Kkr Hears A New Word From Some Backers: `No'

To editorial writers and other critics, the 1988 buyout of RJR Nabisco Inc. was an epic greedfest, the quintessence of everything that was wrong about Wall Street during the 1980s. It was also a public-relations setback for RJR's acquisitor, Kohlberg Kravis Roberts & Co., which has been battling the backlash ever since. But only now is KKR facing judgment by those people whose verdict counts most: its financial backers.

Over the next several weeks, KKR's limited partners, who provide virtually all the equity capital KKR invests in deals, will decide whether to commit more money to the firm's war chest, which hasn't been replenished since the RJR deal. As KKR's fund-raising drive enters its sixth month, it seems assured of raising at least half the maximum of $2 billion it seeks. But the firm has run into resistance from some of its most important and long-standing investors.

For KKR the stakes are fundamental: Its fund-raising prowess is the very foundation of its franchise as Wall Street's preeminent promoter of the leveraged buyout. The outcome of the firm's latest drive--its first since 1987--will go a long way toward determining how much muscle it will be able to muster in the radically reformulated deal game of the early 1990s.

In many ways, KKR has altered its style and strategy to fit the new era of financial sobriety. Senior Partners Henry R. Kravis and George Roberts have acknowledged that the giant, highly leveraged, bust-up buyouts of the mid-1980s are a thing of the past. With admirable forthrightness, the buyout kings even have conceded that the profitability of LBOs will dwindle. But KKR seems determined to preserve the key to its own remarkable profitability: its lucrative fee system.

LITTLE FAITH. "We think KKR is still a premier buyout group, but its financing terms are outdated and problematic for their limited partners," says Scott Sperling, a partner at Harvard Management Co., which runs the university's large endowment fund and which has been a KKR investor since 1982. Without fee concessions from KKR, Sperling says, Harvard University is unlikely to reinvest. The same is true of the Wisconsin Investment Board, which has committed $225 million to KKR over the years. "KKR has done very well, but that doesn't mean it can just go on forever with the same approach," says Robert Zobel, Wisconsin's private placement director.

The most powerful of the dissidents is the New York State & Local Retirement Systems, which, with $45 billion in assets, is the country's second-largest pension fund. "Frankly, better terms are available elsewhere," says a spokesman for the New York fund, which currently has some $325 million invested with KKR. Negotiations between KKR and New York officials are continuing.

Fees are not the only issue--especially with KKR's public pension fund investors, which put up more than half of the $ 5.6 billion it raised in 1987. While public funds remain encouragingly flush, as creatures of government they are particularly sensitive to the popular backlash against LBOs. In several key states, big public employee funds are bumping up against portfolio limits on LBO investing and are loath to seek approval to extend them. Then, too, public officials are hard-pressed to defend the highly aggressive tactics KKR employed in RJR and other of its biggest 1980s deals.

Of the most immediate concern is the move KKR is making into "toehold" investing as LBO opportunities have declined. A few years ago, KKR began buying large positions in the stock of big public companies widely seen as takeover targets. While KKR downplays this new thrust as an "interim investment program," the sums involved are staggering. By the end of 1989 (the most recent results KKR has made available), the firm had made at least a dozen such investments, for a total of $1.7 billion. The largest of its current holdings is a 9.9% stake in First Interstate Bancorp.

In its investment in First Interstate, KKR so far has done nothing to cast doubt on its avowed intention of remaining a passive, long-term investor. But some investors worry nonetheless that KKR's toehold investing will be perceived as a technique of stampeding companies into transactions. They worry, too, that toehold investing will dilute profits from LBOs--and for good reason. At the end of 1989, KKR reported an annualized rate of return of 19.5%, well below its LBO average.

A FAN. The dissent in KKR's inner circle is insistent but muted, stopping far short of organized rebellion. While only a handful of investors have publicly committed to KKR so far, protracted decision-making is standard procedure in institutional-investing circles. Moreover, even some of the fund managers who want lower fees are appreciative of KKR's past performance. "They have done a hell of a job for us," says Howard J. Bicker, executive director of the Minnesota State Board of Investment, which is leaning toward additional investment.

The recent run-up in the stock market has bolstered KKR's cause, adding handsomely to the market value of many of its current holdings, including the largest, RJR Nabisco. Since stock in the restructured RJR began trading on the New York Stock Exchange two months ago, its price has more than doubled. KKR's plans to take Duracell International Inc. public have also excited investors.

