24 RJR Nabisco- A Case Study of Complex Leveraged Buyout - Financial Analyst's Journal

by Allen Michel and Israel Shaked

RJR Nabisco: A Case Study of aComplox Lovoragod Buyout

Several features of RJR Nabisco made it a particularly attractive LBO candidate. Itsoperations exhibited moderate and consistent growth, required little capital investment andcarried low debt levels. Its problems—a declining return on assets and falling inventoryturnover—appeared fixable. And it offered significant break-up value.

Valuing RJR's equity at the time of the LBO requires detailed knowledge of the company'soperations and extensive number crunching. The analysis is obviously quite dependent onthe assumptions made about cash flow in the post-LBO period, as well as the long-term,steady-state growth rate. Nevertheless, the figures suggest that, even assuming a high, 5 percent level of steady-state growth, RJR's cash flows would have to grow at a rate of at least18 per cent per year to justify KKR's bid of $109 per share.

RJR's board played a prominent role in the bidding process. By setting the bidding rules,the board successfully minimized the possibility of collusion and thus increased potentialgains to stakeholders. The decision to accept KKR's offer over RJR management's higher bidappears to reflect the board's concern for employees and existing shareholders.

BOTH THE POPULAR press and the aca-demic press have devoted extensive cov-erage to leveraged buyouts, but neither

has devoted much attention to analyzing thefeatures of a specific LBO.̂ The RJR Nabiscotransaction warrants particular attention. Notonly is it the largest LBO on record, but it alsofeatures a particularly wide range of sophisti-cated players, a complex set of innovative finan-cial instruments, and a challenging valuationprocess.

This article describes the RJR transaction. Itgives a brief history of the company, exciminesthe reasons why RJR was an attractive LBOtarget, provides a valuation of the company,analyzes the bidding dynamics, and describesthe role of the board in determining the winningbid.

Historical PerspectiveIn many respects, RJR was a pioneer. It antici-pated the increasing popularity of tobacco con-sumption, and in 1913 made a risky marketing

1. Footnotes appear at end of artide.

move, introducing four brands simultaneously.The strategy worked well. Among the newbrands was Camel, a name brand that changedthe company's history. In 1914, RJR sold 425million Camel cigarettes; seven years later itsold 18 billion. The combination of creativity onthe production side and a well developed ad-vertising campaign yielded a solid 50 per centmarket share.

During the depression years, RJR was hurt bycheaper brands. But it was not ready to give up.It introduced the single-piece folding carton andmade further improvements in packaging andwrapping. In 1935, the cigarette war ended withCamel regaining the number-one position it hadlost in 1929.

Though Camel retained its leadership for 15years, the post-World War II era was veryturbulent, primarily because of three factors.First, the advent of television introduced a newadvertising medium. Second, filter-tip cigarettescreated the first significant tobacco-market seg-mentation. Third, health concerns raised con-troversy over tobacco consumption.

Responding to increased competitive pres-

HNANCIAL ANALYSTS JOURNAL / SEPTEMBER<KrrOBER 1991 D 15

Table I Selected Financial Data

I. INCOME STATEMENT ($MILUON)TobaccoFood SalesTotal SalesTobacco Oper. IncomeFood Oper. IncomeTotal Oper. IncomeDepredationEBITInterest Exf>enseNet Income

Q. BALANCE SHEET (SMILUON)Total AssetsLong-term DebtWorking Capital

ra. OTHER FINANCIAL DATACapital Expenditures ($million)Return on Equity (%)Return on Assets (%)Asset TurnoverInventory TurnoverDividend Payout (%)Common Stock Price Range:

HighLow

No. Common Shares (mill.)

1985

5,4226.200

11,6221,843

5492,392

3541,949

3371,001

16,4145,6281,617

94626.0415.460.92

10.0131.20

3524%

258.57

1986

5,8662236

15,1021,659

' 8202,479

6052,340

5651,064

16,7015,5141,329

1,02219.0314.130.919.74

39.30

55Ve31

250.40

1987

6,3469.420

15,7661,821

2152,736

6522,304

4891,289

16,8615,6811,717

93620.7813.730.945.08

37.30

71 Vs34 Va

247.36

1988

7,0689.888

16,9561,92412153,139

7302,848

5791,393

16,8955,2621,795

1,14217.1111.501.003.92

36.47

94y254%

223.52

Source: December 6, 1988 prospectus.

sures, RJR responded with four strategies. Itdifferentiated its products. Simultaneously, itdiversified into non-dgarette products. It alsoincreased its focus on overseas markets, wheredgarette growth was increasing at double-digitrates. At the same time, it addressed increasinghealth concerns at home.

RJR as a Potential LBORJR Nabisco was a particularly attractive LBO

candidate. First, it exhibited steady growth unaf-fected by business cycles. High growth and incon-sistent growth often present unacceptable riskswhen it comes to leveraged buyouts. Highgrowth requires a significant investment ofworking capital, whereas inconsistent growthmay threaten cash flow. Successful LBOs aregenerally characterized by both low businessrisk and moderate growth.

RJR's unlevered beta, representing its busi-ness risk, was 0.69. In other words, the firm wasrelatively insensitive to maricet-wide fluctua-tions. Both its tobacco and focKi operations werenon-cyclical and projected to have reasonablyslow growth rates. Although the growth rate ofthe tobacco unit was a robust 9.8 per cent andthe growth rate of food operations was 3.5 percent in the pedod between RJR's purchase of

Nabisco Brands in 1985 and the buyout an-nouncement, most analysts had forecast a sig-nificantly slower long-term tobacco growth rateand a somewhat slower growth rate in foodoperations.

