Barbarians at the Gate: The Fall of RJR Nabisco

“Part of his disaffection was due to the fact that Johnson, now moving into his late forties, was no longer the boy wonder of the mid-seventies. The idea of becoming a sedate corporate elder made him shiver. He wasn’t interested in growing older; he longed to be the enfant terrible, the eternal shit-stirring youth. Everything about him, from the still-shaggy hair to his twenty-six-year-old second wife, suggested a corporate Peter Pan. What was needed, it was clear, was a new adventure.”

The authors convincingly demonstrate that Ross Johnson’s approach to business, including major deals, was often motivated by excitement and adventure rather than business concerns. This approach was in line with his taste for luxury and corporate excess, a trait some of his colleagues considered problematic, especially as Johnson was at the center of major deals.

“But during the next decade the population was forced to question whether it wanted to smoke any cigarette. Ever since tobacco was first rolled into cigarettes, there have been people opposed to smoking. King James I of Great Britain called it ‘the lively image and pattern of hell’ and slapped an import tax on tobacco. Louis XIII of France and Czar Michael I of Russia decreed penalties for smoking ranging from death to castration. Pope Urban VIII threatened excommunication for anyone found smoking in church or on church premises. 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.”

RJ Reynolds Tobacco Company was one of the key companies in the US industry in the first half of the 20th century. However, increasing concerns about the health effects of smoking negatively affected tobacco sales and forced some producers to innovate by expanding into other industries, exploring foreign markets, or creating new products such as Tyree Wilson’s “smokeless” cigarettes. Concerns about the future of tobacco may have impacted the final price of RJR Nabisco stock.

“A retired chairman was entitled to an office and a secretary, and Sticht got one—but in the old headquarters downtown, away from his beloved Glass Menagerie. ‘Sticht is going to be my sexual consultant,’ Wilson was heard to say. ‘When I want his fucking advice, I’ll ask for it.’”

This example displays the leadership transition from J. Paul Sticht to Tylee Wilson at RJ Reynolds. Its purpose is to highlight the personality clashes, a key theme in this book. Subsequently, RJR Nabisco’s chief Ross Johnson had a similar rivalry with Wilson after ousting him. The authors compare corporate in-fighting to the tough worlds of politics or war. This quotation also displays the authors’ wit, sprinkled throughout this book, making the narrative more enjoyable.

“Overnight Johnson became a local pariah. One man had brought Reynolds into Winston-Salem on a horse; another would take it away on a Gulfstream jet.” 

Following the RJ Reynolds-Nabisco merger, Ross Johnson made the decision to move the company headquarters to Atlanta. In many ways, Winston-Salem was a factory town that grew around this tobacco company. The company’s development was not only intrinsically tied to the city’s history, but also its residents depended on its employment. Thus, Johnson’s uprooting of the headquarters was perceived as a ruthless move that threatened the entire fabric of Winston-Salem’s society. The quotation also ties the beginning and the end of Winston-Salem as the company headquarters. It mentions Richard Joshua Reynold, a 19th-century Virginian and the founder of this tobacco company, who preferred horses for transportation, and Ross Johnson, a Canadian with a penchant for luxury corporate jets who radically changed the city by moving the headquarters.

“From his new office above The Galleria, Johnson played the role of master puppeteer, keeping the company and its officers in a constant state of reorganization. Some of the changes seemed like sheer mischief.”

Ross Johnson’s biography is central to understanding this book. For this reason, the authors describe and analyze his actions in every chapter. They outline his story from rags-to-riches: a boy from the Canadian prairies who rose to become a powerful businessman mingling with celebrities in Montreal and New York City. While Johnson’s behavior in private is that of an aging playboy, he is also a ruthless businessman who rose to the top of the corporate world by skillfully maneuvering around his rivals. Here, these two qualities are combined, as Johnson seems to reorganize the newly merged RJR Nabisco headquarters in Atlanta not only for business reasons but also for his own enjoyment.

“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.”

Mergers and acquisitions (M&A) is a profitable realm of Wall Street banking because it generates fees regardless of the outcome of the financial transactions. M&A transactions usually involve company mergers (friendly or hostile). It was M&A that was one of the key factors that contributed to the development of Wall Street in the 1980s. Its critics suggest that this growth included financially reckless behavior that involved an overreliance on debt, as in the LBO transactions, or the use of high-risk junk bonds.

“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.”

Barbarians at the Gate is a book on business history for a general audience. As a result, the authors explain some of the technical terminology used throughout this text. They also briefly examine the history and the rise of the leveraged buy-out because it is a central concept to the story of RJR Nabisco and to the growth of Wall Street in the 1980s at large. 

