The New Tycoons

by Jason Kelly

  With REDF, Roberts has looked for ventures that will hire what he called the bottom 5 percent of society. One such group, a San Francisco-based organization called Juma Ventures, won several concessions including two Ben & Jerry’s Ice Cream stands at Candlestick Park, home of the National Football League 49ers. Through that and other programs, REDF has helped get jobs for more than 6,500 people, Roberts said.

  Cousin-to-cousin meetings are where the seminal decisions regarding the firm are made. It was in Kravis’s small meeting room that he and Roberts sat in 1999 and mulled over the future of the firm that bore their names, one of a series of philosophical explorations. At a partners meeting around that time at the Doral near Palm Springs, the two men were visiting when George turned to Henry and said, in his typically blunt way: “Are you having any fun? Because I’m not.” Kravis admitted he wasn’t. Roberts pushed it further. “We’re making a lot of mistakes,” he told his cousin. They both knew instinctively that things were going wrong and they were trying to understand why. As they spent two days talking it over, Kravis zeroed in on something: the closing dinner.

  The closing dinner is a tradition in the world of mergers and acquisitions, a fancy meal after everything is documented and signed, to celebrate the consummation. It brings together the deal guys from the private-equity firm, the investment bankers and lawyers and others involved in the transaction, to eat and toast the success of at least getting the deal done. What Kravis started thinking about was what’s become an axiom for him over the past few years: Don’t congratulate me when I buy something. Congratulate me when I sell it.

  What he told Roberts back in 1999 boiled down to this: “The team would come out of the closing dinner and start working on the next deal.” It represented a broader mindset that was pulling the firm down. Everyone was everywhere, and therefore nowhere with any focus. That was showing up in the numbers. After the 1986 fund returned a staggering 7 times investors’ money, the 1993 pool had given back 1.7 times what limited partners put in. The 1996 fund’s multiple was 1.8 times.4

  The firm had made some bad deals in telecommunications as the technology boom heated up. A survey of investors showed that their prized limited partners liked them but had virtually no idea what KKR actually did, beyond give back more money than they’d started with.

  Kravis and Roberts initiated a multi-faceted approach. They decided each investment would have a 100-day plan, like General Electric had for its businesses, forcing the dealmakers to think beyond the closing dinner. The pair, who’d been content to have every partner be a generalist, organized executives into industry teams (initially 12 groups, later pared to nine). “We made it clear that we expected them to understand an industry from the bottom up,” Kravis said. “Go to trade shows, meet with purchasing managers, marketing and sales managers, really get into the flow of whatever the business was.”

  KKR also decided to open its first international office. After debating whether to go to the United Kingdom or Germany, they decided to open in London in 1999. They sent Edward “Ned” Gilhuly and Todd Fisher over to bring the KKR way of doing things.

  The global expansion foretold even bigger changes that would test the cousins’ ability to sustain their prized culture. Succession plans took a potential hit in 2005, when Gilhuly and Scott Stuart, who’d headed the utilities and consumer products groups, left to start their own firm. The departure was rare and involved two men “widely believed to be the best and brightest of the next generation at KKR.”5

  Around the same time, Kravis and Roberts were exploring ways to expand KKR beyond private equity, an effort that made sense on paper given the firm’s well-known brand, but was difficult in practice. The first major effort was in credit and the firm set up KKR Financial in 2004. The publicly traded fund was meant to buy debt in situations where KKR determined it couldn’t play an investment idea through a traditional leveraged buyout. “We were frustrated when we’d go to a meeting with an idea to buy a company and the CEO would say, ‘We have no interest in going private or selling a subsidiary’,” Kravis said. “Those were very short meetings.”

  KFN, as it was known because of its stock symbol, endured a troubled few years, barely surviving the credit crisis because of investments in mortgage-backed securities. The CEO of the business, Saturnino Fanlo, left in 2008 and Kravis and Roberts gave responsibility for KFN to the KKR Asset Management subsidiary run by Sonneborn.