RJR had low capital expenditures. Neither of itsbusinesses required much capital investment.Indeed, as Table I shows, in each of the threeyears following the Nabisco Brands purchase,less than 7 per cent of the firm's revenues werecommitted to capital investment. Furthermore,the firm was able to avoid the high-technologyinvestments necessary in many industries,which require a significant R & D commitmpntto remain competitive.

The firm had a low debt level. In an LBOsituation, new management often takes advan-tage of the debt capacity of the firm's assets,hence looks for low debt in the target firm. Inthe ca§p of RJR, the pre-LBO ratio of long-termdebt to assets was approximately 30 per cent.This offered significant opportunity for debtexpansion following the LBO, especially whencombined with RJR's low systematic risk.

It is interesting to note that some studies havedetermined that LBO target firms often exhibithigher debt levels than their non-target counter-parts.^ TTiese high pre-LBO debt levels may

FINANCIAL ANALYSTS JOURNAL / SEFimiffiR-OCTOTHl 1991 D 1 6

Table II RJR Break-Up Value

Food OperationsU.S.:

Nabisco cookies and crackersCanned vegetablesCanned fruitsReady-toeat and hot cerealsPlanter's peanutsLifesaversCandy barsBubble gumMargarineFresh FruitOrtega Mexican foodA-1 Steak SauceMilkbone dog biscuits

IntemationaiMiscellaneous foods

Total FoodTobaccoTotal Estimated Break-up Value

Value per Share:Break-Up Value—Long-Term DebtEquity Value-i-Numbe '̂ of Shares

Break-Up Value Per Share

$5 bin.MOmiU.300 mill.750-$l biU.800-900 miU.400-500 mill.300 miU.200 miU.200-300 mill.700 mill.150 mUl.100-150 mill.200 mill.

$2.5-3 bill.12.1-13.1 bUl.12.5-13 bUl.24.6-26.1 bUl.

24.6-26.1 biU.4.6 bill.20.-21.5 bUI.234 mill.$85-92/share

Source: R. Alsop, A. M. Freedman and B. Morris, "RJR TakeoverCould Hurt Marketers and Consumers," Wali Street Journal, Decem-ber 2, 1988.

have appealed to buyers to the extent theysuggested more stable operating cash flows.

RJR's problems appeared fixable. The firm'sretum on assets had declined steadily from 15.5per cent in 1985 to 11.5 per cent in 1988. Overthe same period, its inventory turnover hadfallen from 10.0 to 3.9. To the extent newmanagement viewed these problems as "fix-able," there was potential for value creation.

RJR offered significant break-up value. In virtu-ally all LBOs, the value of the deal is calculatedbased upon both a cash-flow value of the firmand a break-up option, which assumes that thefirm is to be broken into units and sold offpiecemeal. Table II gives RJR's break-up value,as estimated by Smith Barney and reported inthe Wall Street Jourtial.^ The break-up value of$85 to $92 per shcu:e was significantly higherthan RJR's market price of $56 prior to the initialoffer of RJR's CEO, Ross Johnson.

Discounted-Cash-Flow ValuationThe discounted-cash-flow methodology deter-mines value by taking a projected stream of cashflows and discounting them at an appropriatediscount rate. Though it sounds simple andstraightforwaid, the process, if done correctly.

requires an in-depth understanding of the prin-ciples and tedious number crunching.* The val-uation of RJR consists of three steps:

1. develop a set of base-case cash-flow sce-narios,

2. derive the appropriate discount rate,3. discount the cash flows from Step 1 at the

cost of capital derived in Step 2; account forthe value of existing debt to obtain thevalue of RJR's equity.

Below we discuss RJR's cash flows and determi-nation of the appropriate discount rate. We thenvalue RJR's equity.

Cash FlowsTable III presents the projected sales, operating

profits and cash flows assumed by KohlbergKravis Roberts (KKR) in the supplement to theirDecember 6, 1988 tender offer.

For the operating margins of the tobacco busi-ness, KKR assumed an increase from the 1988pre-LBO level of 27 per cent to 35 per cent in1998. Though one might argue that this is anunrealistically optimistic projection, the tobaccoindustry had attained such operating margins inthe past. In 1987, for example, Philip Morrisreported a 35 per cent margin, the RJR tobaccounit a 27 per cent margin, American Brands an11 per cent margin and Universal a 7 per centmargin.

In addition to its somewhat optimistic marginassumption, KKR assumed that tobacco sales andoperating income would grow by 8.3 per cent andby more than 10 per cent per year, respectively,liiough the U.S. tobacco market is decliningannually by approximately 3 per cent, U.S.exports of cigarettes rose by 56 per cent in 1987and by 25 per cent in 1988. In addition, like anyother acquiring group, KKR expected to im-prove performance. As it indicated in the sup-plement to its tender offer, "Tobacco operatingincome for 1990 and years thereafter grows atrates greater than net sales due to expectedproduction and other operating efficiencies andreduction in product development costs."

KKR's projections for the food business werenot out of line with industry expectations. Theprojected sales growth of 6 per cent, for exam-ple, aithough higher than RJR's historical salesgrowth, was comparable to that of GeneralMiUs.