“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.’”

Henry Kravis is one of the central figures in this book. His firm, Kohlberg Kravis Roberts (KKR), ultimately won the bidding war for RJR Nabisco. For this reason, the authors profile his biography and examine his character as they do with RJR Nabisco’s CEO Ross Johnson. During his early days on Wall Street, Kravis worked for Bear Stearns along with his cousin George Roberts and his mentor Jerome Kohlberg Jr. The three decided to leave Bear Stearns and establish their own firm, KKR. Cy Lewis, a Bear Stearns’ executive and a famous Wall Street businessman, warned the young men that they would fail. The purpose of this quotation is to highlight the irony of this prediction, because KKR became extremely successful and Henry Kravis very wealthy.

“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.”

Only a handful of Wall Street firms specialized in LBOs in the 1970s. In the next decade, however, every large and many boutique firms pursued major money-making opportunities with LBOs, and competition was fierce. In many cases, LBOs depended on high-risk, high-yield junk bonds that raised funds quickly. The authors highlight the development of LBOs within the business history of Wall Street to provide a broader context for the events in this book and to enhance a reader’s understanding of business history. 

“Oh, the fees! The upfront fees alone—for advising and money lending and a ‘success fee,’ maybe $200 million in all—would be a gigantic boost to Shearson’s flagging earnings. And it wouldn’t stop there. For years afterward the money would continue to stream in. There would be fees for refinancing, fees for advice, and fees for simply minding the shop. M&A alone could count on tens of millions in fees from the divestitures they planned as RJR Nabisco’s unwanted businesses were chopped up and sold to meet debt payments. And all before they even thought about returns on their investment: Hill was projecting an annual return of at least 40 percent. On a $500 million investment, that was $200 million a year—for five years or more! It was enough to make Cohen’s head swim.”

Peter Cohen was the chief executive of Shearson Lehman Hutton, working with Ross Johnson’s management group in an attempt to carry out an LBO of RJR Nabisco. The deal was attractive because its success would have meant receiving fees for years to come. These exorbitant fees are a defining feature of Wall Street excess in the 1980s, funding the luxurious lifestyles and glamorous social lives of key players like Johnson and Kravis.

“At the merger crowd’s core is an elite clique of a dozen or so top deal makers who have been fast friends and competitors for more than a decade. When they call themselves anything, it’s simply The Group. They grew up together, their careers intertwined in hundreds of now-forgotten takeover contests . . . Although its members are scattered among several Wall Street firms, The Group sprang almost entirely from a pair of investment banks, First Boston and Lehman Brothers, and a pair of major law firms, Skadden Arps and Cravath Swaine & Moore.”

This quotation explains the hierarchy in the mergers-and-acquisition realm on Wall Street in the 1980s. It offers both a broader and more specific context to understand the RJR Nabisco deal better. Beyond the general information, it was First Boston, Wasserstein Perella (who left First Boston to start their own firm), Shearson Lehman, and Skadden Arps that participated in the RJR Nabisco LBO bidding war. The latter means that it was the top of the Wall Street hierarchy that pursued RJR Nabisco. The authors also emphasize the paradoxical relationship between the leadership of these firms: They were friends but also engaged in aggressive competition. This focus on personal egos and rivalries emphasizes the theme of The Human Factor in Business.

“Cohen’s little speech sent shivers through Kravis. So this is what it’s come to, he thought. Every investment banker with an extra nickel in his pocket thinks he ought to go into LBOs. After five years of steadily mounting competition, Kravis was sick of it. Morgan Stanley, Merrill Lynch, firms he had never heard of, all wanted a piece of his business. Now it was Shearson Lehman. The entire idea behind Kohlberg Kravis’s 1987 fund was doing deals too large for anyone else to handle. Once and for all, Kravis had hoped, his firm could leave the competition behind.”

In the 1970s, Kravis’s KKR was one of a small number of firms that pursued LBOs on Wall Street and, indeed, perfected the mechanism through trial and error. By the mid-to-late 1980s, however, every major and a handful of boutique Wall Street players wanted to pursue LBOs. Kravis disliked the competition not only because he could miss out on some profitable deals, but also because he felt a proprietary claim to the LBO mechanism others were now using. The latter was one of the reasons why KKR aggressively pursued the RJR Nabisco bidding war even as the situation spiraled out of control. 

“Ted Forstmann had been angry for five years now. Wall Street had been taken over by a cartel, Forstmann believed. A junk-bond cartel. A cartel whose guru was Michael Milken of Drexel Burnham Lambert and whose most powerful member was Henry Kravis of Kohlberg Kravis. A cartel that now had the upper hand in the looming battle for RJR Nabisco. 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.” 

