The Famous Case of LBO by alicejenny


									  The Famous Case of LBO

        KKR merger RJR

       Financial Management 0101

Mission group: 兰柳仁 马波 胡刚 徐艺菲 戴丽虹

Brief Contents
    1. Introduction                                                      3

    2. The situation after the LBO                                       3

        The process of KKR sold off RJR                                  3

         The problems KKR was confronted with                            4

    3. A serious problem: Junk bond                                      4

        The function of the junk bond                                    4

        Some basic situation about the junk bond of KKR, RJR             5

        The junk bond’s influence                                        6

               The influence on the junk bond holders                    6

               The influence on the company and on it                    6

               The influence on the correlative interest holders.        7

     4. The lawsuits in the leveraged buy-out of RJR                     7

          The bounder suit                                               7

         The lawsuits from the shareholders                              7

                 The claim of the lawsuit of the shareholders            7

                 The reasons of class action of the shareholders         7

                 Three groups of shareholders in the class action        8

                The judgment of the class action                         8

          The civil lawsuits filed concerning the RJR takeover           8
       4.4 Summery                                                  9

   5. Some views toward this LBO                                        10

    6. Conclusion                                                       10
1. Introduction
    In preparation for our discussion of the case, let’s look at the following information. F. Ross
Johnson, president and chief executive officer at RJR Nabisco, launched a management-led LBO
bid for the company at $75 a share for a total value of $17 billion.

    Word that one of the country's biggest brand-name companies was in play at a price that
seemed cheap to some sparked interest in financial circles, and KKR launched a competing bid for
RJR on Oct. 24, offering $90 a share. Just over a month of jockeying, deal structuring and
back-and-forth bidding later, KKR won the auction for the company with a $109 per share offer
for some $25 billion in total value. Kravis and Roberts became famous, while Johnson became the
physical embodiment of greed

2. The situation after the LBO
2.1 The process of KKR sold off RJR
     KKR invested a staggering $3.2 billion of total equity into RJR Nabisco, expecting the deal
to be worth the time and effort put into the transaction. Only two years after KKR purchased RJR
(1990) it started diluting its take by selling off 100 million new shares which accounted for 60%
of RJR's equity, in an initial public offering.

     In 1995, KKR launched an initial public offering of 19% of its Nabisco business, which
netted approximately $1.2 billion. Late that year, KKR acquired Borden Inc. through a $2 billion
stock swap using RJR Nabisco shares. KKR also sold the rest of its remaining 8% stake of RJR
shares in early 1995 for a price reported to be about $5.73 a share, which was only ever so slightly
more than the $5.63 per share on an adjusted cost basis that KKR paid to acquire RJR.

     Borden sold another big KKR-owned block of RJR on a day when the stock closed even
lower, at $5.6875 a share. And by the time KKR acquired the remaining shares of Borden on
Tuesday, RJR's stock price stood at $5.75. It isn't clear yet when Borden will sell the last KKR
block of RJR.

      KKR sold its remaining RJR shares to Borden Inc., the food and chemicals company it just
finished acquiring. And Borden, will most likely sell the RJR shares on the open market and
utilize the proceeds to enhance its own profits.

     In handing its last remaining RJR stake over to KKR-owned Borden Inc., KKR is swapping
out of a food-and-tobacco company and into a food company. The difference, RJR's tobacco
business, is chiefly what doomed the RJR buyout.

      And just as KKR is redefining itself as it unloads the food and tobacco mammoth, RJR is also
preparing to change its image as well. Earlier in '95, RJR sold 20% of cookie maker Nabisco the
company it purchased 10 years go to the public. And there is conjecture that RJR would just sell
off the rest. That puts RJR where it was 10 years ago a tobacco firm. In fact, a complete spin off
would please RJR shareholders who have been waiting patiently for the stock to bounce back.