  Kravis and Roberts saw another business opportunity in capital markets, specifically in raising equity and debt for companies they owned. Getting a piece of that business had the additional benefit of paring the amount of money KKR and its companies were paying Wall Street banks for those underwriting services.

  Kravis had to assure bankers on Wall Street he wasn’t looking to put them out of business. In reality, KKR doesn’t act as lead manager on any deals, only as a co-manager. Farr, the KCM head who’d come over from Citigroup, preached the same message, telling banks that the strategy was in part about winnowing out smaller relationships. “It’s been a huge work in progress,” he said. “Where we pay our fees has become much more concentrated.” And as Farr found ahead of the Dollar General deal, an arguably tougher audience was a group of KKR partners who were having a hard time embracing anything that wasn’t straight-up dealmaking.

  “At the beginning, it was so hard to get people to think outside of private equity,” Kravis said, referring to both capital markets and KFN. “It was hard for PE guys to accept capital markets at first. They looked at them as a vendor.” Kravis and Roberts set about preaching a one-firm message at every partners’ meeting, a vision that it took to the public as well. At the firm’s first meeting for its public shareholders in 2011 he and Roberts, along with Nuttall and most every executive who spoke, repeated the phrase “one-firm approach.”

  Part of making the case for teamwork was to remind each employee of the firm’s pay structure. Kravis described the experience at Bear Stearns as formative in a number of ways, including how the founders decided they would pay their employees. Like many Wall Street firms, Bear Stearns had an “eat what you kill” culture whereby your compensation was largely based on what business you brought in. Kravis described a culture where you locked your office or your desk when you went home at night so no one took clients or business ideas.

  The KKR founders decided that everyone would have a piece of the firm, however small. During end-of-year reviews in the early days, Kravis would walk each employee through the compensation, consisting of salary, bonus, and then carried interest. To the rank and file that seemed at best difficult to understand, and at worst, essentially made up. That’s why Kravis and Roberts took to personally walking around the office handing out distribution checks. In one memorable case in the 1980s, the sale of a single portfolio company meant secretaries each got a one-time $80,000 check for their participation in that deal hand-delivered by the bosses.

  The underlying theory exists today. KKR has one “carry pool,” that is, a single pot where all the profits from its funds pour into each year. While compensation is tied in part to how well an executive did in his or her individual business line, the single pool gives management wide latitude to reward behavior that inures to the benefit of all KKR. “It helps make it feel like it’s bigger than any one person,” Sonneborn said. “It’s the difference between being a firm and a franchise.”

  While becoming enormously wealthy along the way through the funds (the cousins are mainstays on the Forbes richest Americans list) Kravis and Roberts chipped away at their ownership of KKR during the 1990s and into the new millennium, in part to ensure they could keep spreading some portion of the firm’s ownership through the growing ranks. When KKR finally got its public listing on the New York Stock Exchange, everyone learned the numbers. The two cousins each owned a little less than 14 percent of the firm, a figure Kravis said he thinks surprised some people.

  The decade following Kravis’s and Roberts’s seminal meeting to reset the direct
ion of the firm also saw the cousins begin to come to grips with its profile and its place in the broader and economic landscape. While the RJR deal, and the publication of Barbarians several years later, had thrust the firm into the public eye far more than their peers, KKR still largely maintained the mindset of a private partnership.

  The buyout boom that began in 2005, accelerated in 2006, and crested in 2007 changed all of that. Even excluding RJR, KKR had historically owned a number of companies with recognizable brand names, from the Safeway supermarket chain to Regal Cinemas. But the deals it undertook in the middle of the century’s first decade dwarfed all of the previous efforts on most every measure.

  From 2005 to 2007, KKR announced $244.5 billion worth of deals, according to data compiled by Bloomberg. That’s more than triple the value of all the deals KKR announced from 1988 through 2004, the data show ($70.5 billion). The company also was buying companies that served everyday consumers, from Toys “R” Us to Dollar General, as well as companies that served businesses, companies like First Data and SunGard Data Systems. Every one of those deals was worth $7 billion or more.

