Chapter 3: Redefining Value in Owner-Managed Corporations
"When the deal is closed, the work begins."
-- Paul Raether, KKR partner
As the buyout movement gained momentum, the public response was anything but friendly. "The perception," said Robert Kidder, the CEO of Duracell, "is that buyout specialists are robber barons, that they come into a company, cut it to the bone, and then strip it of its vitality just to make money in the short term."
How else could it be? Leverage a company up to the hilt, and one had little choice but to sell off assets, cut jobs, and then run the remains into the ground. This kind of criticism reached a crescendo in the press and the halls of Congress toward the end of the 1980s, and KKR found itself right in the middle of the controversy.
Stung by charges that they were plundering assets, KKR partners wondered how their intentions and track record could be so misconstrued.
To Michael Tokarz, the criticism defied common sense. Imagine, he said employing an analogy favored by KKR partners, that like any other American, we go driving down the street looking at all the pretty houses.
We see a house and we like it, so we pay the owner a premium price. Like every other American, we borrow money to do it. The average American puts down maybe 10-20 percent to buy a house -- a highly leveraged transaction. We do the same thing. So now that we own this house, what do we do? We don't fix leaks? We don't paint it? We sell the garage? We let the whole thing go to the dogs?
And yet somehow, after a number of years, we sell this house for a compound rate of return of 40 percent to the next guy? How does that work?
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[T]he notion that had become popular in many financial quarters -- that a manager's only obligation was to the owners of capital -- was an argument that many KKR partners found academic. Again Tokarz:
We don't subscribe to that doctrine. The corporation has obligations to all of its constituencies -- suppliers, customers, employees, retirees, existing management, existing labor, the community, and of course, shareholders.
Now, who takes priority? Well, you can make arguments for anybody at any given point in time. We simply do the following: we make as many people in the company shareholders as we possibly can. If managers are really thinking of the shareholders' best interests -- including their own -- they will properly balance the concerns of all the constituencies relevant to the company.
If one constituency's interests gets seriously out of balance, the company will suffer; the shareholders will suffer; society will suffer.
Aligning Owner and Management Interests
. . . Value creation was not something that just happened. It did not occur from a transfer of title. It was not the result of exotic tax accounting. Nor was it the by-product of some invisible market mechanism. It was the product of good management -- good planning, good administrative systems, good operating regimens -- often requiring significant reforms over a sustained period of time.
Once a deal closed, therefore, both management and the new owners had their work cut out for them.
The nature of the relationship between owners and managers in a highly leveraged firm rested on a basic principle: make managers owners by making them invest a significant share of their personal wealth in the enterprises they manage, thus giving them stronger incentives to act in the best interests of all shareholders.
The idea of this management investment scheme was to assure that managers had enough "skin in the game" to care about their company, but not so much that they might be overly conservative. The downside had to hurt, but not too much; the upside had to be sweet.
The important thing was not simply to convert managers into shareholders, but to make them owners in every sense of the word -- "owners of the results of their decisions," as KKR partners liked to put it.
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Ultimately, the success of a buyout depended on a set of interrelated factors that linked ownership incentives to the financial structure of the buyout, on the one hand, and to monitoring mechanisms on the other. KKR always took care to describe the leverage in the buyout as a "financial technique," but it was more than that.
The leverage was inextricably linked to management performance in the post-buyout environment. If the price paid for a company were too high, the demands for debt repayment could undermine the best efforts of management to achieve long-term strategic and operating efficiencies.
At the same time, the debt imposed an ironclad budgetary discipline, compelling management to take the actions necessary to fix short-term problems. The ability of managers to operate under the "discipline of debt" demanded competencies often untested in normal corporate environments.
To ensure that everything was working in timely fashion, the buyout firm exercised continuous board oversight. Indeed, as KKR explained to its fund investors, "the ongoing monitoring role [was] equally as important as the initial structuring and consummation of the transaction."
"Partnership with Management"
There were new rules to the game following a management buyout, regarding both control systems (performance measurements and rewards) and the governance structure of the business (that is, the allocation of decision rights).
Executive managers, like investors, had to learn to focus on unfamiliar measures, such as return on market value and free cash flow, instead of earnings per share, earnings growth, and price-earnings ratios. Those who had worked as division heads of larger corporations now had to take responsibility for managing corporate reporting, tax and treasury functions, and for internal control systems formerly beyond their purview.
They also had to learn to operate more autonomously, and to take direct responsibility for strategic and policy decisions. Those executives who had presided over private companies had to learn to deal with a new set of owners, more sophisticated monitoring, and more rigorous control systems.
Managers in a post-buyout environment had no choice but to relearn their craft; their capital structure bound them to pay close attention to the debtholders whose loans had made the buyout possible. In a typical case, business plans during the first three years after the buyout had to take into account a rapid paydown of debt, especially the shorter-term senior debt, loaded as it was with irresistible regular service requirements overlaid with covenants.