 2.2 The problems KKR was confronted with (The reasons why KKR sold RJR)

   2.2.1 What went wrong
   Analysts say KKR got caught up in a frenzied takeover fight and paid too much for RJR at the
peak of the '80s merger boom. And the firm bought into the wrong industry -- tobacco -- not long
before cigarette price wars and threat of litigation laid waste to tobacco stocks.

     Shortly thereafter, the cigarette industry came under fire: In 1993, Philip Morris Cos., RJR's
archrival, cut prices of its No. 1 brand, Marlboro by 20%. The following year, stringent
government controls loomed on the horizon discouraging investors. This situation is very bad for
RJR. The profit would also decrease as the affect of price decline.

     The collapse of RJR's tobacco profit, which fell from $2.4 billion a year to only $1.2 billion
in 1993 is a good evident that it was confronted with a trouble.

     The RJR Nabisco deal did not perform up to expectations. At the time of the deal, no one
anticipated, which meant no one was ready to factor into their financial models, the anti-smoking
sentiment that gripped the country after 1989 and the litigation hits tobacco companies took. "If
you just looked at the normal price increases that one would have expected to occur, the thing was
a grand slam."

    2.2.2 Another factor caused the deal's flop was RJR's inflated price tag
    The final $25 billion price for RJR was almost double what the stock had been trading before a
leveraged buyout bid attempted by Ross Johnson, RJR's CEO at the time. When the highly
publicized transaction closed six years ago, KKR's equity stake in RJR was $1.35 billion since the
leveraged buyout was paid for primarily with debt. However, when the junk bond market
became shaky in 1990, KKR had to make an additional $1.7 billion infusion in July of 1990 to
refinance some of the junk debt, just to rescue RJR from the possibility of insolvency.

     KKR accustomed to annual returns of 25% to 30% on its buyouts in the 1980s, is barely
scratching out single-digit annual returns for its $3.1 billion investment. Since it made its
investment in RJR at an average cost of $5.62 a share, RJR's stock price has risen only 2.3% to
$5.75, not counting dividends. In the same period, the S&P 500 rose 47%.

     Thus, the great debt make KKR very tired. Also, it became the key factor that make the deal

3. A serious problem: Junk bond
3.1 The function of the junk bond. (In the M&A in the 80s of American)
     The junk bond is the bond with a Standard & Poor’s rating of BB and below or a Moody’s
rating of Ba and below. The junk bond is boom in the middle of 1980s.At this time, many
companies use the junk bond as tools to finance the mergers and other corporate restructure, this

fashion which issued the debt to merge made great impact on the development of the society and
the finance. At the end of 1980s, when MBO turned its goal to the large enterprises, the
dependence on junk bond was become more obvious until the collapse of the junk bond in the late
of 1989, it is even can be said that the ebb of MBO is caused by the collapse of junk bond market,
but during the 1990’s junk bonds performed very well as there were few defaults, becoming
popular once again. During the time of 1980-1990, the times which issued the debt to merge
surpassed one thousand times, and the capital amount surpassed thousand billions.

        The purpose of the people buying the junk bond is not investment, but is the speculation
the tender precondition will not conceal the woeful result. At the end of the 80s, so many
companies which issued the junk bond had the capital problems, they couldn’t pay the high
interest and redeem the bond, and the situation was becoming worse and worse, the commercial
banks which secured the junk bond canceled the surety, which caused a panic among the investors,
the credit problems were flooded in the security market. The junk bond market went to the
dreariness day by day.

         The following table (figure-1) presents data on junk bond financing between 1975-1995,
Column(1) shows the great growth in junk bond issuance, Column(3) shows the default rate on
junk bonds.             (Figure-1)

