An old hand in a strange new world
In the heat of the private equity boom, the octogenarian audio pioneer Sidney Harman agreed to sell his company to KKR and Goldman Sachs. Then they ditched him. Now he has a stock worth one-third of what it was. A tale from the dark side.
(Fortune) -- A year ago, when he was only 88 and not yet jilted, Sidney Harman was autocratically doing what he likes best: running Harman International Industries, a company he built pretty much from scratch. His business, headquartered five blocks from the White House, makes upscale audio and electronic gear that goes by such household names as Harman/Kardon, JBL, and Infinity. Sidney, executive chairman by title and a founding father of audio high fidelity by reputation, along the way constructed an unusually interesting personal life. He is married to U.S. Representative Jane Harman, 62, a California Democrat whose relationship to the very rich Sidney, plus Harman stock she controls herself, makes her No. 1 on the list of wealthiest members of Congress. Sidney - we will call him that to distinguish him from the company - is a patron of the arts, an author of a very readable management book ("Mind Your Own Business"), and the holder of a Ph.D. He is both a fitness nut and a diehard golfer, regularly walking 18 holes, which not many super-seniors do, and often shooting scores lower than his age.
A good, vigorous life - but as an upper octogenarian, Sidney was forced now and then to reflect uncomfortably on his lack of a real plan for the next stage in his company's life. As 2006 ended, he didn't exactly even have a CEO to act as his No. 2. One longtime CEO had left the job earlier that year; a replacement had lasted only three months, and the longtimer had returned briefly before firmly retiring. A search was on for the next contender, but one hadn't been found.
Into this ripe situation, in November 2006, walked Henry Kravis, co-head of Kohlberg Kravis Roberts. That firm and all its private equity brethren were then awash in money and burning to do deals. Or to put it in Sidney-speak, which can be professorial, "The azimuth was straight up." Kravis proposed that KKR take Harman International private. Sidney says he initially resisted, reluctant to see his creation leveraged up and not eager to cede control. Speaking recently to Fortune in his office, from whose half-moon windows he can look down on Pennsylvania Avenue, he dwelled on the primacy of his work: "This is how I define myself. This is my life."
But money talks, and Kravis had plenty in mind, so Sidney ultimately began to negotiate. And on April 26, 2007, he announced that Harman International (HAR) would be acquired by KKR and a Goldman Sachs fund, GS Capital Partners, for a price valuing the company at $8 billion, which was more than 25 times earnings and 20% higher than it had been valued at in the public market. The price - $120 per share - also solidified Jane Harman's position as the wealthiest Congressperson, since the 5.4% share of Harman that she and Sidney controlled was to become worth $425 million.
But that was April. You haven't read since about this deal closing, because it dramatically didn't. As late as June 20, Harman and KKR filed a preliminary registration and proxy statement contemplating that the company would be merged into a new KKR entity by Sept. 30. But in August the horrors of the credit crisis struck Wall Street. And on Sept. 21, the buyers leaned on an escape clause in the merger contract to "declare a MAC," saying in effect that Harman had breached the merger agreement and that therefore they were killing the deal. MAC stands for "material adverse change," and that was what the KKR group claimed had happened - quite suddenly, obviously - to Harman International's business. This accusation was conveyed by KKR's lawyers to Harman's lawyers without specifics. Nor did KKR issue a press release explaining its exit. Next day, news stories reported vaguely that "the buyers" were influenced by a worsening in Harman's business, in particular by a capital expenditure problem.
Privately, Sidney may have broken a few golf clubs over this sudden sacking. Publicly, he simply said he "disagreed strongly" with the buyers' action, meaning he did not think - and he still doesn't - that his company had suffered a "material adverse effect" (the precise wording in the contract, though MAC is the common term). He added that Harman would "be vigorous in defending its position."
The strange, and even occasionally absurd, tale of how Harman and the KKR group got to this standoff and what happened next captures a mood of financial extravagance we won't see again for quite some time. Buyouts worth a total of $522 billion closed last year in the United States, according to Dealogic, more than double the previous year's volume. But many deals launched in the carefree atmosphere of spring started collapsing in the chill of autumn. Harman does not win the prize for biggest announced deal wrecked by the credit crisis - the $26 billion nonacquisition of Sallie Mae (SLM, Fortune 500) claims that distinction. But the matchup of two pioneers, Sidney in sound and KKR in private equity, makes this failed merger a parable of old hands caught up in a weird new world.
