Kravis was a small boy, and sometimes seemed driven to prove himself among the bigger kids. Years later he relished the touchdowns he scored as a high-school halfback after the coach said he was too puny to play. One of his favorite memories was of his first job at seventeen, working in the mailroom for the Sunray DX Oil Company in Tulsa. After a few days he had been given his first big assignment, distributing the mail for the entire company. But when he woke up on the big morning, he couldn’t see. His new contact lenses hadn’t been fitted correctly; the pain felt like needles being driven into his eyes. Unable to remove the lenses, his parents out of town, Kravis got in his car and, practically blinded, managed to navigate the empty, early-morning streets of Tulsa to get to work. Afterward his eyes had to be bandaged. “But I got the mail out,” Kravis recalled proudly.
An economics course at Loomis persuaded him to pursue a business career, and he majored in finance at tiny 600-student Claremont Men’s College in California. (He had applied and was accepted to his father’s alma mater, Lehigh, just to show he could get in.) At Claremont, Kravis spent his freshman year majoring in golf, beach, Las Vegas, and the racetrack at nearby Santa Anita. His junior year he captained the golf team. By his senior year he was focused on a Wall Street career. His senior thesis was on convertible debentures.
Ray Kravis knew the people at Goldman Sachs, the old-line Wall Street firm, and each summer during college his son worked there, beginning as a runner. Plunked down amid the shouting, red-faced men on the trading floor, Kravis decided he couldn’t see himself among them at age forty. For one thing, he wanted an office. His senior year Kravis secured a post-graduation internship at the Madison Fund, one of Wall Street’s hot money management firms. There he made a name for himself as a stock picker. These were the “go-go years,” when every stock seemed to be rising. Friends joked he could have done as well using a dart board.
In the fall of 1967 Kravis enrolled at Columbia Business School and immediately regretted it. He missed the action on Wall Street. His father persuaded him to stick with it, but Kravis called his boss at Madison, a man named Ed Merkle, who let him continue working while he completed his studies. Going through the motions, he graduated two years later, at the height of student riots, with an undistinguished record of Bs and Cs.
Wall Street beckoned. Madison had acquired a small railroad, Katy Industries, and Merkle, impressed with Kravis’s drive, put the young Oklahoman in charge of diversifying its businesses. Kravis settled on an industry he knew, oil field services, and, working for the first time with corporate “finders,” spent a year traveling the backroads of Louisiana buying mom-and-pop companies for Katy: a barge and tugboat outfit and a dredging company. It was good, nuts-and-bolts experience.
As Katy grew, Kravis selected the father of a business school friend, a man named Jacob Saliba, to be its new president. Together they rented a suite at Manhattan’s Delmonico Hotel—Saliba took the bedroom, Kravis the living room—and continued buying a string of companies for Katy. Eventually Katy was sold, and Kravis, at twenty-five a young man in a hurry, looked for a new challenge. Goldman Sachs was too hidebound, too structured, so Kravis joined a small firm named Fahaerty & Swartwood, where he hoped to begin a venture-capital operation. It didn’t pan out and, after a year, he left. Out of work, he turned for help to his cousin, George Roberts.
Just a year older, Roberts had grown up in Houston. His father and Kravis’s mother were brother and sister. The grandfather Kravis and Roberts shared was a Russian Jew who fled to America in the late 1890s rather than fight in the czar’s army. After his name was changed by an Ellis Island clerk, “George Roberts” joined people from his native village in Muncie, Indiana, where he eventually owned a dry goods store and the Roberts Hotel, which still stands. After losing everything in the Depression, he entered the oil business in Tulsa, and eventually died of a heart attack, alone in an oil field tent.
His son, Louis Roberts, grew up to be a freewheeling oilman in Houston, where he made and lost several fortunes in the Texas oil fields. During the 1950s Lou Roberts often took his teenage son George along to business meetings. At an American Petroleum Institute conference one year, father and son sat by a dirt-caked wildcatter in cowboy boots while listening to a speech by the chairman of Humble Oil, the predecessor to Exxon.
“Which one of those two men would you like to be?” Lou Roberts asked his son afterward.
“I’d rather be like the guy up on the stage, the businessman,” young George answered.