                                                            Par        Value
    Year                      Par Value Outstanding                                 Default Rates
    1975                      $7,471                         $204                   2.731%
    1976                      $7,735                         $30                    0.388%
    1977                      $8,157                         $381                   4.671%
    1978                      $8,946                         $119                   1.330%
    1979                      $10,356                        $20                    0.193%
    1980                      $14,935                        $224                   1.500%
    1981                      $17,115                        $27                    0.158%
    1982                      $18,109                        $577                   3.186%
    1983                      $27,492                        $301                   1.095%
    1984                      $40,939                        $344                   0.840%
    1985                      $58,088                        $992                   1.708%
    1986                      $90,243                        $3,156                 3.497%
    1987                      $129,557                       $7,486                 5.778%
    1988                      $148,187                       $3,944                 2.662%
    1989                      $189,258                       $8,110                 4.285%
    1990                      $181,000                       $18,354                10.140%
    1991                      $183,600                       $18.862                10.273%
    1992                      $163,000                       $5,545                 3.402%
    1993                      $206,907                       $2,287                 1.105%
    1994                      $235,000                       $3,418                 1.454%
    1995                      $240.000                       $4.551                 1.896%

           The following table presents data on default rates by Standard & Poor’s on cumulative bases
      for 10 years. It shows that the junk bonds can have a 10-year cumulative rate of 48.4 percent.

                                      Years After Issuance
Default        1       2          3         4         5          6         7          8         9          10
Yearly         1.63%   13.60%     15.16%    8027%     3.05%     8.96%      4.02%      3.36%     0.00%      3.56%

Cumulative     1.63%   15.01%     27.89%    33.86%    36.07%     42.21%    44.53%     46.39%    46.39%     48.38%

      3.2 Some basic situation about the junk bond of KKR, RJR
           One of the famous examples of using the junk bond is that KKR acquired RJR which is a
      tobacco company. At the end of 1988, KKR finished the acquisition, although the price was high
      as 25 billion, but in the whole process of the acquisition, KKR just used its own capital 15 million,
      more than 99.4% of the capital was obtained by issuing the “junk bond”, that is to say, the capital
      the KKR owned was less than 0.6% of the whole capital, primary investors in junk bonds are life
      insurance companies and pension funds, some mutual funds, and individuals.

            The spring of 1990 just one year after the acquisition, RJR whose total assets are controlled
      by KKR faced a financial crisis, the debt which was high as 90% is the fuse. The first 1.2 billion
      debts which were maturated on February 1991 couldn’t be paid because of the new debt and
      another 7 billion PIK bonds (one kind of interest cumulative bonds) because the dual interest, it
      caused the 0.35 billion interest burden. Interest coverage, the ratio of operating earning to interest
      payment, at the beginning of the LBO, was higher than 2 to 1, but near the end of the collapse of
      the junk bond market, it was about 0.75. Under this situation, KKR was forced to do a series debt
      reconstruction in order to trap in a pretty pass. When the junk bond market became shaky in 1990,
      KKR had to make an additional $1.7 billion infusion in July of 1990 to refinance some of the junk
      debt, just to rescue RJR from the possibility of insolvency. At the spring of 1991, RJR declared
      that it would redeem a lager part of its junk bonds at par value, and this announcement made the
      price of bond increased 34%.

      3.3 The junk bond’s influence
           3.3.1 The influence on the junk bond holders:
           Junk bonds have a higher than average chance of defaulting. In good economic times, default
      rates can be as low as 2 percent. If there were more uncertain future for economy, some junk
      bond experts are predicting default rates as high as 9 percent. But there is a huge risk that the junk
      holder will do not get paid back? But why there still have lots of investors, because of money, junk
      bonds are riskier, the amount of annual interest they pay -- what's known in bond speaks as a
      coupon -- is higher. These points to the root of the more politically correct name for junk bonds --
      high-yield bonds

             The RJR’s junk bond holders earned a high interest rate with high risk. The interest rate was

high as 14.5%, yields climbed dramatically, but default rates also climbed from 1988 to 1991
when 10% of junk bonds defaulted in the market, investors underestimated risks of junk bonds.
Even Warren Buffett even referred to junk bonds as "bastardized fallen angels.", but many
investors also were wild about it, include Buffett himself, he got 0.15 billion when RJR redeemed
its junk bonds at par value.