KKR declined BUSINESS WEEK's request for an interview, citing regulatory restraints on public comments while it is raising funds. In refusing to cut its fees, KKR is gambling in effect that its old promotional magic remains intact. Says Sperling of Harvard: "I've told the people at KKR exactly what we think and their response has been quite logical: they say they are testing the market."

KKR established its fee structure in the late 1970s by dint of persistent salesmanship. Under its long-established arrangement with equity investors, KKR charges a 1.5% annual fee for managing the money invested with it and, more important, keeps 20% of any capital gains. In addition, the firm charges companies it acquires an investment banking fee.

Although KKR's charges initially were in line with its closest rivals, they exceeded the norm as the firm established itself as the preeminent name in LBOs. Its investment banking fee often topped the standard 1% even as the dollar value of its deals soared: On its four largest buyouts, KKR garnered up-front fees totaling $240 million. Meanwhile, KKR augmented its income handsomely by instituting divestiture fees and director's fees as well.

As KKR's income burgeoned, some investors have asked to share in its fee bonanza, but the firm has declined-- a refusal that rankles. At the same time, a number of investors have complained that KKR's charges are excessive and might tempt the firm to do unwise deals just to generate fees.

An even sorer subject at the moment is KKR's approach to computing its 20% profit cut. Overall, KKR actually makes substantially more than 20%, since it is not required to net losses in one deal against gains in another. Consider the hypothetical case where one KKR buyout generates $200 million in profits and another $300 million in losses. Although the outside investors take a $100 million loss, KKR gets $40 million by virtue of its 20% cut of the first deal. Some limited partners are demanding that KKR share in losses as well as profits.

Loss-sharing wasn't much of an issue the last time KKR raised money, in 1987. In recent years, though, KKR has lost its aura of invincibility. It sought Chapter 11 protection for Hillsborough Holdings Corp. and was forced into costly emergency restructurings of SCI Television Inc. and Seaman Furniture Co.

Despite these setbacks, KKR has no urgent need of additional financing. Its untapped equity financing commitments total $1.6 billion, which should go a long way in today's shrunken LBO market. Indeed, KKR hasn't made an acquisition since mid-1989, when it invested $325 million to assemble K-III Holdings, a new publishing company. That relatively small deal now looks like a harbinger. "We expect to see fewer very large deals in the future," KKR conceded in a report to its investors last spring.

AN EDGE? Why then is KKR out beating the bushes now? One reason is its bid, in conjunction with Fleet/Norstar Financial Group Inc., for failed Bank of New England Corp., which banking authorities are auctioning off at a minimum capital infusion of $750 million. An added measure of financial solidity might help give KKR an edge over other bidders.

More pertinent, perhaps, to the issue of timing is KKR's archrivalry with Forstmann Little & Co., Wall Street's second-biggest LBO sponsor and its most vociferous KKR critic. The announcement of KKR's plans to raise "supplemental" funds came not long after Forstmann launched its own fund-raising effort, which was completed in January. Forstmann added a fresh $1.4 billion, with some $200 million coming from the New York State fund. According to several of its investors, Forstman Little was able to raise funds without any changes in its fees. Forstmann Little now has a war chest of $2.8 billion, or $1.2 billion more than KKR has on hand.

Whatever KKR's motives in trying to gather funds in today parlous markets the firm is putting its prestige squarely on the line. For more than a decade, KKR has had no equal in LBO fund-raising. From 1978 to 1986, it raised $3.2 billion in five funds marketed mainly to institutions. At the height of the LBO craze in 1987, KKR outdid itself, assembling a bankroll of $5.6 billion.

KKR launched its latest financing campaign in November by announcing a $350 million commitment from its most loyal investor, the Oregon Public Employees' Retirement System. Another KKR stalwart, the state fund of Washington, quickly followed suit with a tentative pledge of $350 million. After this fast start, though, KKR bogged down. To date, Montana is the only other public pension fund to disclose a decision to reinvest with KKR. Montana committed $25 million, matching its 1987 investment.

'NERVOUS.' Although final approval is likely in Washington, signs of discord are apparent even in this KKR stronghold. State Treasurer Dan Grimm has requested a review of KKR's fees in time for the Apr. 11 meeting of the state investment board. What's more, for the first time a board member is opposing KKR. Gary Moore, executive director of the Washington Federation of State Employees, argues that the outlook for high-leverage investing is increasingly dicey and that the state already has too many of its assets--about 9%--invested with KKR. "We've gone far enough," Moore says. "As a fiduciary, I'm getting nervous."

