THE INSIDE STORY OF THE RISE OF KKR A new book tells how Jerome Kohlberg, Henry Kravis, and George Roberts created Wall Street's leading buyout firm -- and then fell out when they began to make all that money.

(FORTUNE Magazine) – KOHLBERG Kravis Roberts & Co. is dominating the headlines once again with an impressive string of coups. In just 11 days the leveraged-buyout leviathan did the following: It agreed to pay more than $600 million to buy nine publications from the debt-laden press pooh-bah Rupert Murdoch. It made the winning $625 million bid in partnership with Fleet/Norstar Financial Group for the Bank of New England. It took Duracell public. The battery maker's shares jumped 36% to $20.75 their first day of trading, making KKR's stake worth more than $1 billion. That's about three times what the firm and its partners % invested when the company went private in 1988. As Paul Newman kept asking about the sheriff's posse in Butch Cassidy and the Sundance Kid: ''Who are those guys?'' Sarah Bartlett, a prize-winning financial reporter now at the New York Times, answers that question in The Money Machine, due out in June from Warner Books, a division of Time Warner, the parent of FORTUNE's publisher. Henry Kravis and George Roberts, two cousins from the oil patch, joined the corporate finance department of Bear Stearns more than 20 years ago. There they met Jerome Kohlberg, a partner many years their senior. He thought managers would be more likely to manage wisely if they owned their companies, rather than acted as self-interested stand-ins for thousands of distant investors. He saw a niche for a Wall Street firm that, with small groups of closely involved investors, could help management take the reins of ownership, realizing undreamed-of efficiencies and profits in the bargain. These bootstrap deals, as they were known then, leveraged tiny amounts of equity from the investors and management with large amounts of debt to take the companies private. In 1976, Kohlberg left Bear Stearns to start his own firm and took his two bright young proteges along. The formation of Kohlberg Kravis Roberts was, by some accounts, the beginning of the leveraged-buyout craze that was to transform corporate America in the 1980s. KKR's concept of bootstrapping changed over time. Kohlberg's original notion was that he and his partners should invest their own money in deals and, most important, should glean profits only if and when owner-managers and other investors did. Everyone would become rich together, and KKR would be management's ally in a friendly transaction. The firm would charge investment banking fees, but only to cover the costs of researching suitable candidates for buyouts and to tide the partners over the period until all the investors could cash out. But by the mid-1980s, while Kohlberg was recovering from brain surgery complicated by a blood clot in his lung, KKR's interests and those of its investors began to diverge. As the size of the buyouts grew, so did the fees, and the firm would profit regardless of how the investors did. The following excerpt from The Money Machine, based on Kohlberg's recollections, Securities and Exchange Commission documents, and other sources, describes why Kohlberg decided in 1987 to leave the firm he had founded and the two young men he had always considered surrogate sons: ^ As 1983 drew to a close, a year during which Kohlberg Kravis Roberts bought three more companies and launched its effort to raise a $1 billion equity investment fund, the largest ever, Jerry Kohlberg began to have excruciating headaches. He finally went to his doctor, who ran a few tests, and several weeks later Jerry and his wife, Nancy, got the bad news: Jerry had a benign brain tumor called an acoustic neuroma. Kohlberg's assistant at the time, Mary Lou Murray, remembers her boss as being calm and matter-of-fact about the whole thing. He spent the few weeks before the operation going over his work load and dividing it up amongst his partners. Kohlberg's doctors had told him he would have to stay away from the office for several months recuperating, so he was trying to make the transition as orderly as possible. On the day of the operation, January 19, 1984, the 58-year-old Kohlberg came into the office as usual and worked until noon before walking over to Mount Sinai Hospital and admitting himself as a patient. On top of his physical troubles, Jerry was growing increasingly concerned about his partners. The day after his operation, Henry Kravis had come by to see him. But Henry never came again, and George Roberts never visited his ailing mentor even once. George and Henry rarely phoned, either. Mentally and physically, the next year was one of the most depressing periods of Jerry's life. George and Henry were busy. The business was changing -- new people were coming on the scene and challenging their turf. They didn't have the time or inclination to sit at the bedside of a sick man. They had to figure out how they could stay on top. BY 1985 many firms on Wall Street started thinking about setting up or expanding their own leveraged-buyout departments. The idea had certain risks: For several firms, KKR was their largest single client ((for a variety of banking services)), their most important source of investment banking fees. Competing with KKR might hurt them badly in the short run. And there was the dicey question of conflicts with their corporate clients. Suppose their LBO group decided to make a bid for, say, a company that made paper cups, and that company at the same time turned out to be a favored target of one of their clients.

