Barbarians at the Gate (26 page)

Now deals where Kravis could once have quietly negotiated a buyout agreement became bidding contests. “Done deals” unraveled in the face of higher bids, sometimes wasting months of work. When Kravis did carry the day, prices were sky-high. “A lot of guys want to do deals just to do them,” complained Paul Raether. “They want to put scalps up on their walls. They say, ‘I gotta do this deal because it’ll make me a player. It’ll put me on the map.’”

For Kravis, a startling case in point came during the fall 1986 bidding contest for Jim Walter, a Tampa construction firm. A Kohlberg Kravis bid was topped by PaineWebber, a firm with no track record in LBOs. When Kravis, alarmed, asked the firm’s chairman, Donald Marron, what he thought he was doing, Marron pointed out that his firm had a lot of money and talent committed to merchant banking and needed to put them to use. It wouldn’t be the last such conversation Kravis had.

If Kohlberg Kravis were to reassert its dominance in LBOs, it somehow had to rise above the competition. The only place to go was up. In early 1987 Kravis and Roberts made a conscious decision to go after the megadeals, the $5 billion and $10 billion buyouts that few others could attempt. They had laid the groundwork by completing a string of mammoth LBOs: the $6.2 billion Beatrice deal, the $4.4 billion buyout of Safeway Stores, and the $2.1 billion buyout of Owens-Illinois in 1987. Now they would push into higher, uncharted territories.

“‘Who else could do a ten-billion-dollar deal’ was the reasoning,” recalled Raether. “Nobody. The only possible competitor at those levels was corporations. And most likely you won’t get competition from corporations at that price level.”

Erasing the competition wasn’t the only attraction of the megadeal. Kravis and Roberts knew from experience that it took little more work to complete a large LBO than it did a small one. Whatever the size of the transaction, however, their percentile fees remained the same. It didn’t take a genius to see they could make more money working on $10 billion deals than “puny” $100 million deals. On Beatrice they had taken a $45 million fee, plus $60 million apiece on Safeway and Owens-Illinois. That money went straight into the partners’ pockets.

The vehicle to attain these new heights was a new fund, their largest ever. Even before spending the 1986 fund, Roberts began lobbying to raise another, bigger one. “We don’t have to finish the 1986 fund,” he argued. “The money is available now. Let’s get it while we can.” Recalled Raether: “By 1987 everyone had a pot of money. We wanted to have by far the biggest pot. That would differentiate us from everybody else. It would be clear we had more power than anyone else, and everyone would know it. Everyone would know the big deals were ours.”

They began raising the new fund in June 1987, using publicity from the Beatrice deal to whip up interest. As an incentive to investors to re-up, Kravis offered to waive the management fee for all deals done before 1990. It worked. When the fund closed just four months later, Kravis and Roberts sat atop a $5.6 billion war chest, more than two times the size of its nearest competitor’s. Of the estimated $20 billion in equity poised for LBO investments worldwide, the two grandsons of a Russian immigrant controlled one dollar of every four. Fully leveraged, it gave them an unprecedented $45 billion in buying power, enough money,
Fortune
pointed out, to buy all ten
Fortune
500 companies headquartered in Minneapolis, including Honeywell, General Mills, and Pillsbury. Wall Street had never seen anything like it before.

Wall Street didn’t know the half of it. For the first time, Kravis and Roberts had sought and received permission from their investors to secretly accumulate stock in their targets. These so-called toehold investments, a mainstay of corporate raiders like Boone Pickens, would give Kravis negotiating advantage with chief executives and allow the firm to profit from the inevitable run-up in a target company’s stock. A reaction
to its new competitive environment, this tactic, more than any other, took the firm away from Jerry Kohlberg’s fireside chats and institutionalized its new, more aggressive bent. Arm-twisting, rather than friendly discussion, would now lead to most of the firm’s deals.