     3.3.2 The influence on the company and on it:
     KKR is a private partnership rather than a corporation. The major holders’ are pension funds,
closed returns, and banks; they put money to use in the hope of getting better returns than they
could find in the stocks or bond markets, and KKR gain returns by buying and selling companies,
so the investors reap their rewards though the capital gains when the RJR is sold or taken public.
The obvious conclusion is that the KKR must hurt the RJR’s long-term prospect by trying to
maximize their short-term value. As a result, the KKR and junk bond holders get richer while the
RJR ends up poorer.

      As mentioned above, RJR’s junk bond holders earned a high interest rate, not only the high
risk, but also because the interest is tax deductible (and about half the costs of interest are actually
expended) in some way, and it believe that earnings from the acquired business will cover interest
payments. So after KKR purchased RJR, the stock dividend of RJR would be paid to its
stockholders was litter even no, the profit instead to pay creditors.

      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 so there's no question that interest of stockholders was

      3.3.3 The influence on the correlative interest holders.
      Since the interest on junk bonds is tax deductible, RJR Nabisco bought at Government
expense, but this is the situation of the whole society, not just RJR. Because the higher interest and
defaulting risk, Junk bond make the LBO more risk. Enlarger the moral risk, the manager holds a
great number of stocks, there is a potential risk for them make the work less efficient, so stock
price underestimated, LBO is easy to achieve , and though IPO, more money would be earned by

4. The lawsuits in the leveraged buy-out of RJR
     KKR acquisition of RJR Nabisco Inc. may be a watershed for many developments in the
merger and acquisition field. KKR did not have to attempt the entire $24.7 billion; actual cash
outlays were about $18 billion. Remaining stock was swapped for exchangeable preferred stock
and convertible debentures that will convert into common stock. Many dealmakers think that the
conversion provision will start a trend, with shareholders of bought-out public firms retaining
some equity stake and share in any value appreciation. Questions have been raised by government
and nongovernment authorities on using leverage in US businesses and on the tolerance of the US
financial system for increased leverage. Suits were brought in November 1988 by 3 large

insurance companies over the loss of value on their RJR bonds. There also has been a backlash by
some states against permitting their pension funds to invest in leveraged buyout funds.

 4.1 The bounder suit
      4.1.1 The reason of the bondholders’ lawsuits
    When the RJR was buy-out by Kohlberg Kravis Roberts & Co, the food and tobacco
conglomerate faces a class-action suit by former bondholders.

     Plaintiffs allege, in short, that RJR Nabisco's actions have drastically impaired the value of
bonds previously issued to plaintiffs by, in effect, misappropriating the value of those bonds to
help finance the LBO and to distribute an enormous windfall to the company's shareholders. As a
result, plaintiffs argue, they have unfairly suffered a multimillion dollar loss in the value of their

       4.1.2 The RJR’s measure in the case
      The RJR Nabisco defends the LBO by pointing to express provisions in the bond indentures
that, inter alia, permits mergers and the assumption of additional debt. These provisions, as well as
others that could have been included but were not, were known to the market and to plaintiffs,
sophisticated investors who freely bought the bonds and were equally free to sell them at any time.
Any attempt by this Court to create contractual terms post hoc, defendants contend, not only finds
no basis in the controlling law and undisputed facts of this case, but also would constitute an
impermissible invasion into the free and open operation of the marketplace.

       4.1.3 The judgment of the suits.
     For the reasons set forth below, this Court agrees with defendants. There being no express
covenant between the parties that would restrict the incurrence of new debt, and no perceived
direction to that end from covenants that are express, this Court will not imply a covenant to
prevent the recent LBO and thereby create an indenture term that, while bargained for in other
contexts, was not bargained for here and was not even within the mutual contemplation of the

    In addition to the bondholder suit, at least three private lawsuits brought by shareholders who
removed themselves from the class actions are pending.