The event that tipped many firms over the edge was the bidding war that erupted in October 1985 over the Beatrice Cos., a Chicago-based conglomerate that made everything from Samsonite luggage to salad dressing. Beatrice marked a significant departure from KKR's previously friendly-only approach. Until then, if KKR sent a letter to management offering to buy a company and was politely told to get lost, it would get lost. KKR had assured its investors that it would never do a hostile takeover. That was for the likes of gunslingers such as Carl Icahn or Ronald Perelman. In the case of Beatrice, however, KKR rewrote its definition of hostile. When management rebuffed its offer, the firm made it known that it only would accept a no if it came from the company's board of directors. Some who were involved with the deal remember that George wanted to go even further and launch a hostile tender offer for the company's shares without any apologies. But Kohlberg, who by this time was peripherally involved in the firm's activities, nixed the idea, and the three men arrived at this compromise. By promoting this new, broader interpretation, KKR vastly expanded the universe of companies for which it would be acceptable to make unsolicited bids. Until then, making a takeover offer for a FORTUNE 500 company whose management was certainly going to resist was simply not done. Suddenly, KKR was saying it no longer had to wrap itself in the mantle of management's closest ally. Suddenly, it was okay to be the aggressor, the force that had come to keep management honest, the savior of the embattled shareholder who was being taken for a ride by greedy, self-serving managers. KKR had moved a long way from one of its founding principles, which George Roberts had summarized to a reporter in 1979. ''We do not do takeovers,'' he said. In making FORTUNE 500 companies targets, KKR had tilted the game decidedly in its favor. Who else, after all, had billions of dollars at its disposal? ''Lots of firms can do smaller deals,'' George bragged to the San Francisco Chronicle as the firm was stalking Beatrice, ''but over $1 billion, we don't have any competition.'' IN THE EARLY YEARS, before any of KKR's deals had been in the pipeline long enough to generate profits, money was tight. The 1% investment-banking fee that the firm charged companies when it acquired them was supposed to bear some relation to the expenses KKR incurred in researching and exploring transactions, many of which were discarded before one finally went through. As KKR's deals began to grow larger, however, that 1% fee came to have less and less to do with expenses and capital and more and more to do with easy money. | When KKR bought Dillingham in 1983, for instance, it invested less than a million dollars of its own money alongside about $50 million of its partners' money. Its fee on the $442 million transaction was $4.5 million pretax -- enough to pay the expenses of deals that were never completed and have some left over. By 1985, however, when KKR acquired Storer Communications, the Florida-based cable TV concern, for $2.4 billion, the numbers were starting to go off the charts. True, KKR invested about $2.5 million of its own money. But the firm's fee was a cool $23 million, far higher than any expenses KKR could possibly have accumulated. No one ever stopped to question the logic of whether it really took ten times the brainpower to orchestrate a $3 billion deal than it did a $300 million deal. Most observers seem to have blindly accepted the 1% explanation. After all, the money never really seemed to come out of anyone's pocket. It didn't take Wall Street sharpshooters long to figure out that KKR had found a way to make almost obscene amounts of money, with little risk to itself. And since bigger transactions meant bigger fees, KKR had positioned itself to become a money machine of vast proportions. When KKR finally acquired Beatrice for $8.2 billion, an amount that included the assumption of more than $2 billion in debt, it charged a $45 million investment-banking fee. That was actually a little shy of its usual 1%. Still, the gasps could be heard in corner offices of Wall Street skyscrapers for days. After all, KKR had had the temerity to go after a FORTUNE 500 company in what a few years ago would have been considered a hostile deal, and it was making $45 million before it did anything with the company. To firms that had been wrestling with the thorny question of loyalty to clients or concerns about conflicts of interest, the issue seemed suddenly to become clear: The profits that could be derived from the LBO business clearly outweighed any of those considerations. Merrill Lynch had been one of the first to see the potential of LBOs and by 1985 had raised a $400 million fund. The money for LBO funds was raised from a variety of institutional investors such as banks, insurance