The LBO of RJR Nabisco: How Has Private Equity Evolved Since the 1980s?

by Louis Paget, Marlon Walde, and Nikolai Verbov

Introduction

Private Equity (PE) as we know it today primarily revolves around one practice, the so-called leveraged buyout (LBO). The LBO is a highly leveraged company takeover within the framework of a structured financing. The use of debt reduces the overall cost of financing, due to its lower cost of capital compared to equity, and thus increases the return on equity (ROE) for the investor.

The LBO dates back to the purchase of the Pan-Atlantic Steamship Company and Waterman Steamship Corporation in 1955 by McLean Industries Inc. for a price of $49m. The following LBO boom of the 1980s was initiated in the 1960s by a group of investment bankers, most notably Jerome Kohlberg Jr., Henry Kravis and his cousin George Roberts. Working as corporate financiers for the investment bank Bear Sterns, they started a series of investments defined under the term “bootstrap”. Many founders of smaller companies were looking for attractive exit opportunities, but since they were too small to go public and did not want to sell to one of their competitors, many of them saw an external financial investor as the ideal solution.

In 1976, Kohlberg, Kravis and Roberts left Bear Sterns to form the LBO fund KKR. This ushered in the golden era of PE in the 1980s, culminating in the 1989 acquisition of RJR Nabisco, arguably the most spectacular LBO in history.

The LBO of RJR Nabisco

RJR Nabisco, Inc. was an American producer and distributor of food and tobacco products. At the beginning of the 1980s, the company ranked among the 20 largest companies in the country, but in the summer of 1988, the price of RJR’s stock was stagnating around $55 a share. In order to avoid negative headlines due to the struggling share price, the CEO at the time, Ross Johnson, and his management board announced a bid of $75 per share to take the firm private in a management buyout.

While searching for financiers, Johnson had also spoken to Henry Kravis, which brought RJR to the attention of KKR. Johnson, however, wanted to retain control in the company, which was not possible with KKR as a partner. He and his management team therefore decided to work with the investment bank Shearson Lehman Hutton. Since RJR was a very attractive LBO candidate due to its steady growth and low capital expenditures, KKR entered the fray with a $90 bid of their own within days of the management’s offer. By the end of November, after multiple bidding rounds, KKR emerged from the ensuing bidding process with an offer of $109 a share, or $25bn total. Even though the management team had offered $112 a share in the last round, the board of RJR Nabisco decided in favour of the KKR offer, considering it more secure.

After the buyout, the tobacco business proved not to be as good a cash cow as the buyers anticipated due to price wars among cigarette companies and tobacco litigations. Those problems hurt RJR Nabisco more than its competitors, since it did not have the financial flexibility to invest in promoting its products and was forced to cut back on promotional spending. This was mainly due to the high debt load the company was burdened with through the LBO.

Furthermore, RJR Nabisco divested multiple divisions, used the additional cash flow to pay down larger chunks of debt, eventually going public in 1991. The company stopped operating as a single entity in 1999, but both RJR (R. J. Reynolds Tobacco Company) and Nabisco (now part of Mondelēz International) still exist.

Given the strong contrast between the RJR buyout and the transactions we observe today, we decided to take a closer look at the drivers of the rise of the LBO in the 1980s and how PE has evolved over time.

Changes in Returns and Financings

The PE industry has undergone massive changes since the 1980s, moving from a niche and controversial industry to a major asset class. One of the main characteristics of the sector back in the 1980s was the use of excessive leverage. This method was seen as the most efficient way to maximise returns on equity. An essential part of the debt used during this first wave of LBOs came from a newly created instrument, high yield bonds, also known as junk bonds, rated below investment grade. According to Opler and Titman, from 1979 to 1989, more than 2000 LBOs had a combined value exceeding $250bn. KKR for example, employed 87% debt financing for its $25bn RJR Nabisco buyout, which was considered the industry standard at the time. This acquisition strategy presented high risks: any liquidity issue from the acquired company could lead to a potential default due to the disproportionate amount of debt. Analysts soon warned against adverse economic conditions which could lead to numerous bankruptcies. Indeed, from a sample of 83 LBOs analysed between 1985 and 1989, Kaplan and Stein (1993) reported a bankruptcy rate equal to 11%, while this number was only 3% from 2006-2007. Another consequence of the massive use of debt to finance LBOs was an inflation of prices. The increasing use of LBOs led numerous buyers to outbid each other to earn a slice of the profits, and this competition produced overpriced transactions. Despite the negatives, investors were still attracted to this new method, mostly thanks to the high returns: Preqin reported a weighted average IRR of 30.9% for the North-American buyout funds in 1984.

