Barbarians at the Gate: The Fall of RJR Nabisco

by Bryan Burrough

He looked hard at the president of RJR Nabisco, America’s nineteenth largest industrial company, a man who held in his hands the fates of 140,000 employees, a man whose products—Oreos, Ritz crackers, Life Savers, Winston and Salem cigarettes—filled every pantry in the country.

In an LBO, a small group of senior executives, usually working with a Wall Street partner, proposes to buy its company from public shareholders, using massive amounts of borrowed money. Critics of this procedure called it stealing the company from its owners and fretted that the growing mountain of corporate debt was hindering America’s ability to compete abroad. Everyone knew LBOs meant deep cuts in research and every other imaginable budget, all sacrificed to pay off debt. Proponents insisted that companies forced to meet steep debt payments grew lean and mean. On one thing they all agreed: The executives who launched LBOs got filthy rich.

Seventeen billion dollars. The largest corporate takeover in history, three times greater than the largest LBO ever attempted. They hadn’t seriously considered bidding much higher; with no competition in sight, there seemed no need.

“An accountant,” Johnson would say during his bookkeeping days, “is a man who puts his head in the past and backs his ass into the future.”

Tony Peskett, who imbued Johnson with a lifelong belief in the creative uses of chaos, put it another way: “The minute you establish an organization, it starts to decay.” Johnson, who carried that idea to every business he ever ran, boiled it down into a personal philosophy called “shit stirring”: a love for constant restructuring and reorganizing.

To do otherwise invited Johnson’s favorite withering line: “That was a blinding glimpse of the obvious” (sometimes shortened to simply “a BGO”).

A former accountant, Johnson camouflaged the company’s poor results with an occasional bit of financial sleight of hand, sometimes stretching generally accepted accounting principles to their generally accepted limits.

But America’s love affair with tobacco went largely unopposed until 1964, when surgeon general Luther Terry issued his landmark report linking cigarette smoke with cancer. Cigarette sales, which had risen an average of 5 percent a year, fell sharply.

The rise of the antismoking movement—the “antis,” Reynolds partisans spat—was taking its toll. By the early eighties, less than a third of Americans smoked. Federal excise taxes on cigarettes were doubled in 1983, to 16 cents

Tobacco remained a fabulously profitable business—prices were still raised twice a year—but even die-hard industry partisans saw the twilight ahead. By diversifying, Wilson was simply readying Reynolds for the inevitable.

Wilson thought company apartments for all the top officers of a cookie-and-cracker company was ridiculous. But he wasn’t giving up his dream over Johnson’s petty concerns; he gave in. Johnson insisted he be named president and chief operating officer, number two behind Wilson. He characterized it as a signal to Nabisco people that they wouldn’t be forgotten; Wilson gave in to that, too.

Wilson cringed at Johnson’s expense account. When he got a tab for a $13,000 weekend at a Colorado country club, he asked Johnson whether all the hoopla was really necessary. Johnson could always spin a superb rationale about how piddling the cost was compared to the goodwill his party had engendered with grocery executives. “A few million dollars,” he quipped, “are lost in the sands of time.”

“Why, if you listened to our guys, you’d think we were kicking the shit out of Philip Morris,” Johnson told them. “It reminds me of the boxer who’s getting beat up something awful and going back to his corner at the end of the round saying, ‘He never laid a glove on me.’ The trainer says, ‘Well, keep an eye on the referee, because somebody’s kicking the shit out of you.’”

Ross Johnson’s rise to the helm of RJR Nabisco had proceeded with blinding speed: CEO of Nabisco in 1984, the Reynolds—Nabisco merger in 1985, CEO of RJR Nabisco in 1986. If he had stopped there, kicked back, and assumed the life of North Carolina gentry, history might have looked very differently on his career. But Johnson, a man who devoted his life to shaking things up, had no intention of changing his ways. Reynolds Tobacco churned out $1 billion a year in cash, enough to fund the wildest schemes and cover the worst mistakes. “A billion dollars,” Johnson sometimes said reverentially. “You can’t spend that much money in a year.”

“You had a town of one hundred and forty thousand people, where you’ve got seventeen thousand people working for the company and ten thousand retirees and you can’t breathe,” Johnson recalled.

