Book Review

On How the Sausage is Made

Beware the naked man who gives you a shirt.

African Proverb

$75! $90! $100! It sounds like a high-stakes used car auction, or an old-timey cattle auction like you might see in the Midwest. But these dollar-for-dollar antics actually took place in a tale about the creme-de-la-creme of Wall Street. In 1988, some of the world’s highest paid business people fought in smoke-filled rooms to acquire (and grow/dismantle) the recently combined RJ Reynolds-Nabisco behemoth.

Born out of incredible reporting at The Wall Street Journal, Burrough & Helyar’s “Barbarians at the Gate: The Fall of RJR Nabisco“, is a movie-like experience chronicling the rise, and ultimate fall, of F. Ross Johnson and the management team of RJR Nabisco in their attempt to quietly perform a leveraged buyout (LBO) of their own firm.

I wish I could write a long treatise on this book, it was that incredible. If you’ve only seen the movie, or talked about it around the water cooler, go read it immediately. Here, instead of trying to dissect the entire 500+page opus, I am going to focus in on one core part of the book: Johnson’s announcement of an LBO and the immediate frenzy to counterbid by ravenous Wall Street bankers.

LBO: What’s in a Name? Many readers will already know that, at its core, a leveraged buyout is simply a corporate acquisition where the transaction is fueled by a small equity boot and a large debt offering secured by the company’s own assets. But, as the saying goes, that’s using ten-dollar words when some ten-cent ones will do.

An LBO is just a mortgage (credit to the TV Movie of “Barbarians” for this great analogy). Private equity shops (like those of Henry Kravis and Ted Forstmann) put a down payment on a company, and large banks (like J.P. Morgan and Merrill Lynch) provide the mortgage. The only difference? The private equity shops don’t make the monthly payment, the company does. And here is where Wall Street of the Roaring 80s turn a homey campfire into a ten-alarm blaze.

Pedal to the Metal. There are plenty of excellent analyses of why LBOs became so big and easy to perform around the time of the 1980s. But the simplest way to describe it, using the mortgage example, is by pointing out that the down payments didn’t get bigger, the mortgages got easier and easier to get. Think of Chase or Bank of America. If you go to your local branch to get a mortgage, you will likely be swamped with months of paperwork, credit checks, collateral demonstration, and more. Now, imagine a well-tailored, good-looking young gentlemen shows up at your front porch and rings the doorbell. “Good afternoon, my name is Michael Milken,” he says, “I work with Drexel Burnham Lambert and I’d like to give you your next $1 million mortgage with only 3% down required!”

Suspicious? You should be! But this is what happened in the 1980s. With the postwar global economy in full gear, escape from the disastrous inflationary period of the 1970s, and interest rates at an all-time low, people in the developed world were running out of places to invest their savings. Rather than putting their money into CDs, the stock market, or tidy corporate bonds, individuals (and the pensions that represented them) began the hunt for yield and gave traders like “The Suave Salesman” Milken access to essentially unlimited funds.

But this alone would not have been enough. Imagine you have your $1 million mortgage from The Suave Salesman and make an offer on your neighbor’s house. There is no need for the neighbor to even contemplate your offer. People don’t have to sell their houses! And they don’t even have to give a reason.

But that’s not the way it works with corporations. Thanks largely to the dogged persistence of the Chicago School of Economics (hi alma mater!), the emergence of “Shareholder Primacy” meant that Boards of Directors always had to make decisions that would maximize shareholder value. So, this standard meant that Board of Directors would have to entertain (and typically approve) richly valued takeover attempts even if they would dismantle companies, cause thousands of people to lose their jobs, or ultimately end in bankruptcy because of such a punishing debt burden.

Value is in the Eye of the Beholder. $75! $90! $100! With The Suave Salesman funneling billions of dollars to any private equity firm on the block, what impediment does price become? Basically, it doesn’t. Which always begs the question, what is a price anyway? Seriously, why is RJR Nabisco trading in the $40-$60 range for years, and then with an overnight announcement becomes a $70+/share stock?

Well, as the adage goes, “Price is what the market will bear”. So, with financing not an issue, and the RJR Nabisco board obliged to entertain any compelling offer, a high opening salvo was launched. F. Ross Johnson opens his bid at $75, causing the stock to soar to $77.25 as traders anticipate the coming escalation. The immediate reactions to Johnson’s offer (as hilariously chronicled in Barbarians) show the folly of letting Wall Street play with unlimited funds:

[Eric] Gleacher [lead banker at Morgan Stanley] was leaning back in his desk chair when he saw the headline cross his computer screen. In a flash he swung forward and stabbed at his telephone console. “I don’t give a shit what you’re doing,” he barked. “Get down here right now.”… [They] were stunned as they stared at the screen. RJR? A deal? Without Morgan Stanley? Look at the price, Gleacher said. At $75, they quickly agreed, Johnson was stealing the company.

Jeff Beck [executive at junk-bond firm Drexel Burnham Lambert] was at Skadden Arps when he heard the news… Beck was floored by Johnson’s announcement. An LBO? Without Drexel? Without me? It made no sense… Beck was fuming. Lock and load! He simply had to talk to Johnson.