But this approach required Kravis to walk a fine line. Most pension funds, the major source of Kohlberg Kravis’s money, were either barred from, or leery of, hostile takeovers. Just a whiff of hostile action could scare off investors and irreparably damage their franchise in strictly friendly LBOs. If Kohlberg Kravis were branded a raider, what chief executive in his right mind would want to work with it? It made Kravis, thin-skinned by nature, acutely sensitive to public criticism.

As stock prices plummeted in the crash of October 1987, Kravis and Roberts made their move, swooping in and secretly buying vast chunks of several major U.S. corporations. In 1988 they brought the LBO idea to one of those companies—its identity still secret—and were rejected. At the end of March, Kravis unveiled a 4.9 percent stake in Texaco, then under pressure from its largest shareholder, investor Carl Icahn. For two months Kravis and Roberts attempted to talk the oil company’s officials into a buyout or major restructuring. “We tried everything in the world to get them to do something with us,” Raether recalled, “and they wouldn’t.” The firm eventually sold its stock at a profit.

The problem, it soon became clear, was that Kohlberg Kravis was all bite and no bark. With one eye trained on their pension-fund investors, Kravis and Roberts couldn’t bring themselves to make an outright hostile bid. And everyone knew it. In mid-September, the firm made an unsolicited, $4.64 billion bid to acquire Kroger, the Cincinnati-based grocery chain that had days before rejected a similar offer from the Haft family. Kroger twice rejected Kravis’s overtures, leaving him with a nice profit on his 9.9 percent stock position and egg on his face.

It wasn’t just new deals that were turning sour. After shedding many of its businesses, Kravis was finding it impossible to sell the remainder of Beatrice. The problem was a nasty knot of liabilities that no buyer wanted to take on. After being perused by every food industry buyer from Ross Johnson to Heinz, Beatrice, for the moment, belonged to Kravis. By midyear, not only hadn’t the $3 billion profit they had hoped for materialized, Kravis and his investors were little better than break-even.

It had been a rotten year. Rejected by his targets, competitors nipping at his heels, Kravis couldn’t be blamed for falling into a foul mood. When
Jeff Beck mentioned approaching RJR Nabisco, Kravis hadn’t thought much of it. Kravis sent out dozens of similar feelers every month. On October 5, Kravis breakfasted with one of his favorite investment bankers, Steve Waters of Morgan Stanley.

“What’s going on with RJR?” Kravis asked. He hadn’t talked with Johnson since their meeting a year before.

Waters said he knew of nothing new. The last time the two had discussed RJR Nabisco, Kravis had been worried about the tobacco industry’s mounting legal problems. After the
Cippollone
case his worries had subsided. “I’ve rethought some of my objections about tobacco liability,” he told Waters. “Maybe we should see if Ross might want to talk.”

Waters telephoned Johnson later that day. Jim Welch returned his call. “Henry has changed his mind about tobacco liability, Jim,” Waters said. “He’d really like to sit down with you guys.”

“Well, that’s interesting,” Welch replied. “Ross is busy now. Let us think about it. We’ll crank through the numbers and get back to you.”

Waters’s call should have been a warning. Johnson ignored it.

The history of merchant banking, with the exception of RJR Nabisco, is that I stayed out of it.

It had been a long flight from Zurich, where Cohen had ended a two-week European business-and-pleasure trip, and he was tired. Cohen was a short man, his skull gripped by a tight cap of brown hair. He liked to joke about writers’ descriptions of him: always small, dark, and, a real favorite, intense.
Institutional Investor
once compared his looks to those of Al Pacino as Michael Corleone in the
The Godfather, Part II.
Cohen looked like a tough guy, and for years that’s pretty much what he was. As a longtime aide to one of Shearson’s founders, Sandy Weill, he had earned a reputation as a hatchet man. If he were an animal, Cohen would be a wolverine.