RJR's total cash flows represent the "free cashflows" available to meet both debt and equity

HNANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 D 17

Table III Projected Cash Flows (millions of dollars)

2989 1990 1991 1992 1993 1994 1995 1996 1997 1998I. Sales:

TobaccoFoodTotal

II. Cash Flows:Tobacco Operating EBIT*-I- Food Operating KBnr= Total EBIT- Corporate Expenses

- Taxes= EBIAT*+ Depredation- Increased Work Capit.- Capital Tfxpenditures= Total Free Cash Flows

7,560 8,29410,438 11,383

19,677

2,0221,1633,185

2872,8981,0291,869

783150

1.708794

3,3361.1842,152

767158

1.4621,299

8,98312,09221,075

1,7861,3484,134

2963,8381.3622,476

794165

1.3451,760

9,73112,84722:5^

4,2161.4972,719

823174930

2,438

10,54013,65124,191

3,3861,5814,967^

4,6341.6452,989840182738

2,909

11,41814,50725,925

•3,7331,7135,446353

5,0931.8083,285841191735

3,200

12,36815,42027,788

5,5%1,9873,609841201735

3,514

13,39716,39329,790

4,5342,0116,545396

6,1492.1833,966841211735

3,861

14,514 15,723\7,Jm 18,53331,942 34,256

4,9982,1787,176420

6,7562.3984,358841222735

4,242

5,5082,3617,869445

7,4242.6364,7888352337^

4,655

Source: December 6, 1988 prospectus. Incremental working capital estimates based on a Prudential Bache report dated October 28, 1988.* Earnings before interest, taxes and corporate expenses.* Earnings before interest but after taxes.

obligations. These cash flows will be discountedin the valuation process, so, to avoid double-counting of the interest cost, interest expense isnot deducted from operating income.

Once operating income is derived, two fur-ther adjustments are made. The first is a vmbngcapital adjustment. If inventory is projected toincrease over time, for example, RJR wiU havefewer funds available to meet debt and distrib-ute to equity holders. In other words, increasesin working capital items decrease free cash flow;similarly, decreases in working capital itemsincrease cash How.

The second adjustment deals with capital ex-penditures. As capital expenditures increase,fewer funds are available for distribution toequity and debt holders.

For the short period following the buyout,KKR's projections were reasonably compatiblewith those of RJR's management in previousyears. For example, in RJR's 1987 armual report,management projected capital expenditures of$5 billion for the foUowing three years, or af>-proximately $1.7 billion per year. As indicatedin Table in, KKR's projection for the first post-buyout year is approximately $1.7 billion; itsubsequently declines over four years to $700million.

The Appropriate EHscount RateDeriving an appropriate discount rate re-

quires three steps. First, the amount of eachdebt instrument must be determined and theweighted average after-tax ccKt of debt calcu-

lated. Second, the rate of return required byshareholders must be adjusted to reflect theincrease in the firm's leverage following theLBO. Third, given the proportions of debt andequity and their costs, a weighted average costof capital must be derived.

Cost of Debt: In a typical corporate financetextbook, the derivation of the cost of debt is asimple exerdse. In virtually all mergers andLBOs, however, the features, cost of funds andeven amoimts are structured in a relativelycomplex marmer. The amounts are frequentlyprovided as ranges, rather than exact values.The features include both cash and PIK (paid-in-kind) securities. Interest rates are floating,based upon various base rates. Moreover^ aninterest rate base is sometimes selected by theborrower and sometimes by the lender. Also,many of the initial sources are assumed to berefinanced at some unspecified time at a rateurJoiown at the time of the transaction.

These complexities are illustrated in Table IV,which provides the sources of financing used inthe RJR buyout. Note that the funds borrowedunder the Tender Offer Facility are to be used topurchase the shares tendered to RJR. Thisamount is to be refinanced upon the completionof the transaction by the Asset Sales BridgeFacility, Refinancing Bridge Facility apd Revolv-ing Credit and Term Loan Fadjity.

Because of their omplexity, many of the ratesare not structured in a manner easily analyzedin the context of an LBO. Consider, for example.

HNANC3AL ANALYSTS JOIflOMAL / ^PTEMKR-OCTC»ER 1991 D 1 8

Table rV Sources of Financing

Type Amount Rate CharacteristicsTender Offer Facility (T,O,F,) $13,6 billion

Asset Sale Bridge Facility $6 billion

Refinancing Bridge Facility $1,5 billion

Revolving Credit and Term $5,25 billionLoan Facility

Bridge Financing

Increasing-Rate Notes

$5,0 billion

$5,0 billion

Senior ConvertibleDebentures

Base Rate +2%' orEurodollar Rate +3%

Base Rate +W2%'or Eurodollar Rate +2Vi%

Base Rate +2V4%''or Eurodollar Rate +3V4%''

Base Rate +1V2%''or Eurodollar Rate

Base Rate +6% for 1st 6 mos,8% for following 3 mos,10% thereafter

Greater ofa) Floating 90-day LIBOR

plus adjustmentb) Fixed rate plus

adjustment^

Partnership Debt Securities $0,5 billion T-bill +4%

$1,8 billion

Cumulative ExchangeablePreferred Stock

Equity

$4,059 bUUon

$1,5 billion

Interest = 550 basis pointsover the greater of1) 3-mo, T-bill2) 10-yr, T-notes3) 30-yr. T-bondsMinimum rate = \1Va%Maximum rate = 16%

Dividend = 550 basis pointsover the greater of1) 3-mo, T-bill2) 10-yr. T-notes3) 30-yr, T-bondsMinimum rate = 12%%Maximum rate = 16%%

No Fixed Dividend

Bank financing used to purchase sharestendered to KKR,

Bank financing used to refinance theT,O,F, At least $5.5 billion must beobtained from the sale of assets.

Bank financing used to refinance T.CF,

Bank firtancing used to refinance theT.CF, After 2 yrs,, both facilities areto be converted to 4-yr, term loansupon satisf3dng key debt covenantsrelating to working capital, assetsales, solvency, etc.

Drexel Bumham Lambert and MerrillLynch commit $1,5 bill, each of SeniorSubordinated Bridge financing andDrexel agreed to provide $2 bill, ofsub, bridge financing.''

