RJR Nabisco Goes Private—Key Shareholder and Public Policy Issues Background The largest LBO in…

RJR Nabisco Goes Private—Key Shareholder and Public Policy

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The largest LBO in history is as well known for its
theatrics as it is for its substantial improvement in shareholder value. In
October 1988, H. Ross Johnson, then CEO of RJR Nabisco, proposed an MBO of the
firm at $75 per share. His failure to inform the RJR board before publicly
announcing his plans alienated many of the directors. Analysts outside the
company placed the breakup value of RJR Nabisco at more than $100 per share—almost
twice its then current share price. Johnson’s bid immediately was countered by
a bid by the well-known LBO firm, Kohlberg, Kravis & Roberts (KKR), to buy
the firm for $90 per share (Wasserstein, 1998). The firm’s board immediately
was faced with the dilemma of whether to accept the KKR offer or to consider
some other form of restructuring of the company. The board appointed a
committee of outside directors to assess the bid to minimize the appearance of
a potential conflict of interest in having current board members, who were also
part of the buyout proposal from management, vote on which bid to select. The
bidding war soon escalated with additional bids coming from Forstmann Little
and First Boston, although the latter’s bid never really was taken very
seriously. Forstmann Little later dropped out of the bidding as the purchase
price rose. Although the firm’s investment bankers valued both the bids by
Johnson and KKR at about the same level, the board ultimately accepted the KKR
bid. The winning bid was set at almost $25 billion—the largest transaction on
record at that time and the largest LBO in history. Banks provided about
three-fourths of the $20 billion that was borrowed to complete the transaction.
The remaining debt was supplied by junk bond financing. The RJR shareholders
were the real winners, because the final purchase price constituted a more than
100% return from the $56 per share price that existed just before the initial
bid by RJR management (Burrough and Helyar, 1990).

Aggressive pricing actions by such competitors as Phillip
Morris threatened to erode RJR Nabisco’s ability to service its debt. Complex
securities such as “increasing rate notes,” whose coupon rates had to be
periodically reset to ensure that these notes would trade at face value,
ultimately forced the credit-rating agencies to downgrade the RJR Nabisco debt.
As market interest rates rose, RJR Nabisco did not appear to have sufficient
cash to accommodate the additional interest expense on the increasing return
notes. To avoid default, KKR recapitalized the company by investing additional
equity capital and divesting more than $5 billion worth of businesses in 1990
to help reduce its crushing debt load. In 1991, RJR went public by issuing more
than $1 billion in new common stock, which placed about one-fourth of the
firm’s common stock in public hands. When KKR eventually fully liquidated its
position in RJR Nabisco in 1995, it did so for a far smaller profit than
expected. KKR earned a profit of about $60 million on an equity investment of
$3.1 billion. KKR had not done well for the outside investors who had financed
more than 90% of the total equity investment in KKR. However, KKR fared much
better than investors had in its LBO funds by earning more than $500 million in
transaction fees, advisor fees, management fees, and directors’ fees. Dissident
bondholders filed suits alleging that the payment of such a large premium for
the company represented a “confiscation” of bondholder wealth by shareholders.

Potential Conflicts of Interest

In any MBO, management is confronted by a potential conflict
of interest. Their fiduciary responsibility to the shareholders is to take
actions to maximize shareholder value; yet in the RJR Nabisco case, the
management bid appeared to be well below what was in the best interests of
shareholders. Several proposals have been made to minimize the potential for
conflict of interest in the case of an MBO. Borden (1987) proposed that
directors, who are part of an MBO effort, not be allowed to participate in
voting on bids and that fairness opinions be solicited from independent
financial advisors. Lowenstein (1987) proposed that a firm receiving an MBO
proposal be required to hold an auction for the firm. The most contentious
discussion immediately following the closing of the RJR Nabisco buyout centered
on the alleged transfer of wealth from bond and preferred stockholders to
common stockholders when a premium was paid for the shares held by RJR Nabisco
common stockholders. It often is argued that at least some part of the premium
is offset by a reduction in the value of the firm’s outstanding bonds and
preferred stock because of the substantial increase in leverage that takes
place in LBOs. However, empirical studies of the change in the value of a
firm’s outstanding debt at the time of a leveraged buyout announcement provide
mixed results. In their studies of numerous LBOs during the 1980s, Lehn and
Poulsen (1988) found no evidence that bondholders lose value; however, Travlos
and Cornett (1993) found statistically significant losses associated with the
announcement of going private. In a lawsuit against RJR Nabisco, it was alleged
but never proved that its $5 billion in bonds outstanding at the time of the
announcement lost more than 20% of their value due to the LBO transaction
(Greenwald, 1988). A recent study by Billett, King and Mauer (2004) found no
wealth transfer between bond and stockholders in an exhaustive study of 3,083
target firms from 1979 and 1997.

Winners and Losers

RJR Nabisco shareholders before the buyout clearly benefited
greatly from efforts to take the company private. However, in addition to the
potential transfer of wealth from bondholders to stockholders, some critics of
LBOs argue that a wealth transfer also takes place in LBO transactions when LBO
management is able to negotiate wage and benefit concessions from current
employee unions. LBOs are under greater pressure to seek such concessions than
other types of buyouts because they need to meet huge debt service requirements.
Empirical studies suggest that employment in firms that undergo a leveraged
buyout does grow more slowly than for other firms in the same industry (Kaplan,
1989a; Muscarella and Vetsuypens, 1990). However, this appears to result from
the more efficient use of labor and the sale of nonstrategic assets following
the LBO. Lowenstein (1985) has argued that the tax benefits associated with
LBOs represent a subsidy of the premium paid to the shareholders of the firm
subject to the buyout. However, this subsidy is offset by the taxes paid by the
shareholders when they sell their stock (Morrow, 1988). If the LBO firm
actually is made stronger as a result of the transaction, taxes paid actually
may be higher than they would have been if the transaction had not occurred.
Furthermore, the eventual sale of the LBO either to a strategic buyer or in a
secondary public offering also will generate additional taxes.

 Case Study Discussion Questions

1. In your opinion, was the buyout proposal presented by
Ross Johnson’s management group in the best interests of the shareholders? Why
or why not?

 2. What were the RJR Nabisco board’s fiduciary
responsibilities to the shareholders? How well did they satisfy these
responsibilities? What could or should they have done differently?

3. Why might the RJR Nabisco board have accepted the KKR bid
over the Johnson bid?

 4. Explain how bondholders and preferred stockholders may
have been hurt in the RJR Nabisco leveraged buyout.

 5. Describe the potential benefits and costs of LBOs to shareholders,
employers, lenders, customers, and communities in which the firm undergoing the
buyout may have operations. Do you believe that on average LBOs provide a net
benefit or cost to society? Explain your answer.

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