RJR's Ghost Haunts Buyout Business - WSJ

History is repeating itself in the private-equity business.

Twenty years ago this week, Kohlberg Kravis Roberts & Co. won the historic battle for tobacco and cookies maker RJR Nabisco. What was then the largest leveraged buyout came to symbolize the frenzied deal-making of 1980s Wall Street, immortalized in the book "Barbarians at the Gate."

RJR was among the least successful deals in KKR's 32-year history, squeaking out a negligible return over six years. "You know what they say, 'That which doesn't kill you makes you stronger,' " said George Roberts in an afterword for a 20th anniversary edition of the book. "You learn from this."

But did they? Today many of the large LBOs struck during the buyout boom of 2006 and 2007, including a few done by KKR, look to be heading for the same outcome as that landmark deal. That means the buyers may never see their original deal price, or may spend years fighting to break even.

Despite the audacious size and complex financial structure of leveraged buyouts, their fate is often driven by a basic investment principle: A company's original purchase price is the key determinant of returns. And in 2006 and 2007, private-equity firms made an unprecedented number of investments at sky-high valuations that could take years to recoup, draining returns along the way.

Nine of the 10-largest U.S. LBOs in history were announced between July 2006 and July 2007, and several have already seen their equity investments severely impaired. Like RJR, many of these deals were high-stakes auctions that drove up acquisition prices, forcing buyers to pay prices for companies well in excess of comparable public companies.

Bain Capital and THL Partners announced a deal to acquire radio giant Clear Channel Communications for $19.4 billion two years ago, which was finally completed this spring for about $18 billion; since then, stocks in radio companies have fallen some 70% or more. Apollo Management and TPG led the acquisition of casino operator Harrah's Entertainment for $17.3 billion, a deal that several owners now value at half that price. Four large buyout firms made a bold bet paying $17.6 billion for Freescale Semiconductor. Today, with the semiconductor business in decline, Carlyle Group, one of Freescale's owners, has marked its holding at 50 cents on the dollar.

Buyout shops still put on an optimistic face. As they see it, they've got flexible financing structures that allow them to ride out nearly any storm. But while those structures might allow these debt-heavy companies to make it through even a deep recession, a key question remains: What will these deals return to their investors?

Running their companies in a recession, private-equity owners are being forced to retrench, cutting costs to maintain the cash flow that services their debt loads. For instance, NXP Semiconductors, a Dutch company for which KKR led an $8.2 billion deal for an 80% stake in 2006, recently announced a major restructuring that will result in plant closings and 4,500 layoffs.

Problem investments such as NXP call to mind KKR's issues with RJR. In 1990, to save the deal, KKR plowed more of its investors' money into the company. It took six years to leave RJR, whose businesses soured after KKR acquired it. In 1995, it exited from the deal by exchanging RJR stock for KKR-owned Borden, barely scratching out a single-digit annual return on its $3.1 billion investment.

That is a puny return compared to the annual rate of return of some 20% targeted by private-equity firms. Some funds also compare themselves to the Standard & Poor's 500-stock index, telling investors they will outperform the S&P by at least two percentage points, even after fees. But these modeled returns have never been tested by a one-year drop in the S&P of 44% and followed by what's likely to be a deep recession.

Indeed, 1990, the year it invested in RJR, is the only year the firm generated negative returns -- until this one. Mr. Roberts recently acknowledged that 2008 would be a money-losing year for KKR investors.

KKR learned a few things from RJR, among them the importance of portfolio diversification. RJR comprised about 58% of KKR's 1987 fund, while the largest percentage of any one investment in the 2006 fund is 13%.

And several large recent deals, made as more-conservative investments heading into a recession, are performing well. KKR's $45 billion co-purchase of Texas utility TXU in is viewed as a core long-term holding not meaningfully correlated to the economy. And KKR says its $22 billion acquisition of British pharmacy chain Alliance Boots has so far validated its thesis of owning a market leader in a defensive industry.

If these deals meet KKR's expectations, at least one industry watcher thinks they'll be exceptions. In an article to be published in the Journal of Economic Perspectives, Steve Kaplan, a University of Chicago business-school professor, finds that private-equity firm returns are low when investments in and commitments to private equity are high. According to Mr. Kaplan, those historical relationships indicate these firms will be unlikely to exit from these large deals at valuations as high as they paid for them.

Others say that's not so bad in the current investment environment. "While many of these deals might generate only a 5% or 6% return for their investors," says Carl Thoma, a 30-year private-equity veteran with Thoma Bravo, "at least it's better than having owned AIG stock or a Lehman preferred."