Barbarians at the Gate: The Fall of RJR Nabisco

by Bryan Burrough

“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 man who referred to his workers as “a great family,” Green made Nabisco a benevolent employer. Within three years of its founding, he installed a system for the company’s employees to buy stock on cut-rate terms, making them what he called “associate proprietors.”

“I can’t fucking believe this!” Murray exploded. “If it’s dangerous out there, don’t wait two hours; close the place down. Nobody’s going to do shit for those two hours, anyway. That’s fucking ridiculous.” A stunned silence ensued. Finally Jim Welch, a senior Nabisco executive chairing the meeting, broke it. “I agree with John one hundred percent,” he said. It was one of the first shots of the cultural revolution that would transform Nabisco.

Someone had once codified the Standard Brands culture into twenty Johnsonisms. Number thirteen was “Recognize that ultimate success comes from opportunistic, bold moves which, by definition, cannot be planned.”

In the context of its age, Reynolds was a remarkable institution. At a time when the South was desperately poor and mired in an agrarian economy, here was a company taking an indigenous agricultural product and making it a major industrial business. At a time when southern businesses were generally controlled by absentee Yankee owners, here was a company under local control raining cash on its community.

The community’s Moravian values became, if anything, even more imbued in the company. Work: Competitors’ tobacco buyers returned home and goofed off after the eight-month tobacco-auction season. Reynolds’s were assigned to cull the tobacco leaves they had bought, forcing them to contemplate the quality of their labors. Thrift: Reynolds workers were expected to turn in the stub of a pencil to get a new one. A young manager running a small fan in his office on a sultry summer day was admonished to unplug it. A waste of electricity. Ingenuity: The company developed a way to recycle scraps and stems of tobacco to greatly increase the usable amount of each leaf—and greatly increase profits. “Reconstituted tobacco,” as it was called, was considered classic Reynolds: a blend of its manufacturing know-how and its waste-not, want-not culture.

He liked to wander the factory floor, greeting workers by name and inquiring after their families. “I remember some mornings pulling up beside Mr. Whitaker in his little brown Studebaker,” a former employee recalled. “He’d give me a wave and I’d give him a wave back. We were going in to work together. We were all after the same thing.” (There was an unwritten rule that Reynolds executives didn’t drive anything bigger than a Buick. Even years later, when David Rockefeller came to Winston-Salem for a speech, an assistant asked that he be provided with a limousine. One couldn’t be found in the entire city.)

In order to top profits aided by loading, the company had to load even more—and so on, ad infinitum. It created huge inventories in the hands of wholesalers and retailers. When those inventories couldn’t be sold, one of two things happened, neither of them good.

Said John Gora, a Nabisco candy division executive: “It was like we’d been bought by the federal government.”

“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.’”

All down the line, Reynolds people were thrown into the streets to make room for Johnson’s Nabisco cronies.

Sticht had begun the process, but under Johnson RJR Nabisco was finally torn loose from the old-fashioned Reynolds value system. Out went Moravian: Make way for bacchanalian.

Johnson was an idea man, not a details man. As ideas like Beck’s began to pile up, he handed them off to an informal group of advisers he took to calling his “financial R&D department.”

The basics of an LBO were relatively simple and familiar to all three men. 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.

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.

After five to eight years they resold their companies, or took them public again, often getting three, four, five, even ten times their original investment. By 1983 Kohlberg Kravis claimed an average annual return of 62.7 percent to their investors. Their own 20 percent stake made the three men rich.

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.

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.

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.

By the mid-1980s competitors such as Morgan Stanley and Merrill Lynch were thrusting into LBOs and, in efforts to compete with Drexel’s junk-bond capabilities, had begun lending their own money in interim takeover financings known as “bridge loans.” These loans were typically refinanced, or bridged, by the later sale of junk bonds. The trend was collectively known as merchant banking, a highfalutin term that basically meant investment banks were putting their money where their mouths had been for years.

“All these guys,” says the chairman of one of Wall Street’s largest firms, “have three balls. Loyalties one, two, and three are to themselves. Loyalties four and five are to their buddies in the deal business. Loyalty six or so is to their client.” In their world, takeovers are “deals,” and the top producers are “players.” The top players juggle work on several deals at once. At any given time, on any number of deals, they may be simultaneously teamed with and opposed by their closest friends.

Around the world there are thousands of commercial banks. In the takeover world, only three count. Citibank, Manufacturers Hanover Trust Co., and Bankers Trust formed a powerful triumvirate with loose control over the spigots through which flowed the billions of dollars in money necessary to fuel Wall Street’s takeover machine.