Turning forty and taking the reins at Shearson had mellowed him, or so it seemed. Friends talked of how much Cohen had “grown” in recent
years, meaning he no longer referred to a tiny competitor like Dillon Read as a “peanut,” as he had in one published interview. Nor he did he publicly label critics “assholes,” as he once had. At the urging of Jim Robinson, his boss at American Express, Cohen had taken strides to become more statesmanlike, making the rounds in Washington, talking loftily of the globalization of the securities industry, and nurturing friendships with heavy hitters like European industrialist Carlo De Benedetti.

He had taken pains to hone his sharp edges. Gone from his office was the sculpted chain saw and the statue of two pin-striped legs cut off at the calves. In their place were family pictures and his children’s finger paintings. Years before it became faddish, Cohen was making an effort to present a kinder, gentler image.

The son of a clothing manufacturer, Cohen grew up on Long Island and attended public schools and Ohio State University. As a teenager he loved poring through the
Fortune
s and
Dun’s Reviews
to which his father subscribed. The elder Cohen bought his son T. Rowe Price mutual funds, and Cohen had been fascinated by the stock market ever since. He worked odd jobs through high school, and at Ohio State made a small fortune brokering kegs of Colt 45 beer to the fraternities.

If hustling came naturally to Cohen, school didn’t. As a finance major he was a solid
C
student. At Columbia Business School, Cohen haunted the midtown brokerage offices, watching the market and investing the proceeds from his beer-brokering days. He canceled plans to enter the family business when his father wouldn’t pay him what Cohen thought he was worth. Instead he headed to Wall Street.

Cohen had married young, at twenty-two, and by his late twenties had two children. As Weill’s assistant he was the one who stayed late, his office light burning deep into the night. He was an administrator, never a trader or an investment banker. In tough negotiations it was Cohen who played the bad cop. He was good with threats. He had no time to learn about wine, art, travel, and the other fine things Wall Street executives seemed bred for. For years he traveled the world’s great cities ignorant of all but their airports. Now, when in Rome or Madrid, Cohen tried to take half a day to take in the things he had missed. At forty he discovered the Louvre, the Musée d’Orsay, the National Museum in Taipei. He improved his tennis and golf games. Friends thought Cohen worked very hard to learn how to relax.

In the early 1980s Shearson, the successor to a long line of smaller
houses, had been a scrappy, fast-growing wirehouse; that is, it made its money handling transactions for individual investors by wire. It had no investment banking arm to speak of. But just a year after taking over from Weill in 1983, Cohen stunned Wall Street by buying its oldest partnership, Lehman Brothers Kuhn Loeb, a topflight, blue-blooded investment bank that had all but disintegrated after a civil war among its quarreling partners.

It was a strange marriage. Lehman was sterling silver cigarette boxes, fresh flowers, Impressionist paintings, and dusty bottles of Petrus and Haut-Brion in the wine cellar. Shearson was empty pizza boxes, half-empty cartons of Chinese noodles, and coffee in a Styrofoam cup. “Shearson taking over Lehman,” an old Lehman partisan quipped, “is like McDonald’s taking over ‘21.’” Much like its chairman, the combined firm of Shearson Lehman came to be marked by a peculiar blend of elegance and streetwise chutzpah: brass knuckles in a velvet glove. Amid the cultured quiet of its nineteenth-floor executive offices, tastefully decorated with Audubon prints and Oriental rugs, visitors were greeted by a gentleman named Gus, who, while leafing through the New York
Daily News,
gave directions in a thick New York accent: “Go true dose dubble dohrs,” he would say.

Backed by the tremendous firepower of American Express, which had acquired majority control of Shearson in 1981, Cohen had looked for ways to put his firm’s capital to work for years. By the mid-1980s competitors such as Morgan Stanley and Merrill Lynch were thrusting into LBOs and, in efforts to compete with Drexel’s junk-bond capabilities, had begun lending their own money in interim takeover financings known as “bridge loans.” These loans were typically refinanced, or bridged, by the later sale of junk bonds. The trend was collectively known as merchant banking, a highfalutin term that basically meant investment banks were putting their money where their mouths had been for years.