Used to redeem non-bank bridgefinancing. Two classes: (1) 8-yr. FirstSubordinated Notes, (2) 8-yr. SecondSubordinated Notes, Can useaddifional notes as interest paymentfor second subordinated notes duringperiod between month 18 and month78,

6-mo, debt security, which can beextended up to 7 years withadjustment in rate schedule,

20-year maturity. For the first 10 years,interest is paid in securities or cash atthe option of KKR, Following the 10-year period, cash payments aremandatory. At option of debentureholder can be converted to commonstock after year 4. Debentures areconvertible into 25% of RJR equity in1993, Security has reset provision totrade at par.

First 6 years, dividends are paid in cashor additional shares, at KKR's option.Following year 6, dividends are paidin cash. Shares have no voting rights.Then shares have a prior claim to thatof the senior convertible debentures.

Provided by KKR investing group set upas a limited partnership.

Source: January 31, 1989 prospectus,a. RJR has the option of making interest rate selection. Base rate is defined as the 30-day commercial paper rate for firms whose bond ratinesare "AA."b. Increasing to 2Vi% for the 6-month period following the first anniversary of the tender offer expiration date and 2^*% thereafter,c. Increasing to 3V2% for the 6-month period following the first anniversary of the tender offer expiration date, and 2Vt% thereafter,d. Subordinated rates have similar structure, but are increased by Vi%.e. Adjustment is based on seniority and length of time since issuance.

the Increasir\g-Rate Notes described briefly ir\Table IV. These eight-year riotes comprise twoclasses. Approximately $1.25 billion are eight-year First Subordinated Increasing-Rate Notesbearing cash interest payment. The other class—$3.75 billion of Second Subordinated Increasing-Rate Notes—^pay interest in cash for the first 18

months, in cash or additional Second Subordi-nated Increasing-Rate Notes (at the option ofKKR) for the following 60 months, and again incash for the remaining 18 months.

The terms for these notes indicate that theinterest rate will be adjusted monthly and willequal the greater of

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 D 1 9

(1) a floating-rate 90-day LIBOR, plus a 400-basis-point spread for the first qiiarter inthe case of the first class of increasing-ratenotes and a 500-point spread in the case ofthe second class. For each class, thespread will increase by 50 basis points perquarter for the first two years and by 25basis points per quarter thereafter;

(2) a fixed rate equal to the floating rate forthe initial quarter detennined in (1) above,less V8 of 1 per cent in each case, increas-ing by 50 basis points per quarter duringthe first two years and by 25 basis pointsper quarter each quarter thereafter. If theinterest rate is above 18 per cent, interestexpense in excess of 18 per cent will bemade in additional increasing-rate notes,not in cash.

Several long-term securities are also relativelyunusual in their structure. For example, thesenior convertible debentures due in 2009 wereset to be repriced to trade at par in May 1991.Several months prior to the required reset, thebonds traded at 80. At this price, the issue'scoupon would have been reset at more than 20per cent. To avoid the reset, RJR decided to buyback for cash the entire amount of the bondissue, costing about $1.7 billion.

Because the bonds were convertible into 25per cent of RJR's equity in 1993, the buybackboosted KKR's holding in RJR from 58 per centon a fully diluted basis to 83 per cent. Interest-ingly, while this security (described in Table IVas Senior Convertible Debentures) had a floorand cap rate, Drexel set the May 1991 resetwithout any cap or floor. The lack of a cap nodoubt attracted buyers for the bonds, but KKR'sexposure increased substantially.

A second junk bond issue aiso faced a man-datory reset in May 1991. This issue resultedwhen RJR, on July 17, 1989, exchanged its $4billion Cumulative Exchangeable PreferredStock for subordinated exchange debentureshaving an identical rate and a maturity date of2007. The exchange resulted from KKR's con-cern about the potential tax liability of preferredstock relative to tax-deductible debt.

Similar reset bonds were a major contributingfactor in the Chapter XI filing of another KKRacquisition—^Hillsborough Holdings. January 1,1990 was the reset date for $624.3 million ofHillsborough bonds. The anticipated reset ratewas far in excess of 20 per cent. As a result.

Table V Cost of Debt

Type of DebtAmouni*(millions) Weight

InterestRate(per

cent)

Short-Term DebtExisting Long-Term DebtSub. Increasing-Rate Notes

(Class I)Sub. Increasing-Rate Notes

(Class II)Senior Convertible

DebenturesPartnership Debt SecuritiesTotal

$13,6005,2621,250

0.51980.20110.0477

3,750 0.1434

1,800 0.0688

500$26,162

11.27%9.75

13.00

14.00

14.50

11.2011.66%

0.01911.0000

After-Tax Cost of Debt = 11.66 (1 - 0.355) = 7.52%

* From January 31, 1989 prospectus.

three days prior to the reset, on December 28,1989, Hillsborough filed for protection underthe bankruptcy code.

Because of the complexity of the RJR LBOfinancing structure, the cost of debt can only beestimated. Table V provides an approximationof the interest rates charged on each of the debtinstruments. It also indicates their respectiveweights as a percentage of the company's totaldebt. The before-tax weighted average cost ofdebt is determined to be approximately 11.66per cent, and the after-tax cost of debt is calcu-lated as 7.52 per cent.

Cost of Equity: Table VI indicates that RJR'spre-LBO beta was about 1.05, while its debt-to-equity ratio was 0.82. Given the relationshipbetween total beta, urUevered (operating) beta,tax rate and debt-equity ratio, RJR's unleveredbeta was 0.69. RJR was expected to have adebt-to-equity ratio of 20.15 following the buy-

Table VI Cost of Equity

I.

II.

in.

IV.

