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Monday, April 5, 1999

An Investment Opinion
by Alex Schay

Selling the Buyout

No, it wasn't an April Fool's gag. At the behest of buyout firm Kohlberg, Kravis, & Roberts (KKR), consumer products giant Gillette (NYSE: G) filed an S-3 on the first of April. The contents of the registration statement revealed that KKR planned to sell slightly more than half of its 51.3 million share stake in Gillette -- assuming the exercise of the underwriters' over-allotment option (which would put the offering at 29.5 million shares, or roughly $1.79 billion). Gillette dipped slightly today, falling $1 1/2 to $57 3/4 after reaffirming that first quarter results will not meet expectations.

KKR's 4.6% interest in Gillette reflects the queer lineage of equity ownership in America, and is also the only tangible link remaining to KKR's buyout of Duracell more than a decade ago. Perhaps the most interesting feature of the liquidity driven sale, however, is that it highlights KKR's status as a principal investor and not just a fee-collecting financial intermediary -- a focus that necessitates a long-term approach to investment.

Financial history of the 1980s is imbued with myth and lore, and having been dubbed "the decade of greed" by the popular press, the most common characterizations of the period invoke words like "junk," "predators ball," "bailout" and "raider," rather than language reflecting the august stewardship of assets (and rightly so). Often, the portrait of KKR in those years is painted with the same broad brush strokes that popularly define the decade -- but to put a finer point on the work, KKR really needs to be painted with a finer brush.

Jerome Kohlberg, one of the K's in KKR, is commonly credited with establishing the buyout as a specialized financial practice during his years with Bear Stearns. In a June 19, 1987 interview with the New York Times, Kohlberg noted that he "refined" the traditional bootstrap deal "by adding the role for management as owners." On top of this development, and perhaps what has become the most overlooked element of the KKR management buyout, was the fact that KKR in its role as financier simultaneously became a principal investor in the business. The vaunted "dealmakers" would end up committing themselves to a long-term engagement, where the success of the entire undertaking was predicated on working closely with management following the buyout. As one partner put it, "When the deal is closed the work begins." KKR's role involved less financial legerdemain and more operational blocking and tackling.

Of course, debt made it all possible. As George Roberts (of odd consonant fame) commented when asked why he was willing to part with conventional wisdom and use lots of the stuff, "because we couldn't afford them [the target firms] any other way." The logic was clear, KKR would invest in cash-rich firms that showed signs of "undermanagement." Executive managers would invest a substantial amount of their own net worth in the remaining equity. KKR would have a "governance function" and look to be an investor for five to seven years (while paying down debt), and then sell the shares for a capital gain.

For those having trouble with the basic buyout business model, here's an example provided by George Baker and George Smith in their book, The New Financial Capitalists:

"To see how this works in general terms, imagine an all equity company that is bought for $100 million. Before the acquisition, this company generates $10 million in cash flows, just enough to give shareholders a 10 percent return. The acquisition is financed with $90 million in debt and $10 million in equity. The company is then able, through improved operations, superior asset utilization, and careful capital investment, to increase cash flows from $10 to $20 million per year, without either increasing or decreasing the value of the assets. By paying no dividends, and by using this $20 million in cash flow strictly for debt service, this company can pay down the $90 million of debt (at an interest rate of 10 percent) in about 6 years. At the end of that period the company would still be worth $100 million, but it would now be all equity. In other words the original $10 million equity investment had been transformed into one worth $100 million, for a 47 percent compound annual rate of return."

Duracell turned out to be a classic example of this strategy. Acquired from processed food giant Kraft in 1988, Duracell's cash from operations soared by a compound rate of 17% from 1989 to 1995, thanks to strong technology investments and an unshackled Duracel management that was allowed to pursue an aggressive five-year plan (as well as one of the earliest high-profile EVA implementations). Duracell was sold to Gillette in 1996 in a swap that awarded 0.904 shares of Gillette for each Duracell share. After almost eight and a half years, KKR managed to realize a 39% compound annual return on its original equity investment. Adjusted for splits as well as the acquisition, the remaining Gillette shares now carry a cost basis of around $2.77 apiece for KKR.

Duracell turned out to be one of KKR's most profitable buyouts, and in its relatively short history controversy has swirled about a number of its other investments. For those investors interested in taking a look at the numbers on all of its deals, as well as a history of the firm, an excellent resource is the previously mentioned work, The New Financial Capitalists.

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