Megabillion buyout gives Wall Street pause
Boston — How high is the sky? How far might the fall be? Those are questions some Wall Street professionals are asking as they try to gauge the impact of the biggest debt-financed corporate buyout in history.
Henry Kravis and George Roberts, two New York City leveraged-buyout specialists, put themselves in the record book Wednesday by winning a bidding war that obligates their company - Kohlberg, Kravis, Roberts & Co. - to pay more than $25 billion for the tobacco-food conglomerate RJR Nabisco. The battle with RJR management was notable for its titanic clash of egos, as well as the huge sums involved. Most of the financing for the deal, up to $22 billion, could in theory be borrowed, though details of the agreement are still unknown.
At almost twice the size of the previous largest merger, between Chevron and Gulf Oil companies ($13.3 billion in 1984) the deal to buy RJR Nabisco will be financed mostly through borrowings from a syndicate of banks, and from high-yield bonds, known as junk bonds.
``I think perhaps its very size has made a number of financial institutions pause for a moment,'' says John Castle, president of Castle Harlan Inc., a New York City merchant banking company. ``We're talking about huge financial commitments here.''
Observers believe Wall Street, like a large python, will spend a considerable period assimilating this financial lump. Sometime over next 30 to 60 days this deal will be ``digested,'' Mr. Castle says. ``At the end, there will be other deals,'' he says.
But whether more and possibly bigger mega-deals are on the way is uncertain. In some ways, RJR Nabisco was the perfect candidate for such a buyout, with recession-resistant, highly profitable consumer product businesses that can easily be cut apart and sold off. Other companies, like IBM or Sears, Roebuck, might not be so easily dismembered to pay off debt.
``RJR is an unusual case that may not be applicable to any other situation,'' says Clinton Mayer, an analyst who follows the company for Bear, Stearns & Co., a New York brokerage.
A recent Prudential-Bache report listed 18 different food industry segments within RJR Nabisco including cookies and crackers, cereals, pet food, Planters Peanuts, etc. Total market value of the segments was pegged at $11.2 billion.
If those food companies could be sold rapidly, debt in the deal might be reduced to the $10 billion range - still a heavy load. The remaining RJR tobacco operations would have to hunker down for years to come.
``The company will still be up to its eyeballs in debt,'' says James Grant, editor of the Grant Interest Rate Observer, an industry newsletter. ``They may also find they have trouble getting rid of the food operations, and the cigarette business is not without its liabilities.''
With interest rates rising somewhat, there is concern about whether highly leveraged companies can survive during a recession. Though people still buy cigarettes in a recession, rising interest rates could push interest payments beyond the company's ability to pay. KKR ``believes they'll be able to sell off the pieces of RJR Nabisco before something bad happens,'' says Warren Law, a finance professor at Harvard Business School.
Rising corporate debt levels, he says, have made a number of United States companies vulnerable to recession. ``We have not had any shake-out since 1982,'' Mr. Law says. ``Inevitably there will be another downturn.''
Law cites computer simulations at the Brookings Institution that illustrate the effects of a recession on highly leveraged companies. If interest rates were at levels of the last recession, some 10 percent of Fortune 500 companies could theoretically be insolvent, because of increased debt loads, he says.
Some observers believe Congress may well act in the spring to cut the tax loophole that allows companies to deduct interest payments on their borrowings from their corporate income tax. And other actions might be forthcoming.
``A lot of people are questioning whether it is desirable for a company to be taken over and cut up - or to have a lot of debt piled on it,'' says A.A. Sommer, a partner with Morgan, Lewis, Bockius, a Washington, D.C., law firm. ``Corporate debt will be a prime concern of the next Congress.''
Paul Giovacchini, an associate at John Hancock Capital Growth Management in Boston, says he is worried about increased regulation. The deal ``will further heighten awareness of increased debt load in some of the leveraged companies,'' he says. ``With the prime rate up, there is going to be concern about these companies' ability to operate in a recession.''
Another reason the deal might snag legislators' attention is the fact that RJR Nabisco's consumer products are so well known.
``It's one thing when it's a machine tool company that's being cut up,'' Mr. Giovacchini says. ``It's another thing when the deal involves the company that makes your crackers and cookies.''
10 largest US acquisitions KKR's buyout of RJR/Nabisco is nearly double value of the largest previous deal Companies Cost in billions Year KKR buys RJR Nabisco* $25.07 1988 Chevron buys Gulf Corporation 13.4 1984 Philip Morris buys Kraft 13.1 1988 Texaco buys Getty Oil 10.1 1984 British Petroleum buys Standard Oil 7.9 1987 DuPont buys Conoco 7.4 1981 Campeau buys Federated 6.6 1988 General Electric buys RCA 6.4 1986 US Steel (now USX) buys Marathon Oil 6.2 1982 KKR buys Beatrice* 6.2 1986 *Leveraged buyouts; others are takeovers or mergers Source: AP
KKR's 10 biggest deals Kohlberg, Kravis, Roberts & Co., with its winning bid of $25.07 for RJR Nabisco, has established itself as one of the most aggressive takeover companies
Value of deal
in billions Year Company of dollars completed RJR Nabisco $25.07 1988 Beatrice Companies 6.10 1986 Safeway Stores 4.20 1986 Owens Illinois 3.70 1987 Storer Communications 2.50 1987 Jim Walter Corporation 2.43 1987 Macmillan 2.36 1988 Storer Communications 1.98 1985 Duracell 1.80 1988 50% of Union Texas Petroleum Unit 1.70 1985 Source: AP; Wall Street Journal
Mounting junk bond debt High-yield bonds have grown from being a tool for small and medium-size companies to raise capital into a prevalent method of funding mergers Year Bond Amount
issues in billions 1980 45 $1.374 1981 38 1.284 1982 58 2.520 1983 98 6.435 1984 185 14.111 1985 184 15.066 1986 212 32.926 1987 195 29.043 1988* 121 20.500 *As of Oct. 21 Source: IDD Information Services