DataPre-LBO BetaPre-LBO Debt/EquityPost-LBO Debt/RjuityTax Rate

Unlevering the Beta

Beta = 0 69Post-LBO Beta

Beta^.LBo = 0.69 (1Post-LBO Cost of Equity

RE = 7.2 + 9.65 8 =

1.05»0.82

20.150.355

[1 + (1 - 0.355) • 0.82]

+ (1 - 0.355) • 20.15] = 9.65

84.4%

* «SKs pre-LBO beta was obtained &om the September 196»isffi)e ofValut Line, the most recent issue prka to the trartsaction.

FINANCIAL ANALYSTS JOURNAL / 1991 D W

Table VII Alternative Beta Estimate

/. Universal CorporationPrimary BusinessBetaDebt/EquityEffective Tax Rate

Universal's

Unlevered beta =//. Flowers Industries

Primary BusinessBetaDebt/EquityEffective Tax Rate

Flowers' Unlevered

Beta —///. Proportion of RJR's

assets inTobacco SegmentFood Segment

RJR's Unlevered Beta =

Tobacco0.8688.1/356.924%

0.860 V^

1 +(1-0 .24) . 88.1/356.9 '

Food0.95103.0/198.033%

0.95

1 + (1 - 0.33) . 103/198 •

33.9%66.1%

0.339 • 0.72 + 0.661 • 0.70 = 0.71

out; its post-LBO beta was thus estimated as9.65.

Panel IV of Table VI gives the post-buyoutcost of equity. With a risk-free rate of 7.2 percent and a historical market risk premium of 8per cent, that cost is 84.4 per cent. This seemshigh, but it is well within the target range ofbuyout specialists in such highly leveragedtransactions.

Table VII gives an alternative estimate ofRJR's operating beta, derived by using twosurrogate firms, one for each of RJR's mainbusiness segments. The direct method of un-levering RJR's beta and the surrogate-firm ap-proach yield nearly identical results (unleveredbetas of 0.69 and 0.71, respectively).

Weighted Average Cost of Capital: Once the costsand extent of financing have been worked out,the calculation of the weighted average cost ofcapital is straightforward. RJR's debt constituted82.47 per cent of its total capital, its preferred

stock represented 12.8 per cent, and its equityonly 4.73 per cent. After accounting for the costof each of these components, we estimatedRJR's cost of capital to be 12.06 per cent.

Valuing RJRAU the inputs needed to value RJR are now

available. We performed the following sequenceof calculations.

First, using 12.06 per cent as the cost ofcapital, we discounted each of the projectedcash flows for the 10 years 1989-98 (from TableIII) back to 1988. This calculation yielded a valueof $15,633.77 million.

Second, we had to make some assumptionsabout the period following 1998. A review of thedifferent assessments made by the acquiringgroup could lead us, for example, to select 3 percent as the steady-state compound growth ratefor the period following 1998. As Table VIIIshows, the present value of post-1998 cashflows, given a 3 per cent growth rate, is $16,952million.

Finally, in order to derive the value of RJR'sequity, we added the present value of the cashflows for the 1989-98 period ($15,633.77 million)to the present value of the cash flows following1998 ($16,952.00 million). This gave a total firmvalue of $32,585.77. From this value we sub-tracted RJR's existing long-term debt ($5,390.20million), which yielded an equity value of$27,195.37 million. Given RJR's 223.52 millionshares of common stock, this resulted in a valueof $121.66 per share.

Obviously, the valuation is dependent on theprojected growth rate. As Table VIII shows, aconservative assumption of no growth follow-ing 1998 yields a value per share of $101.10. Atthe other extreme, a post-1998 growth rate of 5per cent gives a share value of $145.04. Most

Table VIII Per-Share Valuation Based on KKR's Projections

APresent Value

ofCFfor1989-1998($ millions)

BAssumed Growth

Rate for CF oft > 1998

(%)

CPVofCFof

t > 1998($ millions)

D (= A + C)Total PV

ofCF($ millions)

EExisting

Long-TermDebt

($ millions)

F(=D- E)Value ofEquity

($ millions)

GNumber of

Shares(millions)

FIGValue Per

Share($)

$15,633.77 0%12345

$12,354.0113,616.7415,118.5116,952.0019,240.0022,176.42

$27,987.7829,2K).5130,752.2832,585.5734,873.7737,810.19

$5,390.2 $22,597.5823,860.3125,362.(»27,195.3729,483.5732,419.99

223.52 $101.10106.74113.46121.66131.90145.04

Source: December 6, 1988 prospectus. *

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1991 D 21

Figure A Sensitivity Analysis of Value per Share

II $123.6

$109.0

$ 82.6 —

$ 53.1 —

l t>1998

t>1998

t>1998

I I15% 20%

Annual CF Growth Rate 1989-1998

25%

analysts pointed to the 2 to 3 per cent range asthe most likely steady-state scenario, implying avalue in the range of $113 to $121.

The per-share valuation analysis in Table VIIIis based on KKR's 21.7 per cent projected an-nual cash flow growth rate for the first 10 years(1989-98) and alternative assumptions for thecash flow growth rate in the following periods.Figure A presents valuations under a moreconservative set of assxunptions. The per-sharevaluation analysis here is based on annualgrowth rates for the first 10 years ranging from15 to 25 per cent and steady-state growth ratesfor the period following 1998 ranging from 0 to5 per cent.

Figure A shows that, if RJR's cash flows growby 15 per cent per year in the 1989-98 periodand by a steady 5 per cent in the succeedingyears, the value per share will be $82.60. Withthe same initial growth rate, but a steady-stategrowth rate of 0 rather than 5 per cent, value pershare falls to $53.10. And if RJR's cash flowsgrow by 25 per cent in the first 10 years,followed by 1 per cent steady-growth rate, thevalue is $123.6. •

Even with the most optimistic steady-stategrowth rate of 5 per cent, the cash flow in thefirst 10 years must grow by at least 18 per centper year to justify KKR's bid of $109 per share.