Of the two parties, Sidney is the earlier pioneer, having gone to work in 1940 for a New York producer of amplifiers for TVs and, in time, high-fidelity speakers. In 1953 (a full 11 years before another audio name, Bose, entered the scene) Sidney and engineer Bernard Kardon, both in their 30s, left to form Harman/Kardon, whose stylish equipment soon became a cult brand in a burgeoning hi-fi industry. Kardon quit within a few years, and Sidney went on to spend decades building the business, serially selling it, and then recapturing it. In his truly memorable sale, he offloaded publicly owned Harman International in 1976 to an omnivorous acquirer, Beatrice Foods, for $98 million, while himself going off to embellish his Renaissance-man résumé by serving as deputy secretary of commerce in the Carter administration. Then, in 1980, Beatrice sold the part of Harman it still owned back to Sidney and a group of investors for $55 million, in a deal financed largely by Beatrice. To Sidney, as he thought about it much later, this debt-heavy, equity-light 1980 deal seemed an early example of a leveraged buyout. Early indeed - because private equity pioneer KKR was then only four years old and six years way from its own brush with Beatrice, which it took private in 1986.
It bears stressing, as we inspect the 2007 deal that put Harman and KKR on the same stage, that the event bringing the curtain down was a true anomaly. MACs are extremely rare. That is true, to begin with, because when companies are selling themselves, they insist on tightly written contracts that give buyers only the narrowest possible openings to back out of a deal while it is moving to a close. The openings almost never include a mere swoon in profits. A second reason MACs seldom occur is that a private equity buyer finds it both embarrassing and potentially expensive to go back on its contractual word. On the face of it, a retreat of that kind makes the buyer's due diligence look sloppy. And down the road, sellers could conceivably shy away from the buyer or seek special terms to protect themselves from still another broken deal.
Just how rare are MACs? One New York private equity veteran recalls that he was selling a company when 9/11 occurred. The buyers, he remembers with enduring amazement, did not call a MAC. Today's credit crisis, however, has produced a few cases of buyers pulling the MAC lever. In the most noteworthy, a private equity group led by J.C. Flowers & Co. attempted to lower the price on its deal to acquire Sallie Mae by declaring a MAC, claiming that new congressional legislation had shattered the prospects for student lenders. Sallie Mae has sued the Flowers group, contending that it is owed a termination fee of $900 million. Similarly, the contract between Harman and the KKR group provided that if each side had dutifully complied with certain covenants, the termination of the deal would require the terminator - the KKR camp in this instance - to pay the other side a fee of $225 million. KKR never publicly said whether it would or wouldn't. But the $225 million became the stake on the table. Add another stake as well - Sidney Harman's pride.
One important note: Despite our repeated requests, Henry Kravis would not talk to Fortune for this story. Nor would Brian Carroll, now 36, the KKR partner who led the due-diligence work at Harman. A reason, said KKR's Kekst & Co. spokeswoman, was that an agreement between the two sides barred each from talking about the other. In truth, the agreement simply forbade each side to "disparage, denigrate, or malign" the other.
Despite KKR'S silence, a lot is crystal clear about this deal. In a sense, its chronology begins even before Henry Kravis called on Sidney Harman, because Sidney was then in early talks with a man slated to be his next CEO, Dinesh Paliwal, now 50. A native of India, Paliwal is a high-energy, straightforward man who, when Sidney began talking to him, was a U.S.-based executive who had the No. 2 job at the Swiss power-systems giant ABB Group (ABB).
It took until May 2007 for Paliwal to be hired and until July for him to begin work. But through it all he was another rare case. He was hired by a public company that was scheduled to become a private company, and he had to measure up not only with the existing brass, Sidney Harman and board, but also with Henry Kravis and the crew coming on. So with KKR, Paliwal worked out a handsome arrangement that would give him equity in the private entity, Harman, and a chance to make a mint if it did well. (When the deal blew up, Harman had to redo Paliwal's compensation contract to match what KKR had offered him.)
Sidney Harman, meanwhile, was to stay on as executive chairman of the private Harman. Beyond that, he successfully pushed a highly unusual plan whereby he and other Harman shareholders were to have the option of not taking cash for their stock but instead trading it for as much as 27% of the acquiring KKR company. That would have been a $1 billion equity stake. The remaining financing (which covered $296 million in fees as well as the price, with $83 million of the fees going to the KKR group) was to be $2.7 billion in equity from the KKR group and $4.6 billion in debt from five lenders, principally Bank of America, Credit Suisse, Goldman Sachs, and Lehman Brothers. Naturally the lenders expected to quickly syndicate the debt to others.