 4.2 The lawsuits from the shareholders
    4.2.1 The claim of the lawsuit of the shareholders
    NEW YORK -- RJR Nabisco Inc. will pay $72.5 million to former shareholders and
employee stock-option holders who charged the company failed to disclose takeover talks in the
months before its October 1988 leveraged buy-out.

     If approved by a federal judge, the class-action settlement will bring RJR's total payment to
such shareholders to about $125 million in connection with the company's $25 billion buy-out by
Kohlberg Kravis Roberts & Co. RJR denies the allegations in all the suits.

     Notice of the latest settlement is scheduled to be mailed to shareholders today, plaintiffs'
lawyers said. U.S. District Judge Michael B. Mukasey plans to consider approving the settlement
at a hearing in June. Mr. Ricciardi, the RJR attorney, said some of the settlement is covered by

    4.2.2 The reasons of class action of the shareholders
     The class action was brought on behalf of former RJR Nabisco shareholders and employee
stock-option holders who sold their stock after March 30, 1988, but prior to the Oct. 20 buy-out.
After a public bidding war, KKR eventually paid $109 a share to take control of the company.
Prior to the bidding, RJR Nabisco stock traded in the high $40 and low $50 range.

      The lawsuit alleges that RJR Nabisco's management before the buy-out withheld(保留)
important information about the possibility of a deal. If the information had been public, the
lawsuit alleges, the shares would have traded at a higher price and class members might have held
their shares in anticipation of a deal.

      In preparing for a possible trial, plaintiffs' attorneys interviewed more than 20 RJR Nabisco
officials, including F. Ross Johnson, the former chairman. The attorneys never expected to get the
full $50-plus difference between the LBO price and the amount the class members received when
they sold. But they were preparing to argue that top RJR Nabisco officials were reviewing
$75-a-share offers as early as April 1988 and that public knowledge of the talks would have raised
the stock price considerably.

    4.2.3 Three groups of shareholders in the class action
     Specifically, covers three groups of shareholders: anyone who sold RJR Nabisco stock after
March 30, 1988, but prior to the Oct. 20 buy-out; those who responded to a May 1988 stock
buy-back offer by RJR Nabisco at $53.50 a share; and those former employees who sold their
stock options back to the company at $53.50 in August 1988.

     The payout for class members depends on who they are and when they bought and sold their
shares. Those who held stock closest to the buy-out date before selling can expect to get more than
others under the terms of the settlement. That's because plaintiff attorneys allege that the company
held back more evidence as the buy-out grew closer -- such as meetings with investment bankers
and creation of special "golden parachute" contracts for top management officials -- through the
summer of 1988. RJR has denied that these actions were related to the buy-out.

     Employee option holders who sold their shares back to the company in August 1988 for
$53.50 stand to get up to $8 a share. Shareholders who bought their RJR Nabisco shares after
March 30, 1988, and sold them back to the company in the May stock buy-back will receive a
maximum of 10 cents a share.

   4.2.4 The judgment of the class action
    In December, a Delaware state judge approved a settlement of a class action brought on
behalf of shareholders at the time of the buy-out. Those plaintiffs alleged that the company

unfairly favored KKR's $109 offer over a competing bid by Mr. Johnson, then the company
chairman. That settlement, up to $55 million, will give shareholders from 11 cents to 22 cents a

 4.3 The civil lawsuits filed concerning the RJR takeover
    KKR, a leveraged buy-out firm that acquired RJR Nabisco Holdings Corp in 1989, is being
sued by William Rand, a New York attorney and investor in RJR preferred stock, alleging that
KKR charges "excessive fees for minimal work" and that its fees constitute "unfair self-dealing."
Rand's lawsuit is the most recent of several lawsuits filed concerning the RJR takeover.

 4.4 Summert:
    First we can see two kinds of lawsuits, which M&A companies may suffer. One is
government sue, such as FTC, The other is folk sue. Competitors usually impale it, like Dell
impales Gateway. No matter which kind, it can prone or pile up the merger.