The businessman, his father explained, had 50,000 employees to watch over, a long, tiring workday, and could expect a pension of several hundred thousand dollars on retirement. The wildcatter, on the other hand, had maybe 30 employees, several dozen oil wells that pumped away while he slept, and was probably worth $5 million.
“Now who would you rather be?” Lou Roberts asked.*
George Roberts, who grew to be as introverted as his father was garrulous, never, forgot that lesson about the importance of being your own boss. After attending Culver Military Academy in Indiana, he had been a year ahead of Kravis at Claremont. When George was twenty-one, Ray Kravis had landed him a summer job at Bear Stearns, the big Wall Street trading house. Arriving most mornings before his peers, Roberts—quiet, steady, hardworking—struck up a friendship with the head of the firm’s corporate finance department, Jerome Kohlberg. After law school at the University of California-Hastings he went to work for Kohlberg full-time.
Bear Stearns was a cutthroat place, even by Wall Street standards. Run by its hard-charging chief, Salim (“Cy”) Lewis, Bear was essentially a loose group of private fiefdoms. At Lewis’s encouragement, competition rather than cooperation was emphasized, and jealousy and internal politics flourished. Roberts enjoyed working for Kohlberg because the older man sheltered him from the incessant turmoil. But he soon grew tired of New York. He was raising a family and longed to return to California. When Kohlberg arranged a transfer to Bear’s San Francisco office, Roberts, who would continue working for Kohlberg on the coast, nominated his cousin Henry Kravis as a replacement.
Friends joked that Kravis’s new boss, Jerry Kohlberg, had one suit (dark) and one tie (yellow, painfully narrow). A forty-four-year-old graduate of Swarthmore and Harvard Business School, he was a quiet, balding family man who loved tennis, the trumpet, his three children, and books. Like Roberts before him, Kravis was taken under the wing of Kohlberg, who ignored, for the moment, his protégé’s penchant for raising a little hell. Kravis had grown into the kind of young man who, at his thirtieth birthday party, rode one of his gifts, a Honda motorcycle, around his Park Avenue apartment. He stopped only when the band complained.
For the most part, Kravis’s work under Kohlberg was the routine stuff of investment banking: private placements, fairness opinions, stock underwritings. But in his little fiefdom, Kohlberg had also developed a profitable sideline: something known as “the bootstrap deal.”
Leveraged buyouts, as bootstrap deals came to be known, began as a kind of aid to the elderly. By the mid-sixties, many of the men who had founded family-owned companies and prospered during the postwar economic boom were growing old As they looked for ways to avoid estate taxes, yet allow their families to retain control of their firms, they had three options: remain privately held, sell shares to the public, or sell out to a larger company. Each approach had drawbacks. Remaining private ignored the problem. Going public exposed the founder to a fickle stock market. Selling out usually meant losing operating autonomy.
Kohlberg saw the LBO as “the missing link,” a way for aging executives “to have their cake and eat it, too.” His first deal, in 1965, was the $9.5 million acquisition of a Mount Vernon, New York, dental products maker named Stern Metals. It remained his blueprint for years. Kohlberg formed a shell company, backed by a group of investors he assembled, to buy Stern from its seventy-two-year-old family patriarch, using mostly borrowed money. The Sterns retained a stake in the business and continued to run i
t. Eight months later Kohlberg sold some of his stock—which he had bought for $1.25 a share—to the public for $8 a share, using the proceeds to retire debt. Kohlberg then took the company on a buying spree, snapping up a California dental supply company, an Ohio X-ray firm, and a European maker of dental chairs. When the original investors sold off their $500,000 investment in the transformed company to the public two years later, it was worth $4 million.
The approach was refined in subsequent deals. As the vast conglomerates of the 1960s shed businesses in the face of a declining stock market in the early 1970s, Kohlberg branched out to buy their cast-off divisions. He liked basic industry, companies that made things like bricks and wires and valves, whose management, products, and earnings were solid and reliable. Because he borrowed heavily to buy companies, getting a fix on future earnings and cash flows was crucial if Kohlberg was to avoid having his loans called. Balance sheets were his tarot cards, cash flow projections his crystal ball. Once Kohlberg got his hands on a company, he ruthlessly cut costs and sold unwanted businesses, freeing up every extra dollar to pay debts. In most cases he gave management stock incentives, which he found did wonders for their ability to run the business more efficiently. When he was done, the leaner, meaner result was usually worth more than when he bought it. In their most basic guise, LBOs have worked the same way ever since.