As the deal was going forward last spring, it is clear that all the participants thought Harman International was a fine asset - "a great company," one Wall Street analyst called it in April. Harman had five straight years of earnings increases behind it - with profits reaching $255 million in fiscal 2006 on revenues of $3.2 billion - and expected another in fiscal 2007. The company anticipated that the audio and other electronic systems it sold for luxury cars like Mercedes-Benz (DAI) and BMW (BMW) (anchors of a big business Harman does in Europe) could be gradually introduced into lower-priced models. Harman was also building a nascent GPS business. According to CEO Paliwal, KKR was enthusiastic about Harman's long-term prospects. He says KKR people told him the firm had no intention of quickly "flipping" the business but instead saw large expansion possibilities, capable of tripling Harman's market value.
Near term, true, a few stutters were expected. Sidney Harman had told analysts in January that a heavy automotive backlog - $14 billion of business to be booked as revenues over time - was causing research and development costs to "bulge." Sidney said $80 million of extra R&D costs would hurt the last quarter of fiscal 2007 (ending in June) and the first quarter of fiscal 2008. Unfazed, KKR kept pressing for a deal. It also carried out (with Carroll taking the lead) more than two months of "due diligence" - from mid-February through April - and found nothing that scared it off. So on April 26, as noted, the deal was announced, and on June 20, the preliminary merger proxy was filed with the SEC.
The importance of that date can scarcely be discounted: On June 20, when the KKR group surely had a general picture of a June quarter just about to end and at least an inkling of results for the September quarter, KKR was still poised to do the deal. Even two months later, on Aug. 14, Sidney Harman led an earnings conference call for analysts in which he spoke confidently of the merger, expressing his expectation of exchanging "one set of world-class investors for another."
And yet both KKR's world and Harman's position in it had by then been jolted severely. For KKR the trouble was the August freezing of the credit markets. For Harman the grief was two bad quarters in a row - June and September. Among Harman's problems was not only some of that "bulge" in R&D spending but also a general surge in costs, among them inefficiencies at new plants in China and Missouri. A very low tax rate and a strong euro cushioned the bottom line in both quarters and actually gave Harman its sixth year of rising earnings. But operating profits, which private equity buyers crave, told the dismal story: For the June quarter they were down 22%, and for the September quarter 53%.
Overall, Harman seemed during this period to be out of control. Or at the least, it looked like the operation it was: a company that until very recently had lacked a CEO and whose boss, Sidney, had been spending outsized amounts of his time negotiating a merger. In a September analyst call, Sidney himself characterized Harman's recent experience as a "perfect storm," though he thought it would blow over.
One ill wind in that storm, never before publicly explained, was a bizarre episode involving capital expenditures. Soon after Harman's 2007 fiscal year ended, Sidney and the newly installed Paliwal learned to their discomfited surprise that their Harman-Becker division, headquartered in Germany, had binged on capital spending in June, spending $60 million in that one month. And why? Because, Sidney explained reluctantly to Fortune late last year, the division's executives were afraid that Harman's prospective owners might restrict capital outlays when they took control; so the executives were inspired to spend. They engaged, says Sidney, in "exuberant behavior." No, there weren't controls then in place to prevent this - as a German might put it - Überschwang. Paliwal says, in fact, that Harman lacks certain widely accepted management "processes" and that he is now busy installing them.
The Becker binge, in any case, caused Harman's capital expenditures for the year to hit $175 million, vs. a $150 million forecast only three months earlier - and that $25 million overrun became evidence that KKR cited as a justification to kill the deal. Semantics pervaded this argument. According to Sidney, KKR maintained that the $175 million infringed the merger agreement because it exceeded the 2007 "plan" for capital expenditures. But neither "plan" nor "forecast" is the operative word in the agreement's covenants; "budget" is. And, assert both Sidney and Paliwal, the $175 million was within the companywide capex "budget" for fiscal 2007. Therefore, the two men say, the merger agreement was not infringed.
In court, who knows how this argument would have come out? But it is clear that the question of whether $25 million was "material" in an $8 billion deal would have been argued, and it is hard to see how KKR could have prevailed there. Three different private equity veterans Fortune talked to about this broken deal said they couldn't imagine $25 million being grounds for a MAC. Sidney says it is "silly stuff" to think of the capex matter as consequential.
But the seizing up of the credit markets unarguably was momentous, and before long KKR had arrived, says Sidney, at a fixed opinion: "They definitely wanted out of the deal." The September ax then fell. On that morning of Sept. 21, Kravis and Carroll met with Sidney and Paliwal at KKR's offices in New York, both sides flanked by aides, with the two parties facing each other across a long table. The proceedings, which Sidney says were "gracious" and "gentlemanly," began with a lengthy discussion of answers that Harman had previously provided in writing to a string of business questions KKR had asked. Sidney says the meeting seemed less a "let's spread it out and review it together" session than it did a situation in which the KKR representatives had already formed their judgments.