The modern PE industry is characterised by lower profits. Kaplan, Harris and Jenkinson (2014) indeed demonstrated that post-2005 buyout funds’ performance had not significantly exceeded the stock market’s performance. Moreover, a key aspect of recent returns is the important difference between top and bottom PE firms’ performance. According to the three authors, from 1994 to 2010, first quartile funds had average Public Market Equivalents over two and a half higher than fourth quartile funds. The lower and disparate performance can be explained, among other factors, by the increasing competition in the PE industry. More and more newcomers were indeed attracted by the historically high returns and the access to the high-yield bond market. In 1980, only 14 LBO funds were operating according to data from Preqin, against more than 18000 PE funds reported by the Securities and Exchange Commission in 2021.

Changes in Compensation Terms

Another notable evolution of PE over the last decades was the change in compensation terms. In the early 1980s, incentive compensation for fund managers was calculated on a deal-by-deal basis, as opposed to the fund-based compensation we see now. General Partners (GPs) collected their incentive fee on each deal, usually around 20% of profits. This meant that if the fund made a profit of $1m on each of its first two deals, GPs would collect $200,000 in fees from each deal. While this might seem to be perfectly reasonable at first, the flawed nature of this system became apparent when a fund lost money on an investment. If for example the fund made a profit of $1m on its first deal and a loss of $1m on their second one, the GP would still collect $200,000 in incentive compensation while the fund did not yield any returns for investors. This was perceived as highly problematic by investors for several reasons. As depicted in the numerical example above, GPs could be entitled to receive more than the 20% fee on fund performance laid out initially, as long as a few deals would turn out to be highly profitable. Given these findings, GPs were incentivized to pursue highly risky deals, as seen by the RJR Nabisco buyout, as well as to abandon poorly performing portfolio companies earlier in their lifecycle. Fund managers could still earn lucrative fees on a few deals, even if overall fund performance was negative.

The inherent incentive misalignment between investors and GPs would ultimately lead to the adoption of fund-based compensation, which was further fueled by the increasing popularity of the asset class and transition to a more institutional investor base in the 1990s. This aggregated system of compensation netted each investment of the fund against each other and calculated the incentive fee on overall fund performance, mitigating the shortcomings of the older system. Furthermore, today we observe so-called hurdle rates, a minimum return the fund has to clear before GPs become eligible to lay claim on their incentive fee, further aligning fund managers and investors interests. While this is perceived to be a fairer system to investors, it is not without its flaws. As average incentive fees declined, the importance of fixed compensation, i.e. management fees, increased. Inadvertently, this meant that fund performance, while still important, was responsible for a smaller part of generated fees. GPs could increase their compensation by growing their AUM fee-pool, as opposed to generating excess returns. While the growing popularity of PE and tighter restriction on the use of leverage are likely to have had a more significant impact on the muted performance of the asset class post 1980s, the effects of the revised compensation structure should not be neglected.

Conclusion

Given our analysis, we can conclude that the rising popularity of LBOs in the 1980s was both a function of cheap financing and the novelty of the asset class. Being a niche asset class in those years, funds could get away with using excessive amounts of leverage to boost returns, competition was few and compensation structure was weighted heavily in favour of the GPs. These attributes made the asset class highly lucrative, fostering the creation of new funds which aimed to compete in the same space, driving down excess returns. At the same time, the PE client base transitioned to more institutional investors, marking a shift in incentive compensation for GPs. Allinging investors’ and GPs interests more accurately, this led to a less risky investment behaviour of the funds, which can be observed in a significantly lower percentage of bankrupt investments. While these developments lead to overall lower returns, they are simply the effects of a maturing industry, marking the end to the reckless investment behaviour leading to RJR Nabisco’s downfall.