Even some fund managers who profess loyalty to KKR are dismayed that Kravis and Roberts didn't encounter more resistance in the Northwest, where pension officials have acquiesced to KKR's fee demands. Says a pension executive of a smaller state: "I asked KKR if they'd discussed terms with the big investors. They said they had to some extent, but the terms are what they are: Take it or leave it. I would have thought the big investors would have tried to use their leverage to change the fees. We're just too small to do it ourselves."

Other states are nearing self-imposed portfolio limits on LBO investing. Late last year, the board of the Iowa Public Employees Retirement System decided not to sink any more money into LBOs for the time being. Illinois, which put $ 100 million into KKR's last fund, is fast approaching its 5% limit on "alternative" investments. Says Gregory C. Nagle, director of the Illinois State Board of Investment: "If we do anything, it would be with KKR, but right now we are undecided about further LBO investing."

In other key states, KKR's prospects are obscured by political job-shuffling. The director of the Massachusetts Pensions Reserve Investment Management Board was ousted recently and has yet to be replaced, causing considerable disarray at the MPRIM. In Michigan, a newly elected governor has replaced State Treasurer Robert Bowman, who was one of KKR's most outspoken supporters in the 1980s. Michigan contributed $413 million to KKR's last fund. Bowman's successor, Douglas Roberts, has prohibited his staff from commenting on pension-fund investing.

KKR's strongest sales pitch is its investment record. While many of its investors report average annual rates of return of 30% to 40%, it's difficult to assess accurately KKR's overall performance, given the complexity of its dealings and the skimpiness of its public disclosures. In this regard, KKR is not unusual. A 1989 study commissioned by the MPRIM noted: "Skeptics have not been convinced that LBOs yield as high an overall return to equity investors

as has been thought. They have pointed, rightly, to the remarkable paucity of data on LBO investment returns and to the questionable quality and reliability of data that do exist."

During its last fund-raising drive, KKR circulated a prospectus that projected a stunning 49% annual return to investors on buyouts done from 1982 through mid-1987. However, actual returns have fallen below projections. In an unaudited statement distributed in May, 1990, KKR listed these updated figures on annual returns to investors: 41.8% in the 1982 fund, 28% in the 1984 fund, and 29.6% in the 1986 fund. It did not attempt to calculate a return for its huge 1987 fund. KKR refused to provide more recent numbers to this magazine.

TOO SOON. Gauging the performance of KKR's last fund is especially problematic. Its biggest holding by far is RJR Nabisco, which has been recapitalizing almost from the moment the deal was done. By deleveraging, RJR has solidified its finances and brightened its operating prospects. However, it's still way too early to count the deal a success for KKR's investors. In rejiggering RJR, KKR pumped in another $1.7 billion in equity, doubling the original cost of the acquisition.

If KKR were to lose public pension fund backers, they would not be easily replaced. Very few states are newly diversifying into LBO investing or even contemplating such a move. One that has, Colorado, recently opted for Forstmann Little.

The largest pension fund of all--the California Employees' Retirement System--recently conducted a lengthy study of LBOs before deciding against investing. "I'm not sure that the term LBO will be valid in the Nineties as it was in the Eighties," says Basil J. Schwan, assistant executive officer of CALPERS. "Corporate restructurings will take shape with a lot less L and a lot less B. O." They may also take place with a lot less KKR.



Pleased with KKR but close to portfolio limit on LBOs


Has reached limit on LBO investments and will pass on KKR deals


State investment director, who backed KKR, has departed. A major new

commitment to KKR is less than an even bet


State treasurer, a big cheerleader for KKR, has been replaced. New treasurer

declines comment


Leaning in KKR's favor, but commitment is unlikely to equal 1987 investment of $140 million


Has invested $25 million more


One of KKR's biggest investors, but resisting KKR's demand for high fees, a

topic of controversy in several states. Got KKR's attention in making recent $200 million pledge to KKR arch-rival Forstmann Little


Decision to invest an additional $350 million prompts anti-LBO legislation and

a scathing AFL-CIO response


Undecided but considers KKR's high fees a non-issue


Investment board will vote on Apr. 11 whether to approve its tentative

commitment of $350 million. For the first time, the state employees union is

opposing KKR


Has $225 million invested with KKR but will not put up more without fee



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