By far Kohlberg’s most spectacular failure was his sixth buyout, in 1971, the $27 million acquisition of a California shoemaker, Cobblers Industries. Three months after George Roberts closed the deal, the company founder and creative genius walked up to the factory roof during a lunch break and committed suicide. “Jerry called me and screamed, ‘The fucker jumped off the roof!’” recalls Robert Pirie, a Cobblers investor. Rudderless, its Jamestown, Pennsylvania, factory washed away in a subsequent flood, Cobblers ultimately went bankrupt. Kohlberg and his investors lost their entire $400,000 investment.

As Kohlberg and the two young cousins spent more time on their buyouts, it took them away from the bread-and-butter business of corporate finance, prompting grumbling among many at Bear Stearns, including their boss, Cy Lewis. “Cy was a legend,” says Bob Pirie. “Legendarily difficult.” Lewis was also a trader, and traders are notoriously short-term oriented. Decisions on the trading floor are made in a split second, profits on fractions of a point. Kohlberg’s buyout business, in contrast, was based on returns that took three, four, five years to realize, an eternity to Bear’s dominant trading culture. “Overnight was long-term for Bear Stearns,” Kravis liked to say. Cy Lewis thought Kohlberg was spending far too much
on his silly buyout sideline. It simply took too long to make a buck, when it made a buck at all.

Matters came to a head in 1976 in the wake of Kravis’s disastrous decision to invest in a Hartford, Connecticut, direct marketing firm named Advo. Initially he and Kohlberg had turned down the deal as too risky, but reconsidered when Travelers, the big insurance company, suggested they do it together, offering Kravis 40 percent of the $7.5 million acquisition for just $200,000. “Hell,” Kravis said, “how can we lose?” Easily, it turned out. Advo’s business headed downhill fast. Kohlberg removed the president, leaving Kravis the interim chief for three weeks. Cy Lewis hit the roof when he found a Bear Stearns partner running a sputtering direct-mail outfit instead of producing income for the firm.

“What the hell are you doing up there?” Lewis demanded in a phone call. “Goddamn it, you should be at home drumming up new business. Forget this deal. We’ve got our fee, let’s go on with the next deal.”

“But Cy,” Kravis protested, “that’s not the way it works. You’ve got to stick with it a while.”

Kravis stuck with it long enough to unload his backers’ $200,000 investment for half that. Advo was a nightmare for him. If his losses weren’t bad enough, Bear Stearns and several Bear partners, including Lewis, had invested alongside them in the deal, further widening the gulf between Kohlberg and his colleagues.

As the political infighting worsened, Kravis threatened to quit. “Everyone, some of the partners, was telling me, ‘do this, do that,’ and I didn’t like anyone telling me what to do,” Kravis recalled. Kohlberg urged him to stay the course. He proposed to Lewis that the three of them—Kohlberg, Kravis, and Roberts—set up a freestanding LBO group within Bear Stearns. Lewis said no.

“After that Jerry’s position within the firm really deteriorated,” Roberts recalled years later. “They were going to make life very difficult for him. Some administrative people were going to be put over him. It was clear he was going to be put in a box.” After much gnashing of teeth, Kohlberg repeated his request to begin an LBO group. Again Lewis refused.

Kohlberg and the two cousins began talking among themselves of resigning. With a nest egg of $5 million or so, Kohlberg had little incentive to remain. Roberts, anxious to follow his father’s lead into private business, pushed Kravis to leave, too. The two estimated how much
money they could make at Bear Stearns over the next decade, compared to going their own way. Bear won. Kravis left anyway.

When Kohlberg announced their intention to resign, Roberts flew in from San Francisco to tell Cy Lewis personally. The chairman of Bear Stearns was a large, imposing man, and as Roberts delivered the bad news, Lewis leaned way over his huge desk. “You know, young man,” he said, “you’re making a terrible mistake. No one has ever left this firm and been successful.”

Then things got nasty. A few mornings later, Kravis walked in and found his office emptied, its door locked. A tall man in paratrooper boots stormed up to him.

“You vill not be in that office,” the man said in a German accent.

“What do you mean?” Kravis said. “I’m a partner here.”

A similar “hit man” arrived in San Francisco. The contents of Roberts’s office were saved only by the timely intervention of his West Coast colleagues. Dumbstruck, Kohlberg and Kravis confronted Lewis: “What the hell’s going on?”

Lewis had declared war on the traitorous trio. On their departure, he demanded that Bear Stearns retain control of all Kohlberg’s deals, even though the three had millions of their own money sunk in them and, in most cases, controlled the companies’ boards. Lewis attempted to apply pressure through Kohlberg’s investors, including insurance giant Prudential and the midwestern bank First Chicago. “But the Pru told him to ‘shove it,’ and so did First Chicago,” Kravis recalled. Eventually lawyers were brought in and, in a long, difficult negotiation, the trio kept control of its investments.

They set up shop in the old Mutual of New York building on Fifth Avenue. Kohlberg preferred a low profile, so for years there was no name on the door. Roberts continued to work out of San Francisco. For overhead they raised $50,000 from each of eight investors, including Ray Kravis and the Hillman family of Pittsburgh. Kohlberg Kravis Roberts & Co. would take 20 percent of the profits from every deal, and charge a 1 percent management fee (later 1.5 percent).

For five years they stuck to Kohlberg’s guiding tenets: the deals were always friendly, always with management, always careful. They identified many of their targets with the help of a Los Angeles finder named Harry Roman. It was difficult, uphill work. LBOs were still Greek to most people, and the trio spent much of its time explaining how three unknowns
and a handful of executives could borrow enough money to buy an entire company. Their own low profile didn’t help. “Investment bankers, everyone, looked at us and said, ‘KKR, what is that, a delicatessen?’” remembered a Wall Street executive who worked for the firm in the seventies.

Despite the physical distance between them, Kohlberg remained close to the sobersided Roberts, closer than with Kravis, who was still prone to sowing his wild oats. Roberts, quieter and, many believe, smarter than Kravis, had known Kohlberg longer and was considered his intellectual equal. When one of Kohlberg’s sons had problems as a teenager, Roberts took him into his California home. Kravis, on the other hand, seemed to be regarded by Kohlberg as a hardworking subordinate. The two men had little in common besides their work. On weekend outings Kohlberg would wear chinos and hiking boots. Kravis would come in Italian slacks and Gucci loafers. After working side by side for sixteen-hour days, Kohlberg headed home to sleep, but Kravis headed out on the town with his wife. “Jerry would see Henry going out and remark dryly, ‘Oh, off again, Henry?’” said a former Kohlberg Kravis associate.

The deals came in spurts: three in 1977, none in 1978, three more in 1979, including the first buyout of a major publicly held company, Houdaille Industries. Then, after a small deal in 1980, Kohlberg Kravis went on a tear in 1981, completing six deals and generating the first spate of press coverage for the tiny firm.

During this period the trio fine-tuned its craft. They found larger companies could be acquired as easily as small ones, for the simple reason that they had larger cash flows; by diverting that money to pay down its debt, Kohlberg Kravis was able to use a company’s own strengths to acquire it. They began accumulating pools of money from investors, allowing them fast access to larger amounts of cash. Beginning with a $30 million fund in 1978, they raised a series of steadily larger pools, eventually reaching $1 billion in their fourth fund in 1983. The size of the deals grew in lockstep, reaching a peak during this period with the $440 million buyout of a Hawaiian construction company, Dillingham Corp.