Now just as [Henry Kravis’s firm KKR] had carved out a territory for themselves, here came Peter Cohen, a man who probably didn’t know the difference between LBO and BO, claiming he had a right to do an $18 billion deal! Kravis couldn’t believe the ingratitude, the gall. One part of him wanted to teach all of them, particularly Peter Cohen, a very rough lesson.

The classic text on the concept of “Valuation” (a ten-dollar-word for “What’s this hunk of junk worth?”) is written by McKinsey. In business schools around the world, eager young MBAs gobble up this information so they can ace their case and launch a successful Wall Street career as the shrewdest negotiator ever! With one small exception: it’s largely bunk. Sure, DCFs are useful and all, but look at the quotes above. Given these reactions, do you think that the choice of round numbers to top competing bids was based on changes in fundamental valuations of the RJR Nabisco assets? Overnight, did the company find $3 billion worth of cash lying on the factory floor?

How the Sausage(s) Gets Made. With gas on the fire, value in the eye of the beholder, and the press covering (ahem, glamorizing) backroom professional and personal drama, what is left? Honestly, how the sausage gets made is a series of calls, documents, revisions, meetings, dinners, flights, and cab rides until the decision makers get comfortable with everything going on. As I often say around the office, “there is no magic spreadsheet”.

“Trust is the coin of the realm.” – George P. Shultz

One particularly funny passage demonstrates the importance of group cohesion toward building a strong business:

Time after Time, [Peter] Cohen [chief executive of investment bank Shearson Lehman Hutton] attempted to pull his friend [Tom] Strauss [executive of bond firm Salomon Brothers] off to the side for a heart-to-heart talk. Each time, Mike Zimmerman or one of the other Salomon bankers would trot out and join the conversation. Cohen began to think of the Salomon executives as sausages, linked together wherever they went.

Which is where this book reveals how disheartening the past was. When the reader looks at the matte inserts photographing the main players of the Barbarians at the Gate saga, all we see (with Linda Robinson the lone exception) are a plethora of white male faces. And this is why diversity is, in my opinion, a per se good thing. How the sausage gets made is not really about merit. The most well analyzed, best tackled plan in corporate M&A is often not the one that goes through. What matters is trust, storytelling, and general excitement! In order to build a diverse workforce, which has been shown to produce better corporate outcomes overall, junior employees need to see decision makers who resemble themselves and are trusted to tell the stories and build the excitement around weighty matters like a $20 billion leveraged buyout.

There is no doubt the talent to build these relationships and close these deals exists across all demographic and ideological spectrums. One can only hope that future business novels (perhaps chronicling the high-stakes drama of WeWork’s fall or Michael Dell’s massive privatization of his eponymous firm) will contain a more diverse cast of decision makers all working to build trust, consensus, and better outcomes.

The Pride Goeth Before the Fall. I could go on and on with the quotes, but the ultimate lesson of the book to me is this: when money is no object, the lights are flashing brightly to land on the airstrip, and the team is right, don’t get cocky. Everything is lining up in the bankers favors to take the company private at a huge price point, rake in massive fees, and rule the day. But at every turn, what could have been a simple negotiation is derailed by the insane egos of “titans” on Wall Street. As the bidding heats up, Ted Forstmann (who ultimately loses in his bid to Henry Kravis’s firm KKR), proclaims:

Fuck them. This is not going to be the next KKR deal… I know Ross Johnson. I know Jim Robinson. Henry Kravis will not run off with this deal.

Salomon Brothers, the bond trading firm that ultimately lost out to Drexel, puts ego before everything even though the company has barely done any LBO deals, let alone one of this size!

Through all the machismo, through all the greed, through all the discussion of shareholder values, it all came down to this: John Gutfreund and Tom Strauss [of Salomon Brothers] were prepared to scrap the largest takeover of all time because their firm’s name would go on the right side, not the left side, of a tombstone advertisement buried among the stock tables at the back of The Wall Street Journal and The New York Times.

And what of Henry Kravis? The mastermind who wins the ultimate Pyrrhic victory by bidding an outrageous $24.9 billion (more than $50 billion today) takes the better part of a decade to see the error of his ways in overloading his target company with huge amounts of debt:

In 1995 KKR ran up a white flag, swapping its RJR Nabisco stock for shares in another company it controlled, Borden. Whatever profits it made – and it would take advanced calculus to figure that out – were minimal. “You know what they say, ‘That which doesn’t kill you makes you stronger,'” Roberts says. “I know this firm today is far stronger, despite that experience. You learn from things like this.”


Happy Holidays everybody! Next up, I am going to review The Price We Pay, an investigation of what drives U.S.’s soaring healthcare bills by the passionate, and always certain, Dr. Marty Makary. Looking forward to discussing healthcare with you all in the New Year!

About “Executive Book Report”. This is a passion project brought to you by Thaddeus Diamond, a Computer Science and MBA grad currently working in the Kansas City area.

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