Caledonia Group Inc.

The New Financial Capitalists: Kohlberg Kravis Roberts and the Creation of Corporate Value by George P. Baker and George David Smith (Cambridge University Press, 1998, 275 pages, $24.95).

Churchill observed that people have a remarkable ability to stumble upon truth and then to pick themselves up and pass it by. Though founded in 1977, the impact of Kohlberg Kravis and Roberts and the broader LBO phenomenon on American business was already recognized in the early 1980s. "This massive corporate restructuring may simply be a fad, the brainchild of a few enterprising investment bankers foisted upon impressionable corporate managements," wrote academic researchers in 1984. But they added: "However, the empirical findings suggest that these restructuring transactions create significant value for stockholders. Such widespread changes may in fact reflect a major development in the evolution of the corporate form--an evolution toward greater efficiency, toward a corporate structure more effective in generating and storing value for stockholders."

More than twenty years have passed since KKR was founded and there's now an ample track record to assess the early promise discerned by research economists. Returns on investment for KKR have been 28.2 percent per annum in gross terms from 1977 through 1997, while KKR's limited partners have realized $22 billion in cash on a total cumulative equity investment of $10.9 billion in 58 companies, with an estimated $18.1 billion still unrealized.

Now, George P. Baker and George David Smith, two business school professors (Harvard and New York University, respectively) have written The New Financial Capitalists: Kohlberg Kravis and Roberts and the Creation of Corporate Value. As they see it, the KKR approach has been remarkably consistent throughout the firm's history. In 1983 Henry Kravis summarized it, saying: "Our approach is that we do not know how to run a company. We know that we are very good at financing, we are financially oriented. We know how to control a company and we know when it is getting off course. We know how to set long-range goals for companies and we know how to maximize value in a company."

Baker and Smith conclude that what explains KKR's results is "A carefully nurtured combination of flexible financing, strong management talent, well structured incentives, active board monitoring and constant attention to detail."

For turnaround professionals who, like KKR, are committed to creating long-term value, the KKR model is instructive. This book looks in detail at many individual deals and how they worked out (or didn't--KKR's failures get as much attention as the successes). Generalizing, the genius of KKR and the instructive model for turnaround professionals is the strategic blending of financial structure, operating improvements, incentive alignment and governance.

Although today there are some 800 LBO funds, KKR more than any other is probably still synonymous with debt financing and highly leveraged transactions. LBO critics anticipated that the short-term gains of debt binges would surely be disgorged, but with some exceptions it didn't turn out that way, at least for KKR. To the contrary, debt was often paid down faster than planned. And therein lay a key to increasing value. Baker and Smith nicely summarize the basic mechanism:

To see how this works in general terms, imagine an all-equity company that is bought for $100 million. Before the acquisition, this company generates $10 million in cash flows, just enough to give shareholders a 10 percent return. The acquisition is financed with $90 million in debt and $10 million in equity. The company is then able, through improved operations, superior asset utilization and careful capital investment, to increase cash flows from $10 to $20 million per year, without either increasing or decreasing the value of the assets. By paying no dividends and by using this $20 million in cash flow strictly for debt service, this company can pay down the $90 million of debt (at an interest rate of 10 percent) in about 6 years. At the end of that period the company would still be worth $100 million but it would now be all equity. In other words, the original $10 million equity investment has been transformed into one worth $100 million, for a 47 percent compound annual rate of return! [p. 60; emphasis in the original.]

As a core principle, conservative forecasts of projected cash flows available to service debt governed the types, levels and terms of a financing; all flexibly arranged to match lender preferences and the characteristics of a specific business within the constraint of the likely ability of that business to meet interest and principal payments. Debt creates opportunities for "transformations" that generate rates of return like those in the example above.

But there's more to success than borrowing, of course. Merton Miller of the University of Chicago was awarded a Nobel Prize in Economics in 1990 for his contributions as the father of modern corporate finance. Miller holds that when isolated from other factors, the mix of debt and equity in a company's capital structure shouldn't affect the company's real value. But, again, there's more. In his Nobel lecture, entitled "Leverage," he said, with characteristic modesty: "The source of the major gains in value achieved in the LBOs of the 1980s lies, in fact, not in our newly recognized field of finance at all, but in that older and long-established field of economics, industrial organizations that the LBO entrepreneurs have achieved substantial real efficiency gains by reconcentrating corporate control and redeploying assets has been amply documented." Thus Miller points us toward the other elements of the KKR approach.