Shearson’s entry into merchant banking had been both late and lackluster. Lehman’s active takeover business gave Cohen access for the first time to a wealth of investment opportunities. But for all its eagerness, Shearson backed into the LBO business. After the Lehman merger, a number of senior Lehman partners jumped to other firms, and Cohen was determined not to lose any more. In late 1984 he flew to England with a proposition for the chief of Lehman’s London office, Stephen W. Bershad. His idea was intriguing: Would Bershad come back to New York
and devise a means to generate profits to line top executives’ pockets? “The idea was, let’s get these guys richer,” Bershad recalled. “Just make money however you can.”

Bershad came up with an answer: LBOs. But after a number of false starts, he managed only one buyout of any size, and that proved a nightmare. Six months after the $482 million buyout of Sheller-Globe, a Toledo-based auto parts maker, news accounts reported that Cohen and fourteen Shearson executives had been slapped with subpoenas as part of an insider-trading probe by the Securities and Exchange Commission. Cohen denied any wrongdoing, and an investigation never turned up any, but it was a mortifying experience. “The deal that’s dragging Shearson into the spotlight,”
Business Week
called it.

It was a tough introduction to LBOs. “Cohen had never really been around corporate finance,” recalled Bershad, who resigned after a tiff with Cohen during Sheller-Globe. “Peter knew what he read in the magazines, but he had about as much experience in investment banking as my father,” who had advised Bershad to stay away from Wall Street.

Bershad’s replacement, hired in June 1986, was a controversial figure named Daniel Good, who as merger chief at E. F. Hutton had built a thriving business backing corporate raiders. Good, so boundlessly optimistic he was sometimes called “Dan Quixote,” didn’t back four-star investors like Carl Icahn or Boone Pickens. His clients were little-known “wanna-be” raiders, third-tier greenmailers such as Asher Edelman, a Fifth Avenue arbitrager, and Herbert Haft, the pompadoured scourge of the retail industry.

Instead of LBOs, Cohen chose to funnel Shearson’s money into bridge loans for Good’s raiders. With a wink and a shrug they could call this merchant banking, but for the most part, Good’s clients were interested only in hounding Corporate America’s sick and wounded until they either bought back their shares or sought a merger elsewhere. Either way Shearson profited.

A number of Shearson executives were violently opposed to Good’s hiring, especially the M&A team, Hill and Waters, who considered Good a glorified shakedown artist. Good’s raider clients, Hill argued, would stain Shearson’s reputation and prevent it from establishing contacts with the blue-chip corporate giants it needed to build its traditional merger-advisory business. Hill campaigned tirelessly against Good, a crusade that didn’t stop even when he joined the firm; he and Waters took to keeping
a list of Good’s mistakes. “Hill,” said a colleague, “was out to cut off Dan’s balls from the beginning.”

But after Good’s first deal—Paul Bilzerian’s 1986 raid on Hammermill Paper—produced a fat $6 million fee, Cohen’s doubts vanished. It was the easiest money Shearson had ever made. “Jesus,” enthused George Sheinberg, a Shearson vice chairman, “this is great!” For fifteen months Good’s clients kept fees pouring into Cohen’s coffers, as Shearson backed raids on several companies, including Burlington Industries and Telex.

Over time, though, Cohen began to lose confidence in Good. The sale of junk bonds is normally among the most profitable aspects of merchant banking. But because Good’s raiders rarely bought anything, Shearson’s junk-bond department sat idle, atrophying. When Asher Edelman finally managed to snag a company—the steakhouse chain, Ponderosa—Shearson’s junk-bond offering was a disaster, and the firm took steep losses. Cohen steamed. Good took the blame.