  Kravis and Roberts decided in 2006 to sell shares in Europe for a fund called KKR Private Equity Investors, which traded in Amsterdam. The fund was designed to raise money to co-invest in KKR deals, and did so. A few other things happened along the way: The fund didn’t do especially well, it gave the firm a window into being public, and the public a glimpse into the firm, and it ultimately provided a roundabout way to get KKR itself publicly listed after a stalled attempt in 2007.

  KPE went public in 2006 at $25 a share, and it never saw that price again. Public investors, as Steve Schwarzman would learn when he took his own firm public, were puzzled as to how to value illiquid investments in private-equity funds. Illiquidity took another form in the case of KPE; since few people bought the stock, it was thinly traded.

  Through quarterly earnings reports, KPE did provide a sense of how some of KKR’s investments were performing; since KPE was an investor in many of the deals, it disclosed publicly where KKR was marking those holdings. Kravis and Roberts alternated giving commentary on the quarterly conference calls, providing the broader world an opportunity rarely afforded beyond KKR’s limited partners—the worldview of an increasingly important investor putting money to work around the world.

  With KPE not living up to its promise and KKR’s efforts to get itself onto the New York Stock Exchange stalled, KKR and its lawyers came up with a clever solution, one that, even for guys used to complicated deals, was blazingly complex. The firm merged itself with the fund, which it already owned a part of, and the combined entity continued trading in Amsterdam. At the time of the merger, KKR told investors that it had the option to move the listing to New York within a year, which it did. KPE plus KKR became KKR (Guernsey) and then became KKR on the NYSE.

  For KKR, nothing illustrated the new world of big takeovers more than its pursuit and ultimate purchase of what was then known as TXU, the biggest power producer in Texas. To win the deal, KKR and TPG employed a small army of outside advisers and relied on their own founders to win over environmentalists, regulators, and legislators. The experience of that deal, and what followed for both the company and private-equity industry, marked the beginning of a new era defined by more publicity and more scrutiny.

  Announced with fanfare in 2007, Energy Future was headed toward being a bad deal from an investment perspective within two years, and the biggest deal in history may in fact end up being among the most disappointing for investors. By early 2012, a debt default was seen as virtually certain. Credit-default swaps, a financial instrument investors use to bet on whether a company will meet its debt obligations, put the chances of default at 91 percent within three years.6

  At issue were natural gas prices, which were central to the business case to buy TXU in the first place. The buyers believed prices for natural gas would continue to rise, driving the price for wholesale power, which the company provides, higher. That would in turn increase the value of TXU. Along the way, they made other changes to the company, including shuttering some coal-fired plants and modernizing other facilities, but this was really a bet on gas prices. Instead, a recession in the United States crimped demand and, to make matters worse for Energy Future, huge stores of natural gas became drillable in shale deposits, mainly in Pennsylvania.

  It’s worth noting that KKR, ever opportunistic, seized on the shale boom and broader interest in natural resources to great success. Marc Lipschultz built a portfolio of shale-related companies, two of which KKR sold within roughly a year of buying them. Lipschultz tripled the value of one investment in 2011 through a sale of oil and gas leases in Texas. That followed a deal in 2010 where KKR quadrupled its money on a shale investment.7 What ultimately undid TXU’s investment thesis—natural gas supplies and prices—made KKR and its investors huge amounts of money through the shale plays. “Those are investments made on two different sides of a revolutionary change in the energy world,” Lipschultz said.

  Those deals were part of a typical grind-it-out strategy that dated back to 2000, when KKR created industry groups and they began swarming around strategies to make money in areas like energy. Oil and gas tied back to Kravis’s and Roberts’s own roots in Texas and Oklahoma; “this is anchored to the heritage of the firm,” Lipschultz said.