For KKR, the real work of a deal begins after closing on the acquisition. A leveraged capital structure involves discipline as well as opportunity. The pressure of debt service forces management to take decisive action on short-term problems. Low-hanging fruit can't be left unharvested. On the other hand, the multi-year process of transforming debt to equity value works against profit-taking myopia. The future can't be plundered for the present. Results depend on the hard work of cost control, standardizing and rationalizing production, effective capital investment programs and the institution of administrative systems and a planning process that support continuous improvement.

Strong management is essential to maximizing value. Further, KKR acts on the truism that people perform in accordance with what they're rewarded for. Suppliers, customers, employees, retirees and the community are among those acknowledged as stakeholders in a company, in addition to the shareholders. To the greatest extent possible, KKR attempts to align these disparate interests. Effectively structured incentives tend to unleash strong performance. Thus, one KKR partner puts the matter baldly: "We make as many people in the company shareholders as we possibly can. If managers are really thinking of the shareholders best interests they will properly balance the concerns of all the constituencies relevant to the company." Through mechanisms such as phantom stock KKR works to create incentives for performance throughout the whole company.

To tie together financial structure, management considerations and operations in a KKR company, the board is run as the forum in which owners and managers meet to harmonize different perspectives in pursuit of value. Strategy is hammered out in this venue, after which implementation is closely monitored. To link back to an earlier theme, the authors observe that, "The strict discipline of debt allows for no slack, no surprises, no deviance. If a problem lurked, candor was crucial. Under buyout conditions, management became transparent."

The New Financial Capitalists is excellently written, without jargon and with much more substance than a pop business book. Its six chapters can be read independently or selectively according to a reader's interests and available time. As a company history, it's outstanding, in part because it avoids both the congratulatory whitewash and the kiss-and-tell focus on personalities that characterize so much of the genre.

With so much in favor of KKR, Baker and Smith feel compelled to account for the hostility that the firm and LBOs generally have engendered. Insight is drawn from a seminal economist: "Entrepreneurs are, after all, agents of creative destruction, as Joseph Schumpeter so aptly labeled the processes of change that they set in motion; their successes invariably upset existing social arrangements, transferring wealth and power from old to new sectors of the economy."

But there's a somewhat different, better way to look at the role of such entrepreneurs. Baker and Smith open their book with a quote from the same economist, Joseph Schumpeter: "Economic progress, in capitalist society, means turmoil." A technical name for this turmoil is disequilibrium, a phenomenon studied by Theodore Schultz, another of the University of Chicago's great Nobel laureates.

Building on Schumpeter's insight, Schultz recast the role of the entrepreneur. Rather than causing disequilibrium, Schultz saw the entrepreneur as restoring equilibrium when things went wrong. Of course, finding ways to restore equilibrium virtually defines professional life in the turnaround business. Although the urgency of bankruptcy and crisis resolution often limit attention to the immediate and the short-term, the example set by KKR points turnaround professionals toward ways to achieve long-term, sustainable value.

For many situations, however, leverage isn't an answer. KKR itself has looked in a disciplined way for companies with sufficient cash flows to support their basic debt-to-equity transformation strategy. But the general principle of linking financial structure to measures of value creation appropriate to each organization is a universal goal. More broadly, for many troubled companies, leading them toward the kind of incentive-aligned, board-governed, financially tailored structures pioneered by KKR is surely a route to long-term "restored equilibrium." The New Financial Capitalists brings these issues to the fore so that, in contrast to the people Churchill observed, we needn't be blind to the potential.

Hite, Gailen L. and James E. Owers. The Restructuring of Corporate America: An Overview. Reprinted in The Revolution in Corporate Finance. Edited by Joel M. Stern and Donald H. Chew, Jr. Oxford: Basil Blackwell, Ltd., 1986, pp. 418-427.

Miller, Merton H. Leverage. Reprinted in Merton Miller on Derivatives. New York: John Wiley & Sons, 1997, pp. 141-150.

Schultz, Theodore W. Restoring Economic Equilibrium. Cambridge, Massachusetts: Basil Blackwell, 1990.