The authors describe Ted Forstmann of Forstmann Little as a one-man crusader against a specific kind of high-risk junk bond in Wall Street deals. Forstmann even published opinion pieces on this subject. For this reason, his ultimately failed bid for RJR Nabisco may have been motivated by a personal vendetta against Henry Kravis, who popularized the use of junk bonds. At the same time, Forstmann’s criticism of excessive risk-taking on Wall Street, rather than relying on more standard investment strategies, appeared accurate, especially after his predictions regarding the 2008 financial crisis.

“This was a different Ross Johnson than many at Shearson had seen. The shock of Kravis’s bid was evident on his face and in his voice. It was the first time Steve Goldstone had seen cracks in his client’s sunny facade. Hill thought Johnson ‘looked like he’d been hit by a load of bricks.’”

When the idea of an LBO for RJR Nabisco first emerged, Ross Johnson believed that his management group’s bid, backed by Shearson Lehman Hutton, was going to be virtually guaranteed. He also naively thought that he could work with Henry Kravis—in a secondary role—as part of the process. Thus, when KKR bid for RJR Nabisco, Johnson considered their move an ambush. The stress was so immense that many, like RJR Nabisco’s legal counsel Goldstone, noted a significant change in Johnson’s demeanor. 

“The car buyer wants to know more than just what’s in the ad. He wants to talk to the owner, check under the hood, go for a ride around the block. For LBO buyers, a thorough inspection is equally crucial. More so than any takeover artist, the LBO buyer must know his prey. His success depends on determining exactly how much debt the target company can take on, and figuring precisely what budgets can be cut and what businesses sold to pay down that debt quickly. To take the used car analogy a step further, the LBO buyer must estimate, in precise detail, how many miles the car has left, how many spare parts he will need, and how much maintenance will be required. His margin of error is so thin that a worn crank shaft or a blown gasket could prompt the bank to call his loan. Similarly, in an LBO, a wrong calculation or an inaccurate projection can bring both buyer and seller down in an avalanche of debt.”

Because this book is meant for a broad audience, the authors often explain technical financial instruments by analogy to more familiar business transactions. Here, they compare the process of making an LBO offer to shopping for a car, noting that the accuracy of financial calculations is paramount because the financing largely comes from debt. Once the LBO is successful, this debt must be paid down by divesting company assets deemed unnecessary in order to free up additional cash flow. It is also worth noting that the authors refer to the company about to be taken over through an LBO as “prey” to highlight the at-times hostile manner in which such companies were taken over and the negative impact on employees.

“The RJR Nabisco directors who gathered at Skadden Arps on Monday morning, November 7, were a sullen, irritated bunch. For three weeks they had watched in growing horror as Ross Johnson turned their company into the centerpiece of a $20 billion circus, and more than a few on the board felt like fools for allowing it to happen. Disclosure of the management agreement shocked most of them and, by Monday, a rising anti-Johnson feeling was fast crystallizing on the board. Steve Goldstone had been right: These directors were no longer Johnson’s friends, they weren’t about to give him favors and they resented him for putting them at the eye of an increasingly public hurricane. “

Skadden Arps was the law firm managing the RJR Nabisco LBO bids. The RJR Nabisco directors regretted that an LBO was allowed in the first place, in part, because of Ross Johnson’s financial adventurism. For them, the last straw was the outrageous management agreement, which was meant to benefit Johnson rather than the company, its stockholders, or its employees. The subject of Corporate Excess and Wall Street Greed in 1980s America is one of the persistent themes in this book. The authors also note the importance of personal relationships in the corporate world and on Wall Street. Finally, by using such words as “circus” and the “hurricane,” Burrough and Helyar underscore the chaotic nature of a deal gone out of control.

“On a national scale, the fight for RJR Nabisco prompted new debate on the danger LBO debt held for the country. ‘Our nation is blindly rushing toward the precipice,’ warned Martin Lipton, the famed merger attorney, in a memo to clients.”

Because the RJR Nabisco bidding war was getting so much publicity in 1988, it opened a national conversation about the subject of LBOs and the wisdom of relying so heavily on debt to finance such deals. There were many critics of this debt-backed strategy, and even the Federal Reserve wondered “how LBO loans would fare in a recession” (349). However, such discussions did not overhaul the Wall Street modus operandi per se, as the subsequent Wall Street-linked financial crises indicate.