For all his free-spending ways, the fact was Johnson remained a prude about corporate debt, the core of any LBO. He remembered the backbreaking trips to GSW’s bankers twenty years before and cringed. Banks didn’t understand the need for golf tournaments and corporate jets. They cramped his style. No, he told Benevento, he’d take a pass on an LBO.

The jets were also a symbol of the increasingly fuzzy line between what constituted proper use of a corporate asset and what constituted abuse.

Johnson claimed his jocks yielded big benefits in wooing supermarket people, but the line between corporate and personal services was a blurry one at RJR Nabisco.

A firm such as Kohlberg Kravis, working with a company’s management, buys the company using money raised from banks and the public sale of securities; the debt is paid down with cash from the company’s operations and, often, by selling pieces of the business.

Johnson scanned Benevento’s work, paying particular attention to the coverage ratios, the cushion between cash flow and debt payments. They were simply too thin. Post-LBO companies were run in a notoriously spartan manner to conserve cash. As much as he tried, Johnson simply couldn’t drum up any enthusiasm for cutting costs, not to mention his precious perks.

It was the beginning of Johnson’s road to ruin, for the low stock price would haunt him for months to come. In December the company posted a 25 percent profit increase, and the Street ignored it. Even when food stocks rose that winter, RJR Nabisco remained in the dumps. No matter what Johnson did, buyers treated his stock like a tobacco stock, even though 60 percent of its sales came from Nabisco and Del Monte.

Mergers and acquisitions—M&A—were the ultimate creature of Wall Street because win, lose, or draw, they produced fees: fees for advising, fees for divesting unwanted businesses, fees for lending money. Just as they had fueled the Street’s mushrooming growth throughout the 1980s, takeover fees would again prop up the securities industry’s profits that spring.

As the bankers circled, Johnson remained transfixed by his stock price. It was like a scab at which he constantly picked. Most chief executives wouldn’t have bothered; many companies live with low stock prices all their lives, and almost no chief executive thinks Wall Street gives his stock its due. RJR Nabisco’s directors weren’t concerned. Profits were up; sales, too. But Johnson couldn’t leave well enough alone. The old urges to action were returning, and the stock price was simply their latest manifestation.

Henderson outlined the basics, as best he could. After management proposed a buyout, a special committee of board members was formed to consider it. At some point, they would have to make the offer public. And when they did, other companies, even Wall Street raiders, would be free to top it. Therein lay the risk.

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 it. 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.

Measured by the total sales of acquired companies, the LBO phenomenon increased tenfold between 1979 and 1983. By 1985, just two years after Gibson Greetings, there were eighteen separate LBOs valued at $1 billion or more. In the five years before Ross Johnson decided to pursue his buyout, LBO activity totaled $181.9 billion, compared to $11 billion in the six years before that.

Of the money raised for any LBO, about 60 percent, the secured debt, comes in the form of loans from commercial banks. Only about 10 percent comes from the buyer itself. For years the remaining 30 percent—the meat in the sandwich—came from a handful of major insurance companies whose commitments sometimes took months to obtain. Then, in the mid-eighties, Drexel Burnham began using high-risk “junk” bonds to replace the insurance company funds. The firm’s bond czar, Michael Milken, had proven his ability to raise enormous amounts of these securities on a moment’s notice for hostile takeovers. Pumped into buyouts, Milken’s junk bonds became a high-octane fuel that transformed the LBO industry from a Volkswagen Beetle into a monstrous drag racer belching smoke and fire.

Kohlberg Kravis and other firms were swamped with requests from chief executives to become “white knight” rescuers of their raider-besieged companies. It was a symbiotic relationship repeated in deal after deal: raider seeks target; target seeks LBO; and raider, target, and LBO firm all profit from the outcome. The only ones hurt were the company’s bondholders, whose holdings were devalued in the face of new debt, and employees, who often lost their jobs. In the sheer joy of making money, Wall Street didn’t pay too much attention to either group.

Central to the success of most LBOs is a ruse known as the “gun-to-the-head” strategy. In it, a group of senior corporate executives secretly works with a Wall Street firm such as Shearson to assemble financing. Once the financing is lined up and an offering price agreed on, the chief executive presents the bid as a take-it-or-leave-it proposition to his board.