The Bidding GroupsIn a deal as large and complex as the RJRbuyout, the quality of the bidding team is a keyfactor to success. As Figure B shows, eachinvesting group tried to retain the best availableinvestment bankers, legal advisers and financialbackers. Below we summarize the main issuesrelated to the participants in the RJR transac-tion, their roles and their compensation.

KKR's strategy was clear: Recruit every signif-icant player so that the other bidding groupswouldn't be able to retain them. Implementingthis strategy, KKR retained Drexel BumhamLambert, Merrill L)mch, Morgan Stanley andWasserstein Perella as dealer managers for thetender offer. This left the management-Shear-son bidding group with only two available play-ers with significant access to capital rrwrkets—Salomon Brothers and First Boston. However,

HNANOAL ANALYSTS PURNAL / ^PTEMBER-OCTOBH? 1991 O 22

Figure B The Bidding Groups

KKR

Investment Banker•I>excl Burnham LambertDealer Managers for the Tender Offer•Drexel Burnham Lambert•Wasserstein Perella•Merrill Lynch Capital Markets•Morgan Stanley

Comanaging (bank) Agents:•Manufacturers Hanover Trust•BarJcers Trust•Citibank•Chase Manhattan

Other Investors:•State Pension Funds•Corporate Pension Funds•University Endowments•Foreign Corporations/Governments

Ugal:•Simpson Thatcher &Bartlett

RJR NABISCO

Board's Special CommitteeAdvisers:•Dillon Read•Lazard Freres

Legal:•Skadden, Arps, Slate,Meagher & Rom

FIRST BOSTON

Investment Banker•Harry Gray & Co.Investois:•First Boston•Resource Holdings

MANAGEMENT GROUP

Investment Bankers:•Shearson Lehman Hutton•Salomon Brothers

Lead Banks:•Citibank•Bankers Trust

Legal:•Davis Polk & Wardwell

FORSTMANN LnTLE

Investment Banker•Goldman Sachs

Backers:•Procter & Gamble•Rakton Purina•Castle & Cooke

because First Boston was preparing its own bid,only Salomon remained.

Even with Salomon on its team, experts feltthat the management group would face diffi-culties finding an outlet for billions of dollars inbonds that would have to be sold to finance anybuyout of RJR. Indeed, KKR's "Get Them All"strategy worked. For example, Paine Webber, amid-tier investment bank, had privately decidedit would not join the management-Shearsongroup, citing the problems it expected the groupwould encounter in financing the bid.

Forstmann Little's bidding group was a uniquecoalition of an investment banking firm andinterested corporations. Forstmann's invest-ment bemker, Goldman Sachs, approached sev-eral of its corporate clients, trying to entice themto join the bidding group. Even though it wasnot spelled out publicly, the idea was to "pre-sell" RJR's different business segments to cor-porate buyers with maximum potential syner-gism. It seemed initially as if this strategy wouldsucceed. The buyout firm of Forstmarm Littlewas joined by thiee strategic buyers—Procter &Gamble, Ralston Purina and Castle & Cooke.

The group had a very unusual relationshipwith RJR's board. Because the board did notwant sensitive infonnation going to RJR's com-petitors, Forstmann had to screen some of thedata from its prospective partners, which com-peted with RJR in several markets. RJR's boardalso objected to any advance selling of RJR'sbusinesses. This implied that Forstmarm's cor-porate backers had to present themselves asmere investors in the bid, not acquirers ofbusinesses.

The most complex bid was that of the FirstBoston bidding group. It proposed to buy theRJR food business for installment notes, whichit said could immediately be turned into cash bya banking syndicate. The group planned to thensell RJR's food businesses, distributing some ofthe proceeds to shareholders, before acquiringthe company's tobacco business for itself. Themost significant impact of First Boston's bid wasthat its complex use of installment notes ledRJR's board to extend one of the bidding con-test's deadlines.

As Figure C shows. First Boston's $118 a sharebid was outstanding simultaneously with KKR's

FINANCIAL ANALYSTS JOURNAL / SEPTOrfBER-OCTOBER 1991 D 2 3

Figure C The Bidding Dynamics

Bidding Date (1988)

Bidder

RJRManagement

Oct. 19 Nov. 4 Nov.25 Nov.29 Dec.l

$H2/sh.

$101/sh.

$100/sh.

$92/sh.

$75/sh.

Amount/Form of Payment

$84 Cash$24 Preferred Stock$ 4 Convertible Stock$88 Cash$ 9 Preferred Stock$ 4 Other Security$90 Cash$ 6 Preferred Stock$ 4 New Common Stock$84 Cash$ 8 Debt Securities

Bidder did not specify form of payment

KKRAcquisition

Group

$109/sh.

$106/sh.

$94/sh.

$90/sh.

$81 Cash$18 Preferred Stock$10 Debentures$80 Cash$18 Preferred Stock$ 8 Debentures$75 Cash$11 Preferred Stock$ 8 Convertible Bond$78 Cashinsecurities

Fitst Boston $118/sh.$110 Notes$ 3 Other Securities$ 5 Warrants

$94 a share and management's $100 a share.However, First Boston's offer, in addition tobeing complex, was conditional upon furtherreview of nonpublic infonnation. RJR's boardtherefore announced a new round of bidding,allowing First Boston to come back with a firmerbid. In retrospect, it is dear that, in placing itscomplex and uncertain bid. First Boston enabledKKR to reshape its winning strategy.

The costs associated with obtaining invest-ment banking advice, distributing securities andraising capital amounted to more than $700million, plus an equity position. Table IX showsthe distribution of the fees to the investmentbarJters involved.