“Panicking, Goldstone grabbed the phone. ‘Get out of the cab and run!’ he barked at Truesdell. The four attorneys piled from the taxi and began sprinting the two long blocks to Skadden Arps. By then Johnson was laughing uncontrollably. ‘I hope your guy was a cross-country runner,’ he told Goldstone, ‘because there’s no way he’s going to make it by five o’clock.’”

This quotation shows the stress and the hectic pace needed to get the bids for RJR Nabisco’s LBO submitted before the deadline at the law firm Skadden Arps when not even a taxi or a courier service would have helped. The authors note that such last-minute actions were typical for Wall Street. Such descriptions also add to the suspense of the narrative keeping the reader wondering whether the bid would be submitted on time.

“Rosen and Finn hadn’t specifically discussed RJR Nabisco; they didn’t work that way. Finn talked in hypotheticals, tossing what-if scenarios to Rosen. In a kind of mental tennis game, Rosen swatted the ideas back to him, usually not knowing what companies he was discussing. But as he looked at the First Boston proposal, Rosen easily identified it as the fruit of the pair’s recent conversations. Conflict of interest: Rosen hated the thought. But he knew it might apply to him. Given the nasty nature of the RJR Nabisco fight, it would only be a matter of time before someone found out about his work with Finn.”

Matt Rosen was a legal advisor at Skadden Arps handling the RJR Nabisco bids. When he read the bid by First Boston, he was alarmed to find a strategy based on his personal conversations with his friend, investment banker Brian Finn. Rosen was thus concerned about a potential conflict of interest coming to light considering the national attention focused on RJR Nabisco. However, because Rosen had integrity, he mentioned this situation to his higher-ups. Here, the authors highlight the close-knit nature of the corporate world and Wall Street and the importance of personal relationships.

“Afterward, there was pandemonium among the Kravis troops. As they rode down to the lobby, the elevator was filled with curses and shouts. ‘They’re cooking the books!’ people were yelling. ‘They’re cooking the books!’ Beattie was incensed. ‘This is outrageous. Goddamn it, they haven’t given us accurate information. We’ve been screwed.’” 

Richard Beattie worked with KKR. Along with others, he realized that the financial data that RJR Nabisco had did not quite match the data that they were given. They assumed the worst: that the company was deliberately misrepresenting their financial standing, putting the entire deal in question. The emotional release of men under immense stress is obvious. The author’s usage of “troops” is also noteworthy as a consistent symbolic motif of war throughout the book.

“From the beginning, the committee’s mission had been to keep alive two viable bidders. When it got two, it aimed for three, and so on. It tried anything, in short, to produce the highest possible value for shareholders. If both First Boston and Kravis failed to surface with second bids, the committee was left with one alternative: Ross Johnson.”

The purpose of the special committee—comprised of board members and lawyers—was to evaluate the buyout that was initially suggested by the Johnson-led management. Once the process was launched, the committee was to focus on evaluating which bids would benefit the company, the shareholders, and the employees the most. Since the RJR Nabisco bidding was so aggressive, there was a second round of bids. Indeed, the general bidding procedure was vaguely defined and mutable. Here, the authors create a sense of suspense for the reader by questioning whether the competitor bids would even be submitted during the second round.

“‘Are we morally obligated to First Boston for this?’ Tom Pritzker asked.

Klein thought for a moment. He glanced at Maher.

‘Yes.’

‘Do you think First Boston thinks we should step forward with the equity?’

‘Yes.’

There was a long silence. Mel Klein held his breath.

‘Dad…’ Tom Pritzker began.

‘I know,’ Jay Pritzker said. ‘That’s it. We’ll do it.’”

Just before the deadline for the second bid for RJR Nabisco, First Boston was hundreds of thousands of dollars short of equity after Chase Manhattan pulled out. As a last resort, First Boston’s Tom Pritzker asked his father, investor Jay Pritzker, for help with the remaining money. This behavior highlights the importance of personal relationships, including at times nepotistic ones, on Wall Street.

“Despite the Time cover, despite the avalanche of bad publicity, despite the obvious ill will among board members, Cohen and Hill were convinced they were on the verge of victory. No one gave Kravis much thought. Everything now depended on First Boston.”

Time generated significant negative media publicity by underscoring what they described as Ross Johnson’s greed. At the same time, the board was growing displeased with Johnson’s behavior. However, Shearson Lehman Hutton, which backed Johnson’s management group’s bid, was convinced that they were going to attain LBO success with RJR Nabisco. The authors highlight another suspenseful moment when all the major players seem to have forgotten about Henry Kravis who, in the end, proposed a winning bid and caused a major upset for Shearson.