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RJR Nabisco

On October 28, 1988, the board of directors of RJR Nabisco revealed that Ross Johnson, the company`s chief executive officer, had formed a group of investors prepared to buy all the firm`s stock for $75 per share in cash and take the company private. Johnson`s group was backed up and advised by Shearson Lehman Hutton, the investment bank subsidiary of American Express.

RJR`s share price immediately moved to about $75, handing shareholders a 36 percent gain over the previous day`s price of $56. At the same time RJR`s bonds fell, since it was clear that existing bondholders would soon have a lot more company.

Johnson`s offer lifted RJR onto the auction block. Once the company was in play, its board of directors was obliged to consider other offers, which were not long coming. Four days later, a group of investors led by LBO specialists Kohlberg Kravis Roberts bid $90 per share, $79 in cash plus preferred stock valued at $11.

The bidding finally closed on November 30, some 32 days after the initial offer was revealed. In the end it was Johnson`s group against KKR. KKR offered $109 per share, after adding $1 per share (roughly $230 million) at the last hour. The KKR bid was $81 in cash, convertible subordinated debentures valued at about $10, and preferred shares valued at about $18. Johnson`s group bid $112 in cash and securities.

But the RJR board chose KKR. True, Johnson`s group had offered $3 per share more, but its security valuations were viewed as ¬softer ­ and perhaps overstated. Also, KKR`s planned asset sales were less drastic; perhaps their plans for managing the business inspired more confidence. Finally, the Johnson group`s proposal contained a management compensation package that seemed extremely generous and had generated an avalanche of bad press.

But where did the merger benefits come from? What could justify offering $109 per share, about $25 billion in all, for a company that only 33 days previously had been selling for $56 per share?

KKR and other bidders were betting on two things. First, they expected to generate billions of additional dollars from interest tax shields, reduced capital expenditures, and sales of assets not strictly necessary to RJR`s core businesses. Asset sales alone were projected to generate $5 billion. Second, they expected to make those core businesses significantly more profitable, mainly by cutting back on expenses and bureaucracy. Apparently there was plenty to cut, including the RJR ¬Air Force, ­ which at one point operated 10 corporate jets.

In the year after KKR took over, new management was installed. This group sold assets and cut back operating expenses and capital spending. There were also layoffs. As expected, high interest charges meant a net loss of $976 million for 1989, but pretax operating income actually increased, despite extensive asset sales, including the sale of

RJR`s European food operations.

While management was cutting costs and selling assets, prices in the junk bond market were rapidly declining, implying much higher future interest charges for RJR and stricter terms on any refinancing. In mid-1990 KKR made an additional equity investment, and later that year the company announced an offer of cash and new shares in exchange for $753 million of junk bonds. By 1993 the burden of debt had been reduced from $26 billion to $14 billion. For RJR, the world`s largest LBO, it seemed that high debt was a temporary, not permanent, virtue.