The Role of RJR's BoaidUpon receipt of aui unexpected bid, a board ofdirectors typically makes an announcement thatthe offer "does not serve shareholders' bestinterests." That armouncsment is soon followed

by solicitations for other offers, once it becomesapparent that the firm will be acquired.^ RJR'sboard proved an exception to this process: Itplayed an active role in structuring the biddingrules, monitoring and adjusting the biddingprocess, and choosing the winning bid. Wesummarize below the board's active participa-tion in the process.

The board defined its task not as just gettingthe best immediate price for RJR, but as ensur-ing that shareholders did not get locked out ofpossible future gains. It did so by stating thatone of its considerations was the proportion ofstub equity left in public hands.

The board defined its fiduciary duty broadly,considering not only shareholders' interests,but also the welfare of its primary stakehold-ers—die company's emjrfoyees and its commu-nities.^ By maldng its preferences known, theboard implied that it would evaluate factorsother than merely Ae Hd price, such as the

HNANOAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 19910 24

Table IX Investment Advice and Capital-Raising Costs

Drexel's FeefFees as adviser and dealer managerCommitment Fee: 1,5% on a $3,5 billion

bridge loanFunding Fee: 0.5% on a $3.5 billion

bridge loanFinancing Fee: 3.875% on a $2 billion

junk bond offeringFinancing Fee: 1.8125% on a $3 billion

junk bond offering''Total Drexel's Fees

Merrill Lynch's fees"Fees as adviser and dealer managerCommitment Fee: 1,5% on a $1,5 billion

bridge loanFunding Fee: 0,5% on a $1.5 billion

bridge loanFinancing Fee: 1.8125% on a $3 billion

junk bond offering""Total Merrill Lynch's Fees

Morgan Stanley's Fees as dealer managerWasserstein Perella's Fees as dealer managerTotal Inziestment Banking Fees

$25.0$52.5

17.5

77.5

$54,4

$226.9

$25.022,5

7,5

54,4

$109,4$25,0

25,0$386.3

million

million

million

millionmillionmillionmillion*^

a. In addition to these fees, Drexel got to buy 2% and Merrill Lynch1% of the stock in the new RJR, along with warrants to double ttiosestakes,b. Drexel and Merrill Lynch would collect the financing fees on thejunk bond offering even if the bridge loans are refinanced in someother way,

c. For its share of the financing, a large syndicate of commercialbanks received $325 million in fees. The bank syndicate consisted ofabout 200 institutions led by Manufacturers Hanover, Bankers Trust,Citibank and Chase Manhattan,

extent of asset sell-offs, the number of employ-ees fired and the stock equity component re-maining in the public hands.

The board, in an unusual move, immediatelycriticized as unacceptable management's firstoffer to invest only $20 million for an 8.5 percent stake in the company (with an option toraise the stake to 20 per cent).

The board asked interested bidders to submittwo bids—one for the whole company and onefor the tobacco business only. This gave it moreflexibility and also enabled it to fetch a bettervaluation for RJR. In addition, the board wasconcerned that, because of the size of the trans-action, some of the bidders would cooperaterather than compete with each other. It there-fore asked for a sealed bid, thus discouragingalliances between groups. Typically, in a lever-aged buyout plcin, the acquiring group attemptsto secure buyers for assets it plans to sell. Toavoid this, RJR's board emphasized that itwould not allow potential bidders to "pre-sell"businesses—^that is, obtain commitments in ad-vance to divesl themselves of the company'sbusinesses.

Prior to the first round of bidding, the boardannounced that the bidding deadline would notbe extended. This put time pressure on thebidders' advisers, by then already overwhelmedby the extent of information they had to ana-lyze.

Following the first round of bidding (withfirm offers including KKR's $94 a share andmanagement's $100), the advisers to the board'sspecial committee gathered the bidders in aninformal discussion, suggesting $100 a share asthe floor for the next round of bidding. On thesurface, it seemed like a risky strategy, whichcould scare off all the bidding groups. But theboard had an alternative plan—break up RJR onits own.

As events unfolded, the more aggressivestrategy prevailed. The board advisers infonnedthe bidders (prior to the second round), that theboard members were prepared to unveU theirown restructuring plan unless bids for RJR sur-passed the restructuring estimated value, be-lieved to be at least $100 a share.

Factors Leading to Selection of theLowest BidBy traditional standards, RJR management

should have won the bidding war. Its offer, $112a share, was higher than KKR's by nearly $700million, its cash portion of the offer ($84) washigher than KKR's ($81), its members were allindustry experts with an intimate knowledge ofthe company, and management was on goodterms with the board members. Nevertheless,when the bidding ended, traditional factors didnot determine the winner. The managementgroup lost. The following factors led to theultimate victory of KKR's lower bid.

The Break-Up Factor: The board's five-personspecial committee wanted to keep the companyas intact as possible and minimize turmoil andnegative effects on employees. While KKRpromised to keep the tobacco and most of thefood business intact, the management groupplanned to keep only the tobacco business (seeTable X). Indeed, KKR specified that it wouldsell only $5 to $6 billion of RJR assets in the nearfuture. The management group intended to sellthe entire food business for an estimated $13billion. Keeping its options open, KKR did notdisclose its longer-term plans.

The Equity Factor: The board's five-person spe-cial committee wanted to provide existing share-holders with an option to participate in the

FINANCIAL ANALYSTS JOURNAL / SEFTafflER-OCTOBER 1991 D 25

Table X KKR's Bid vs. Management's Bid

KKR's Bid Management's Bid

Financial$81 a share in cash$18 a share in

exchangeable preferredstock

$10 a share indebentures, convertibleinto a total of about25% of the newcompany's equity

Total: $109 a shareNon-Finandal

Keep the tobacco andmuch of the foodbusiness intact

Guarantee severance andcither benefits toemployees who losetheir jobs because ofchange in control

Finandal$84 a share in cash$24 a share in preferred

stock

$4 a share in additionalstock, convertible into atotal of 15% of the newcompany's stock

Total: $112 a shareNon-Finandal

Keep only the tobaccobusiness

Give equity to 15,000employees

buyout and thus share in any future KKR profitsfrom the transaction. The desire was to leavesome stub portion of the company's stock inpublic hands. While KKR proposed to distribute

25 per cent of the equity in the future companyto existing shareholders, the managementgroup offer included only 15 per cent.