This was grimy, street-level work, and as “Jerry’s boy,” Kravis pursued it with abandon. For the buyout of a Rockwell International division named Incom, Kravis compiled a seventy-five-page prospectus, crammed with balance sheets, operation summaries, and debt projections, and sent it to major insurance companies. One spring morning a handful of potential investors assembled in Quincy, Massachusetts, where Kravis escorted them through Incom’s Boston Gear plant. Piling into three limousines, the group continued on to Holyoke to tour Acme Chain, then to Fairfield, Connecticut, to see Helm Bearing. Finally they caught a plane to Cleveland to visit Incom’s Air Maze and Morse Control divisions. It wasn’t glamorous, but it worked.
By 1973, after three years of tutelage, Kravis was ready to call the shots on his first deal. Like Stern Metals and other Kohlberg targets, Boren Clay Products, a small North Carolina brick maker, was owned by a strong-willed, elderly founder looking to cash out before his death. Orten Boren, then in his early seventies, didn’t have much use for Yankees or, for that matter, Jews.
“Boy,” Boren said at one of his first meetings with Kravis. “What faith are you?”
Kravis clinched. “Well, I’m Jewish.”
“I thought so.” A pause. “You Jewish boys are pretty smart, aren’t you?”
Kravis gritted his teeth. If anti-Semitism was the price of success, it was the price he would pay. Over the course of a six-month courtship, Kravis would pay plenty more. At one point, Boren showed Kravis through one of the company’s brick factories.
“Henry, see those kilns?” Boren asked, pointing to the giant containers where bricks were baked. “Those are just like the ovens the Germans used.” He repeated the remark for emphasis.
Kravis forced a smile.
“Boy,” Boren urged, “come on over here, a little closer, and see ’em.”
“Oh, no,” Kravis replied. “I can see them fine from here.”
After buying Boren Clay, Kravis moved on to Providence, Rhode Island, where he began negotiations to buy a tiny, family-owned jewelry maker, Barrows Industries. “I always had the impression Henry just wanted to show he was doing better than his father,” recalled its retired chairman, Fred Barrows, Jr. “He always set very strenuous goals for himself…. Even then you got the sense Henry was getting too big for Jerry Kohlberg to stomach. Henry was just so aggressive. Jerry was much more conservative.”
The Barrows buyout, Kravis’s second deal, ended three years later after a series of rancorous disputes. Kravis charged that company executives were “playing games with the figures” to enable them to obtain incentive bonuses. Fred Barrows remembered the falling out differently. “Very frankly, I thought they were milking the company,” he says. “They wanted directors’ fees, but they weren’t directing. And then they had what they called maintenance fees. I said, ‘Look, why do we need all this expense?’…It just went against my Yankee grain.”
In the end, Barrows bought out Kravis and his investors, giving Kravis a 16.5 percent annual return on his money, little better than a certificate of deposit. Kravis was disappointed, but ultimately better off: Gold prices shot up shortly after, and Barrows eventually went out of business.
In fact, Kravis and Kohlberg’s experience with Barrows wasn’t all that unusual. After three successful buyouts in the mid-sixties, Kohlberg had yet to discover the Midas touch that would later bring Kohlberg Kravis to prominence. A graph of the returns from the fourteen buyouts he completed between 1965 and 1975 would start high on the left, then plunge straight down, ending in a series of low hummocks.
When stock prices turned down in the early 1970s, Kohlberg’s returns turned dismal, at least by later standards. Eagle Motors Line, an Alabama trucking outfit acquired in 1973, was a disappointment and had to be merged with another trucker. Boren Clay, Kravis’s first deal, hit a long slump before rebounding nearly a decade later. By far Kohlberg’s most spectacular failure was his sixth buyout, in 1971, the $27 million acquisition of a California shoemaker, Cobblers Industries. Three months after George Roberts closed the deal, the company founder and creative genius walked up to the factory roof during a lunch break and committed suicide. “Jerry called me and screamed, ‘The fucker jumped off the roof!’” recalls Robert Pirie, a Cobblers investor. Rudderless, its Jamestown, Pennsylvania, factory washed away in a subsequent flood, Cobblers ultimately went bankrupt. Kohlberg and his investors lost their entire $400,000 investment.