WEEKS ONE THROUGH THREE: Preliminary work on values and price discussions. WEEK FOUR: Meet with banks to discuss loans. WEEK FIVE: Banks work to refine a loan structure. WEEK SIX: Management decides whether to pursue LBO. WEEK SEVEN: Directors are quietly informed and asked to secretly form an “independent” committee to analyze any LBO proposal. WEEK EIGHT: Management prepares a merger agreement. WEEK NINE: Management makes an initial proposal to the board. Negotiations begin with the independent committee. A press release is issued stating the board is “considering a buyout proposal.” WEEK TEN: An acquisition agreement is executed and announced publicly.

Hugel didn’t know what to say. Did Johnson know what he was saying? Did he realize he was offering, in essence, a bribe? Was he scheming or merely naive? With Johnson you never knew. “I can’t do that,” Hugel said hurriedly. “I’ll be chairman of the special committee.”

Wasserstein, also trained as a lawyer, paraphrased former Supreme Court justice Louis D. Brandeis. “Sunlight is the best of all disinfectants,” he told Kravis. If Kravis was worried about Johnson stealing this deal in some darkened back room, Wasserstein argued, he should shed some sunlight on the process. And the best of all illuminations, he continued, was an immediate tender offer. A meeting of the entire Kravis team was set for the next day.

Wall Street had always been split into two, sometimes warring, camps: investment bankers—smooth, dapper, trained at Andover and Harvard—and traders—red-faced Jewish and Irish kids who went to City College and made their living hollering at each other on the trading floor.

Gutfreund placed a call to one of Salomon’s most influential directors, Warren Buffett. Buffett was renowned as one of Wall Street’s most intelligent investors. His prognostications could move markets, and often did. He wasn’t a quick-buck artist—no raiding for Warren Buffett. Buffett invested the old-fashioned way: buy and hold.

The cartel’s product, the high-yield, or “junk,” bond, was by 1988 being used to raise money—usually for takeovers—by virtually every major investor, brokerage house, and leveraged-buyout firm.

Goldstone tried to swivel Johnson’s focus from the past to the future. Kravis’s ambush drastically raised the stakes: If they were going to fight, they now would have to top $90 a share. Running a post-LBO company at $90 a share, Goldstone said, would be radically different than running one bought at $75. The added debt would require wholesale cuts of the kind Johnson dreaded. The planes, the Atlanta headquarters, even Premier, would have to be reassessed.

Jim Robinson’s alarm grew as he read a copy of Johnson’s management agreement for the first time Monday afternoon. It was worse than he had feared: the veto, the free ride, the incredible total all bothered him. But what worried the chairman of American Express most was what Wall Streeters called the “cosmetics” of the deal: From a public point of view—and Robinson had no doubt the document would ultimately be disclosed—the agreement simply looked awful. In a reporter’s hands it would be turned into a document of greed incarnate. To Robinson the prospect of seven men’s sharing up to $2 billion was a public relations disaster waiting to happen.

The subject of cost cutting, one of the keys to a successful LBO, was raised. To Roberts’s surprise, Johnson said he didn’t care much for wielding a budgetary ax. Anyway, he explained, cutting costs was an overrated procedure. “Any Neanderthal can go in there and whack away and cut costs,” he said. “Show me a guy that can spend money.”

“How high is this thing going?” Johnson wondered aloud. “We’re talking serious money here, now. Jimmy, you know, basically, the business can only produce what the business can produce. No matter how good it is, if you pay too much, you’ll lose.”

In one way, an LBO is a lot like buying a used car. A target company’s annual report and public filings can be compared to a classified ad. Like an advertisement, they contain useful information, although a savvy buyer knows the numbers can convey anything a clever accountant needs them to.

An image began to form in Forstmann’s mind. The junk-bond hoards are at the city gates, Forstmann thought. We could stop them, once and for all. This is where we could stand at the bridge and push the barbarians back. Wouldn’t that be phenomenal?

In the end, then, perception was the issue. Perception about who was running a set of bond offerings that, to Johnson or any other acquirer, was a detail. For despite its status as a full partner in Johnson’s deal, despite all the high talk about merchant banking, Salomon’s principal mission wasn’t owning Oreos. It was selling bonds. And it was willing to sacrifice Johnson’s interests—indeed, his entire deal—to avoid the perception that it was taking a backseat to its hated rival, Drexel.

Johnson’s problem was that he insisted on thinking in terms of the real world, real money, real investments. In effect, Goldstone said, this wasn’t the real world. This was Wall Street.

And it would include what Johnson dubbed the three rules of Wall Street: “Never play by the rules. Never pay in cash. And never tell the truth.”