Financing Structure: As Table X shows, bothgroups offered a combined $28 a share in theform of either exchangeable preferred stock anddebentures (KKR's offer) or preferred stock andaddition^ convertible stock (management's of-fer). However, based on an analysis performedby the advisers to the board's special committee,KKR was offering $500 million more equity thanthe management group. This, again, accommo-dated the board's objective of maximizing cur-rent shareholders' participation in futureprofits.

Employment Commitment: In its effort to beresponsible to all stakeholders, the board's spe-cial committee wanted to minimize adverse ef-fects on employees. While KKR's offer guaran-teed severance and other beriefits to employeeswho lost their jobs because of layoffs, manage-ment's proposal focused on giving equity to15,000 employees. Though these two proposalswere not compiurable in value, the board be-lieved that KKR's plan was potentially moreremunerative for the employees.

Post-LBO Laidership: The intensive biddingwar affected all parties involved—management,employees, communities and tiie Indders tiiem-

selves. Ehiring. the bidding period, the uncer-tainty was high and business was affected. Inthe interest of restoring stability, the board'sspecial committee assessed each offer in termsof its effects on RJR's identity and culture. KKRquickly read the board's mind and announcedits plan to install J. Paul Sticht as the compan/schairman and CEO. He had been in these posi-tions in the 1970s and early 1980s and wasknown for emphasizing the company's respon-sibility to stakeholders—^primarily employeesand communities. Alternatively, the manage-ment group proposed to let F. Ross Johnsoncontinue as RJR's CEO. For various reasons(including poor handling of his own PR) theboard associated Mr. Johnson's group withgreed, lavish spending, and insensitivity to em-ployee and community needs.

On a purfely monetary basis, the two offerswere very dose; the final decision was based onother factors. KKR was attimed to the board'sgoals and the impact on other stakeholders suchas employees and communities. It also recog-nized that finandal, but not immediately quan-tifiable, factors as well as the acquiring group's

goodwill would play a decisive role.ConclusionsTransforming a complex set of financing instru-ments into a simple estimate of the cost ofcapital requires many approximations and sim-plifications. Moreover, the assumptions under-l)dng the valuation process must be carefullyassessed and modeled.

The RJR buyout is a dassic example of howthe bidding process itself can affect the out-come. In particular, the board's role in settingthe bidding rules minimized the possibility ofcollusion and thereby increased potential gainsto both shareholders and the firm's other stake-holders. In addition, KKR's weD structured se-quential bidding strategy may well provide arole model for future buyouts.^ M

Footnotes1. See, for example, M. Jensen, "The Eclipse of the

Public Corporation," Harvard Business Review, Sep-tember/October 1%9; S. Kaplan, "ManagementBuyouts: Evidence on Taxes as a Source of Value,"Joumal of Finance, July 1989; A. Michel and I.Shaked, Tke Complete Guide to a Successful LeveragaiBuyout (Homewood, IL: Dow Jones-Irwin, 1988);and K. Torabzadeh and W. Bertin, "LeveragedBuyouts and Shareholder Returns," Joumal of Fi-

mnckl I^smdi 4, pp. 313-3^.

HNANOAL ANALYSTS JOURNAL / SEPTEMBHt-OCrOBER 1991 D 26

2. Michel and Shaked, Complete Guide, op. cit.3. R. Alsop, A. M. Freedman and B. Morris, "RJR

Takeover Could Hurt Marketers and Consumers,"Wall Street Journal, December 2, 1988.

4. For a discussion of the valuation issues related tobuyouts, see C. Crutchley and R. Hansen, "A Testof the Agency Theory of Managerial Ownership,Corporate Leverage, and Corjrorate Dividends,"Financial Management, Winter 1989; H. DeAngelo,L. DeAngelo and E. M. Rice, "Going Private:Minority Freezeouts and Shareholder Wealth,"Joumal of Law and Economics, October 1984; and I.Inselbag and H. Kaufold, "How to Value Recapi-talizations and Leveraged Buyouts," Joumal ofApplied Corporate Finance, Summer 1989.

5. For a discussion of the role of the board, see B.Cornell and A. Shapiro, "Corporate Stakeholdersand Corporate Finance," Financial Management,

Spring 1987, and "Corporate Governance: TheRole of Boards of Directors In Takeover Bids andDeferwes" (a roundtable discussion at the Univer-sity of Michigan, April 7,1989), in Journal of AppliedCorporate Finance, Summer 1989.

6. Boards in general have tended to broaden theirview of their fiduciary responsibility, in part be-cause of the increased fraudulent-conveyance liti-gation resulting from failed transactions. See"Note," Columbia Law Review, November 1987; A.Michel and I. Shaked, "Assessing LBO Risk: TheCase of Fraudulent Conveyance," Financial Man-agement, Winter 1989; and A. Michel and I.Shaked, "The LBO Nightmare: Fraudulent Con-veyance Risk," Financial Analysts Joumal, March/April 1990.

7. We thank Adrian Gustavo Becher for his researchassistance.

O

'Ihm Asmi iyioeation Eigprert

Other Capabilities

HNANCIAL ANALYSTS JOUf»iAL / SHPTEMBER-OCTOBER 1991 D 2 7