  With default effectively certain and their equity most likely wiped out, the owners sought to accentuate the positive. Even with a crippled balance sheet, TPG and KKR did in fact modernize a number of the facilities. Employment at Energy Future grew. From a broader perspective, the deal created within both firms a sense of the new world order for their business. TPG and KKR, largely because of Energy Future, now have established executives devoted to environmental and sustainability issues. The deal also precipitated the hiring of senior executives overseeing public affairs. Former Republican National Committee Chairman Kenneth Mehlman is at KKR; Adam Levine, who worked in the George W. Bush administration, is at TPG. Both worked as outside advisers before going in-house at their respective employers. Over at Carlyle, government relations falls under the purview of David Marchick, who worked in the Clinton administration and then as an outside lawyer to Carlyle before joining the firm.

  Even before the TXU deal, Kravis and Roberts were becoming more and more aware of the increasingly public nature of the business. “If you want to own the Hiltons and the HCAs of the world, you’re going to bring a lot of scrutiny,” Mehlman said. “You’re going to be the center of attention.”

  The process of negotiating for, buying, and winning regulatory approval for TXU only served to underscore all of that, he said. “That made us realize we had to do it in a methodical way.” All of it speaks to a theme hammered on across the big firms. This is not the same business it was at the outset or even at the turn of the century.

  Roberts said being public hasn’t changed the firm much, or at least how he thinks about KKR. Gaining the ability to have a balance sheet, a credit rating that allows the firm to borrow more, and a currency with which to make acquisitions is worth the additional scrutiny and rigors of quarterly reporting. Roberts and Kravis intentionally don’t participate in the public calls with analysts and investors around earnings releases, a choice Roberts pointed out was the same as at Goldman Sachs, where the chief financial officer handles those duties. Blackstone’s Schwarzman and James do speak and answer questions on calls to announce earnings results.

  But being public and being in the public eye are different, and Roberts conceded that the outside world has forced a change in his and his competitors’ behavior. “It’s gone from all that matters is shareholder value to being much more than that,” he said, rattling off efforts around the environment, government relations, and outreach to unions. The firm has sought the advice of former U.S. House Majority Leader Richard Gephardt. Andy Stern, in the past decade the fiercest critic of private equity in the labor world, spoke at a KKR meeting in 2011.

  “W
e have close to a million people working for our companies,” Robert said. “We can’t be tone deaf to that.”

  Notes

  1. Bryan Burrough and John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco (New York: Harper Perennial, 1990), 133.

  2. Jason Kelly and Oliver Staley, “Kravis Pledges $100 Million for Columbia Business School Campus,” Bloomberg News, October 5, 2010.

  3. www.redf.org

  4. Oregon Public Employees Retirement Fund Alternative Equity Portfolio. www.ost.state.or.us/FactsAndFigures/PERS/AlternativeEquity/FOIA%20Q3%202011.pdf

  5. Henny Sender, “KKR’s Two Rising Stars Depart to Launch Fund,” Wall Street Journal, September 14, 2005. http://webreprints.djreprints.com/1552540178006.pdf

  6. Mary Childs and Julie Johnsson, “KKR’s TXU Buyout Faces 91% Default Odds in Shale Boom: Corporate Finance,” Bloomberg News, January 19, 2012.

  7. Devin Banerjee, “KKR Hires RPM’s Farley, Rockecharlie to Grow Oil and Gas Investments,” Bloomberg News, November 1, 2011.

  Chapter 6

  Put on Your Boots

  The Rise of “Ops”

  You’d never guess Deb Conklin is a native New Yorker. Her whole vibe is Southern, from her deep accent to her backslapping nature to her impressive knowledge of college football.

  Three days before we met in something close to the geographically dead center of Pennsylvania, her team, Clemson, got clobbered by Georgia Tech and she was, as they say in the South, still spittin’ mad. “I can’t even talk about it yet,” she said as we drove to lunch. Then she proceeded to talk about it extensively, and passionately, deconstructing her beloved Tigers’ loss and the implications for their now-faded national championship hopes. Later, when the talk turned back to her work at the private-equity firm TPG, she used a couple of football analogies to explain what she actually does.