The final run of Shearson’s raider express began on Black Monday, October 19, 1987. As the market crashed, scores of pending takeovers unraveled, and Cohen and Sheinberg panicked. For the first time they realized that the firm could actually lose the hundreds of millions of dollars it was lending. When a buoyant Dan Good appeared before the investment committee a week later seeking approval for a Bilzerian raid on Singer, the former sewing-machine maker, he received a rude shock. Instead of the $100 million down payment he had expected, Cohen demanded Bilzerian put up $250 million. “If he can’t come up with it, fuck him,” Sheinberg said. “I don’t give a shit. The rules of the game have changed.”

No one was more shocked than Cohen when Bilzerian came up with the money, dragging Shearson kicking and screaming into its last great corporate raid. When Singer quickly capitulated, Bilzerian was forced for the first time to raise the money to buy a company, not an easy task given Wall Street’s postcrash sobriety. It was a long, uphill fight, and before it ended Sheinberg and Good nearly came to blows. At one point, Good fled New York for a Caribbean vacation, and Sheinberg brought in his sworn enemy, Tom Hill, to bargain with Bilzerian. With what one imagines must have been unparalleled glee, Hill began to play hardball with Good’s best client. “When the deal started falling apart,” Hill would later boast, “I had to come in and break Bilzerian’s legs.”
*

Eventually Bilzerian acquired Singer, but the deal was Good’s Waterloo. Although Singer generated well over $30 million in fees, he had lost all credibility within the firm. “Good already had two guns at his head,” Hill recalled. “And then Peter Solomon put one in his mouth.”

Solomon, formerly Good’s superior as cohead of investment banking, was a boisterous, bullying Lehman veteran who coveted Good’s domain as a way to exert control over the latest evolution in Shearson’s merchant-banking drive: an LBO fund. Cohen’s long-overdue decision to raise a fund was a reaction to competitors’ success with similar funds and to Black Monday. Investing other people’s money, any fool could see, was far safer than investing one’s own.

Cohen and Solomon, however, had wholly different visions of the fund, which was to raise more than $1 billion. At other firms, LBO funds are semiautonomous, but friends say the ambitious Solomon saw Shearson’s as a chance to establish a personal fiefdom and get rich at the same time. He sought to claim a sizable piece of the fund’s profits, something to which Cohen was staunchly opposed. Cohen regarded the fund as just another Shearson department, and couldn’t see why Solomon should receive “a special deal.” Both men were headstrong and temperamental, and by the spring of 1988 they were barely speaking. Bob Millard, Shearson’s suave head of arbitrage trading, became the reluctant conduit through which they communicated. It was hardly an auspicious start for Shearson’s drive into LBOs.
*

With Solomon and Cohen at loggerheads, Tom Hill was riding to his greatest glory. Four days before Steve Waters’s resignation that March, Hill unveiled his flashiest takeover attempt yet, a $1.27 billion hostile tender offer by a British firm, Beazer PLC, for a sleepy Pittsburgh company named Koppers Co. But this particular deal had a twist: Shearson owned 45 percent of the acquisition vehicle, Beazer just less than half. Never before had a major investment bank taken a high-profile position in a hostile takeover vehicle. Shearson was stepping over an invisible line, and Hill was practically giddy at the prospects the innovative deal might have for his business and, presumably, his reputation. He was convinced the deal would be an easy victory—“a slam dunk,” in Wall Street parlance.

He couldn’t have been more wrong. Koppers’s defense became a cause
célèbre in Pittsburgh. Shearson and American Express were publicly attacked by everyone from Pittsburgh’s mayor to the Pennsylvania State treasurer, who cut off all state business with both firms. Koppers employees posed for pictures cutting their American Express cards in half, and sent letters to other companies denouncing American Express’s support for the bid.

No one was angrier than Jim Robinson, who felt he hadn’t been adequately consulted about the move. “It created a lot of heat for Jim Robinson, and heat from Jim Robinson shoots through from the fifty-first floor to the nineteenth floor pretty fast,” said a Cohen confidante. “It was a painful experience for Peter.”