     At the same time, law can also make many problems inducing litigations. There mainly exist
internal and external problems. External problems focus on protecting creditor benefits, and
External problems that acquiring how to deal with acquired benefit conflict.

     And buys are in the LBO, offers to be able to use the goal company the property to guarantee
as financing obtains purchases own fund, under this situation, the goal company existing creditor
regarding takes over control the income which produces and does not have the right, but actually
must suffer the credit risk. After in other words, after LBO the shareholder and creditor's benefit
has had the conflict. But, in fact any creditor can in the related contract stipulate the advantageous
provision, causes it to exempt the after other creditor's rights adverse effects; But offers to avoid
with first the goal company shareholder's similar credit loss, also not impossible completely to set
at the goal company's creditors to not to attend to. Moreover, the American recently some
legislations, the statute of Elizabeth, the Uniform fraudulent Transfer Act), the American
bankruptcy statute book, had considered protected creditor's rights and interests, caused to offers
exploit "regarding company creditor's " to be more difficult.

      In the M&A, protects to all shareholders profit sacrifice bond possessor, the bond credit rank,
the plaintiff bondholder not full information redeems the corporate debt about the defendant
intention and therefore incompetently exercises the transformation in front of the suitable final
deadline and so on, all is the common lawsuit reason, because the debit prestige and lender's
ability arrives the borrower the property enormously to worsen. To the debt, the sales property, the
merge, the dividend, the limited payment and loan and the incurrence restriction is possibly helps
to the member to protect the lender their debtor to change the involvement at the event the
merger/takeover situation., which not welcome to act as agent, and these defenses opposes to take
over, generally causes the lower bond rating. Certainly, a vital question is debt holders, compared
with the shareholder, they has less strengths in the management decision-making. Their right is
limited by the debt level of the company.

     Therefore, in the M&A process, will be supposed to pay attention to the creditor and the

ordinary investor's benefit.

      IN the M&A, acquainting and acquiesced, shareholder and bondholder, and other benefices
have conflicts, so lawsuit becomes an important solution. But lawsuit can vindicate one group
certainly harm another. In some cases a serious lawsuit happened after M&A. so when KKr run
into lawsuit, its stock’s price more or less declined. The serious one is shaped down to 10.6%.
So a company should avoid lawsuit.

5. Some views toward after this LBO
5.1 The fizzling of what was supposed to be a signature deal both for the industry and for KKR
does not seem to have had staggering negative after-effects, beyond affecting the firm's overall
rate of return. "In terms of how it affected the firm, they had a lot of money tied up in the
transaction that hasn't gotten them any great returns, so that's not good," says a GP that was close
to the deal. "But the company did well; it divided up, paid off its debt, created value."

     From this view, we can find that though he acknowledged this LBO is a failure, he believe
this LBO is a great deal. Yes, we also support it.

5.2 Although it has become a cliche to note that records are made to be broken, most agree it is
unlikely the industry will ever see a deal as large as the RJR Nabisco buyout.

5.3 "Could you raise $30 billion to purchase a company now?" asks the GP source. "The high
yield market is not as effervescent as it was. The bank debt market isn't as effervescent. So you'd
need more equity today....Considering you could even do it, you'd have to put in the neighborhood
of $10 billion in equity. I'm not sure there's that much out there in terms of value."

     That is really true that you can not financial large money easily to make such a large deal that
we may use our own money more. At that time, the background of the market make so large LBO
can be done. Nowadays, if you want to financial large money, IPO may be your best chose.

6. Conclusion
   After discussing the situation after KKR bought RJR, there is still lot of things that we can learn.
It is universally acknowledged that the final result of this LBO is not as people expect. However,
we can not emphasize the great affect of this large LBO too much. It is a great deal.

   From this case, it enlightens that the risk is a key factor in business. No matter how well you do
your financial analysis, no matter what advance method you have used in your project valuation,
the result is not certain. You have to fact the variability. You should have the courage to fact the
failure. Then you can do business. And you have the quality to do a great deal.


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