A man who had ruthlessly frozen out his own mentor and who seemed to take pride in firing challengers to his power, Gutfreund found himself spending much of his time suppressing internal revolts. As he did, profits and morale plummeted. A series of ill-advised restructurings led to a spate of high-level resignations, including those of Chicago deal maker Ira Harris and economic guru Henry Kaufman. At his lowest point, Gutfreund narrowly escaped a takeover attempt by the investor Ronald O. Perelman.

Gutfreund was skeptical, attributing their passion to “deal heat,” the state that occurs when an investment banker finds the takeover of a lifetime. In most “deal guys,” Gutfreund had observed, the symptoms cropped up every month or two. The bankers, Gutfreund recognized, believed they had stumbled on their Holy Grail: the deal that could Bring Us Back. RJR Nabisco was to be Salomon’s salvation, the deal that would, in one fell swoop, rewrite history, wipe out their past embarrassments, and instantly establish Salomon as a major force in the LBO field. An admirable goal, Gutfreund thought, but an unlikely one. And certainly risky.

Go for it, Buffett advised. Once one of RJR’s largest shareholders, he knew tobacco and liked it. “I’ll tell you why I like the cigarette business,” he said. “It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”

Would Buffett himself like to join forces with Salomon? No, the investor said, not this time. Cigarettes were a fine investment, but owning a tobacco company, with its social baggage and all that Death Merchant business, wasn’t a burden Buffett felt he was ready to bear. “I’m wealthy enough where I don’t need to own a tobacco company and deal with the consequences of public ownership,” he said.

No longer, Forstmann believed, did buyout firms buy companies to work side-by-side with management, grow their businesses, and sell out in five to seven years, as Forstmann Little did. All that mattered now was keeping up a steady flow of transactions that produced an even steadier flow of fees—management fees for the buyout firms, advisory fees for the investment banks, junk-bond fees for the bond specialists. As far as Ted Forstmann was concerned, the entire LBO industry had become the province of quick-buck artists.

Ruttenberg told Forstmann something the younger man would never forget. “I have a reputation, it’s all I have, and I don’t want to lose that reputation,” he said,

In the spirit of men bailing out a sinking ship, the gnomes at Shearson quietly tossed each of Johnson’s corporate playthings overboard to make possible a higher bid. “All the planes, the penthouses, Premier, the country clubs, the Atlanta headquarters,” recalls Tom Hill, “had to be napalmed.”

But on Wall Street, with its steady flow of gossip and inside information, a score of public relations professionals have managed to achieve considerable power. Their rise is understandable: As the business press devoted more space to the great takeover battles of the 1980s, the importance of manipulating its coverage grew. By the end of the decade, each entrant into a takeover fight routinely hired a p.r. firm to work alongside its investment banker and attorneys. For years Wall Street public relations has been dominated by a single firm, Kekst & Co., and its well-connected founder, Gershon Kekst.

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. Through all the machismo, through all the greed, through all the discussion of shareholder values, it all came down to this: John Gutfreund and Tom Strauss were prepared to scrap the largest takeover of all time because their firm’s name would go on the right side, not the left side, of a tombstone advertisement buried among the stock tables at the back of The Wall Street Journal and The New York Times.

The backbone of any successful LBO is a set of projections: profits, sales, and, most important, cash flow. Because they dictate the amount of debt a company can safely repay, projections are the key to formulating a bid. And the right bid means everything to an LBO: The higher the price, the higher the debt. Too much debt can crush the healthiest companies.

After eleven years at the Big Eight accounting firm Peat, Marwick, Mitchell & Co., where he worked with Pritzker and other big-name investors,

Wouldn’t lots of people lose their jobs? Sure, Johnson said, “But the people that I have, particularly the Atlanta people, have very portable types of professions: accountants, lawyers, secretaries. It isn’t that I would be putting them on the breadline. We have excellent severance arrangements.” That wasn’t quite true. The special committee wanted each bidder to include employee-protection guarantees in their draft merger agreements, a notion the management group was stoutly resisting. The point would take on significance, because a longtime employee was lobbying hard for the employee protections.

There were no rules governing the bidding process. What exists is a constantly changing body of law developed during a series of takeover battles in the mid-1980s. The cases, most decided by the Delaware Chancery Court, say volumes about the obligations of directors to run fair auctions. What they don’t say is how to end one. During the late 1980s board after board unsuccessfully grappled with the question. The $6 billion auction of Federated Department Stores in early 1988 stretched on for weeks, despite determined attempts to conclude it. In the end, most auctions closed when bidding got too high for all but one party.