As Kohlberg and the two young cousins spent more time on their buyouts, it took them away from the bread-and-butter business of corporate finance, prompting grumbling among many at Bear Stearns, including their boss, Cy Lewis. “Cy was a legend,” says Bob Pirie. “Legendarily difficult.” Lewis was also a trader, and traders are notoriously short-term oriented. Decisions on the trading floor are made in a split second, profits on fractions of a point. Kohlberg’s buyout business, in contrast, was based on returns that took three, four, five years to realize, an eternity to Bear’s dominant trading culture. “Overnight was long-term for Bear Stearns,” Kravis liked to say. Cy Lewis thought Kohlberg was spending far too much on his silly buyout sideline. It simply took too long to make a buck, when it made a buck at all.
Matters came to a head in 1976 in the wake of Kravis’s disastrous decision to invest in a Hartford, Connecticut, direct marketing firm named Advo. Initially he and Kohlberg had turned down the deal as too risky, but reconsidered when Travelers, the big insurance company, suggested they do it together, offering Kravis 40 percent of the $7.5 million acquisition for just $200,000. “Hell,” Kravis said, “how can we lose?” Easily, it turned out. Advo’s business headed downhill fast. Kohlberg removed the president, leaving Kravis the interim chief for three weeks. Cy Lewis hit the roof when he found a Bear Stearns partner running a sputtering direct-mail outfit instead of producing income for the firm.
“What the hell are you doing up there?” Lewis demanded in a phone call. “Goddamn it, you should be at home drumming up new business. Forget this deal. We’ve got our fee, let’s go on with the next deal.”
“But Cy,” Kravis protested, “that’s not the way it works. You’ve got to stick with it a while.”
Kravis stuck with it long enough to unload his backers’ $200,000 investment for half that. Advo was a nightmare for him. If his losses weren’t bad enough, Bear Stearns and several Bear partners, including Lewis, had invested alongside them in the deal, further widening the gulf between Kohlberg and his colleagues.
As the political infighting worsened, Kravis threatened to quit. “Everyone, some of the partners, was telling me, ‘do this, do that,’ and I didn’t like anyone telling me wha
t to do,” Kravis recalled. Kohlberg urged him to stay the course. He proposed to Lewis that the three of them—Kohlberg, Kravis, and Roberts—set up a freestanding LBO group within Bear Stearns. Lewis said no.
“After that Jerry’s position within the firm really deteriorated,” Roberts recalled years later. “They were going to make life very difficult for him. Some administrative people were going to be put over him. It was clear he was going to be put in a box.” After much gnashing of teeth, Kohlberg repeated his request to begin an LBO group. Again Lewis refused.
Kohlberg and the two cousins began talking among themselves of resigning. With a nest egg of $5 million or so, Kohlberg had little incentive to remain. Roberts, anxious to follow his father’s lead into private business, pushed Kravis to leave, too. The two estimated how much money they could make at Bear Stearns over the next decade, compared to going their own way. Bear won. Kravis left anyway.
When Kohlberg announced their intention to resign, Roberts flew in from San Francisco to tell Cy Lewis personally. The chairman of Bear Stearns was a large, imposing man, and as Roberts delivered the bad news, Lewis leaned way over his huge desk. “You know, young man,” he said, “you’re making a terrible mistake. No one has ever left this firm and been successful.”
Then things got nasty. A few mornings later, Kravis walked in and found his office emptied, its door locked. A tall man in paratrooper boots stormed up to him.
“You vill not be in that office,” the man said in a German accent.
“What do you mean?” Kravis said. “I’m a partner here.”
A similar “hit man” arrived in San Francisco. The contents of Roberts’s office were saved only by the timely intervention of his West Coast colleagues. Dumbstruck, Kohlberg and Kravis confronted Lewis: “What the hell’s going on?”
Lewis had declared war on the traitorous trio. On their departure, he demanded that Bear Stearns retain control of all Kohlberg’s deals, even though the three had millions of their own money sunk in them and, in most cases, controlled the companies’ boards. Lewis attempted to apply pressure through Kohlberg’s investors, including insurance giant Prudential and the midwestern bank First Chicago. “But the Pru told him to ‘shove it,’ and so did First Chicago,” Kravis recalled. Eventually lawyers were brought in and, in a long, difficult negotiation, the trio kept control of its investments.
Barbarians at the Gate Page 18