Further along in the meeting, Kravis talked about the credit crisis. The bankers scheduled to back the deal were nervous about Harman's deteriorated profits, and financing looked hard to get. That, it should be noted, was not Harman's immediate problem; it was KKR's. The firm was permitted by its agreement with Harman to delay the merger's closing because of financing problems but could not lean on them to kill the merger altogether. So the KKR group was seemingly on the hook to complete this deal - this high-priced, capital-hungry deal for a company whose good looks had at least temporarily faded - or to pay the $225 million termination fee.
The meeting concluded with Kravis saying that KKR was uncomfortable with Harman's financials and that it did not expect to proceed with the merger. Both Sidney and Paliwal say Kravis did not mention a MAC, but that is unlikely to have been something he imaginatively thought up in the next few hours. That same afternoon, a KKR lawyer called a Harman lawyer and said a MAC was being declared. The reaction at Harman? "A lot of emotion," answers Paliwal. The stock market reacted emotionally too, sending Harman stock from $112 a share to $80 in two days. More market angst was to come: In the wake of the bad results for the September quarter and a mid-January announcement by Harman that it was lowering its 2008 earnings expectation, the stock price has sunk drastically, to around $40.
There remained the question of whether Sidney would stick with his vow to vigorously defend Harman's position - hello, litigation - or would instead choose compromise. The calculations will sound familiar to anyone who has weighed a lawsuit. Sidney avers that Harman would have proved that no MAC was justified and would have been awarded the $225 million fee. But $50 million to $70 million of that, he thinks, would have gone to lawyers and the company's investment banker, Bear Stearns - and then the remainder would have been taxed. Beyond money was the question of time: perhaps a year and a half in which the attention of Harman's executives would have been diverted, just when the company needed maximum care.
As often happens in business, compromise won: On Oct. 22, the two parties, filing a "termination agreement," announced that the KKR group would buy $400 million of Harman senior convertible notes, with a term of five years. The notes are convertible at $104 per share, 21% above Harman's price at the time the bargain was struck, and pay only nominal interest, 1.25%. Another provision of the agreement, which Sidney says he requested, placed a KKR representative, who turned out to be Brian Carroll, on Harman's board. Showing only bridled enthusiasm, Sidney says Carroll is "an admirable young man who will bring financial competence to our board." He chuckles, "I can hardly have the greatest affection for him."
You can look at the $400 million in various ways. First, it is obviously more than the $225 million breakup fee the KKR group might have had to pay. But that fee would have been a straight-out expense, whereas the $400 million is an investment that, though a limp thing now, could in time pay off. And ironically, the very term "investment" means that KKR still has its own investors tied up with this company it didn't think worth owning.
Another perspective on the $400 million concerns what it bought. A senior convertible note paying only 1.25% interest (far below a market rate) and convertible 21% above the market when issued was not then worth par. So the $400 million was exchanged for a security worth less. By now, with Harman's stock down another 50%, the value of the notes has fallen also, because the option to convert is at least temporarily irrelevant.
At bottom, the $400 million should probably be viewed as simply the hammered-out, hard-won tangible result of two parties trying to make the best of a messy deal. Residue of the hammering may be seen, in fact, in the termination agreement filed with the SEC. The KKR group still maintains that there was a "material adverse effect" and that Harman "violated the capital expenditures covenant in the Merger Agreement." In near-duplicative words, Harman denies - no, "steadfastly denies" - both allegations.
Today, about nine months after the deal was announced and four after it was killed, Sidney Harman no doubt thinks often about the $120-per-share price that flew out the window. But in conversation, his doctorate in social psychology seems an influence, leading him to muse about the "philosophical tapestry of this thing." There are, he says, "no villains, just victims, with all of us caught in a well-intended web." The year's events remind him of a John Fowles novel ("The Magus," for example) in which there is "something intertwining, this serpent wrapped around a serpent" and there is "this riddle" and "the almost unimaginable complexity of it with so many players and so many moving parts." And yet, Sidney says slowly and reflectively, "all of us are pawns."
It is a stretch to move from that to real life - a real life indeed in which Harman is priced at only a third of what it once was. Sidney nonetheless congratulates himself for having emerged from this tangled year with a CEO, Paliwal, whom he thinks both "stunningly" talented and easy to work with. Paliwal's presence even led Sidney, in the year he turned 89, to give up the title "executive chairman" for just "chairman." He told analysts recently that the shift in title probably wouldn't change his working habits. Sidney also said it was wonderful, after unremitting distractions, to be "breathing clean, fresh air" and doing "serious work." And then he went back to walking 18 holes on the course, in still fresher air, and shooting better than his age.