This imposed a stringent discipline on management, forcing executives not only to keep costs down, but also to divest any business that might fetch a price higher than the value they had placed on it. Every budget projection -- from growth targets to marketing plans, to new capital outlays, to research and development, to staffing and compensation -- now had to be more than the kind of loosely enforced intellectual exercise that budgeting had become in most large public corporations.
The strict "discipline of debt" allowed for no slack, no surprises, no deviance. If problems lurked, candor was crucial. Under buyout conditions, management became transparent.
Since managers had to focus on the longer-term interests of the shareholders, they had to avoid the temptation to cut costs for the sake of cutting. So long as cash flow from operations and divestitures remained healthy, and stayed within the bounds of what was projected during the structuring of the buyout, there was no conflict between long-term investment and short-term debt reduction.
Cut costs where appropriate; invest and build where the prospects for value creation were good. Indeed, the structure of the buyout set conditions that encouraged management to satisfy debtholders in the short run while building equity for the future.
KKR attempted to ensure this through the role its partners played as corporate directors, where owner-manager relationships were cemented. What KKR came to call its "partnership with management" was no idle phrase, no pitch designed merely to woo managers into a state of ownership.
Its partnership with management was nurtured in the bidding process -- when KKR discussed with the executives of target companies the entire range of issues relating to strategy, operations, and management equity participation -- and was made good after the buyout through the mechanism of the buyout board.
The Buyout Board
Board monitoring under buyout conditions involved considerably more effort than what had normally passed for fiduciary oversight. On the one hand, KKR wanted to avoid the pitfalls of meddling in the managerial process; good managers demanded (and deserved) operating autonomy. The first rule for KKR directors was to respect the proposition that managers be left to manage, or, as Henry Kravis put it: "Management and KKR buy companies -- they become partners, but ultimately managers make things work."
On the other hand, value creation under the stringency of buyout conditions required vigilance and more. The KKR-controlled board would serve as a conduit to those who could provide critical tax and legal advice, function as a critical forum for strategic ideas, take the lead in financial restructurings, and help managers provide information to fund investors and to public investors following an initial public offering.
In the process, KKR partners had to labor in their capacity as board members to a degree unprecedented in contemporary corporate America.
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The mission of the buyout board, from the first day of its control over a company to the last, was to ensure the creation of long-term value. This objective had to be managed carefully, since KKR often found itself acting as a buffer between managers with visionary goals and institutional fund investors with less-than-patient appetites.
Managers had to watch their costs, but they also needed support for their business-building strategies -- funds for capital investment, for research and development, for marketing. "We are long-term players," KKR partner Perry Golkin explained:
We can't manage quarter to quarter with respect to our fund investors. We often get pressured to issue monthly reports when we don't even want to do quarterly reports, because it misses the point philosophically. We still won't value the privately-held companies more than annually. If the plan is to build value over time you think about things differently; you have to be patient.18
KKR saw to it that managers were managing every day to make the major changes, the incremental improvements, and the investments necessary to maximize longer-term shareholder value. How managers accomplished these tasks was left to them to decide; KKR was loath to interpose its views on strategy or operating philosophy. Accordingly, serious tensions in the boardroom were rare. Interviews with KKR partners and company CEOs alike reveal little conflict.
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"The fact that managers are so heavily invested financially in their businesses takes care of more than 90 percent of the problems," Stuart said. "The rest, we simply work through."
Board governance in a KKR corporation did not rest on a quarterly or monthly meeting but was a weekly, sometimes daily, series of conversations between KKR and management. This put a heavy burden on KKR partners to become continuously active board members as well as dealmakers.
In general, directors were most heavily engaged in governance during the initial three years or so after a buyout, when the debt burdens were most severe and when the opportunities for, and risks of, managerial difficulties were greatest. Afterwards, a lot depended on where a company was in accomplishing its strategic and financial goals and what kinds of problems it had encountered in doing so.
Financial strategies commanded the most attention. Merger and acquisition activity would send KKR board members into high gear, as would times of legal or financial exigency.
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In sum, management decisions were to be examined, questioned, and even debated, but rarely overruled. KKR exercised a board's authority to review and help implement strategic financial decisions. It provided advice on accounting and control systems. It insisted on continuous and interactive discussions with management.
It did, in short, what corporate board directors are supposed to do; but it did not dictate corporate strategic or operating decisions or meddle with their implementation. And KKR boards proved to be willing investors in management strategies. Capital expenditures, investments in research and development, and employment were generally sustained or increased over pre-buyout levels in KKR companies. Charitable contributions and community involvement were also encouraged.
Ongoing communications -- candid, informal, and fluid -- better enabled KKR to grasp the changing realities of its holdings while providing managers opportunities to get their ideas heard, their plans critiqued, and their strategies ultimately represented and defended to KKR's limited partners.
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Posted with permission of Cambridge University Press. Copyright George P. Baker and George David Smith 1998. The full book can be purchased at this site: www.cambridge.org/us or at http://www.cambridge.org/us/catalogue/catalogue.asp?isbn=9780521642606