companies, and pension funds. It was used to finance the equity portion of a buyout. Merrill later stepped on the gas and in 1986 raised $1.5 billion more. Morgan Stanley was not far behind. Although its first effort in 1985 netted it just $55 million, by 1987 it was up to $1.7 billion, and by mid-1989 it had topped $2 billion. Shearson Lehman Brothers persuaded its parent, American Express, to kick in about $700 million, and Shearson raised another $500 million on top of that. Later entrants included Wasserstein Perella and the Blackstone Group. And there was always KKR's biggest competitor, Forstmann Little & Co., which kept raising larger funds. THE NEW ARRIVALS made Henry and George's lives vastly more complicated. Gone were the days when KKR could circle around a company, carefully inspect its financial details, make an offer, and then negotiate a final price with management and directors that would be slightly higher than its original offer but not significantly so. Now, every time KKR bid on a company, two or three others would try to muscle in too. KKR went from dictating its own terms to being a bidder in an auction. KKR may have had access to plenty of equity and bank debt, but the firm could not have been the highest bidder in a corporate auction without the help of Drexel Burnham Lambert, the investment banking firm. Over the next few years an important alliance developed, in which Drexel helped raise an estimated $20 billion in junk bond financing for many of KKR's deals, making Henry and George important Drexel clients. It is clear that KKR benefited from Drexel's involvement in takeovers, many of which were hastened along when arbitragers like Ivan Boesky bought large blocks of stock sometimes at the behest of Drexel's junk bond guru, Michael Milken. And it is also clear that Drexel enjoyed financial rewards from its KKR relationship that exceeded Wall Street norms. A prime example of the Drexel-KKR relationship involves Storer Communications. In early May of 1985, KKR offered to buy Storer for $75 a share plus a package of other securities. At around $2 billion, it was the largest leveraged-buyout deal ever proposed. KKR immediately turned to Drexel to help line up the financing. By July 1, while all the details were still being ironed out, rumors began circulating that another company had decided to make a run at Storer too. The interloper turned out to be the Comcast Corp. According to the government's indictment of Milken, from about July 8 until about July 16, Milken caused arbitrager Ivan Boesky's organization to buy about 124,300 shares of Storer stock, with a secret agreement that any profits or losses on those shares would belong to Drexel. On July 16, Comcast did indeed come in with an offer to buy Storer for $82 a share plus additional securities. Several days later Boesky filed a disclosure document with the SEC stating that his firm had purchased more than 5% of Storer's common stock. ONE COULD certainly conjecture that the simultaneous arrival on the scene of an arbitrager -- whose business is speculating on the outcome of takeovers -- and a competitor interested in swallowing Storer whole would help persuade Storer to come to terms with KKR, a friendlier bidder than the other two and that claimed it wanted to leave Storer's management in place. At the end of the month, Comcast raised its bid to $83.50 plus other securities. Determined not to lose its prey, KKR immediately countered with an offer of $90 a share, plus securities, and shortly thereafter upped its bid again, to $91 a share plus other securities. Storer finally accepted this bid. Even in the overheated atmosphere of the mid-1980s, KKR's $2.4 billion pricetag for Storer was considered steep. It amounted to about $1,000 per cable subscriber, a figure that a KKR executive, commenting later on the transaction, acknowledged was ''clearly pushing the market at the time.'' When asked whether he was concerned that KKR was paying too much for the company, the executive, Theodore Ammon, replied: ''I was concerned. I think it's fair to say a number of people in the firm were concerned.'' But they were willing to give it a try. After all, KKR had Milken. And he viewed the deal as a creative challenge. Undeterred by the prospect of financing the largest LBO up to then, Milken and his team came up with a smorgasbord of securities: equity, senior subordinated bonds, senior zero-coupon bonds, and ''pay-in-kind'' preferred stock, which meant that investors would receive more preferred stock instead of dividends. In the end, Drexel persuaded KKR to offer warrants for 32% of Storer's stock that the Drexel sales force could offer its institutional customers as an inducement to buy securities from the Storer smorgasbord. The warrants meant a concomitant reduction in the amount of the company that KKR's own investors were getting for their money. Initially, KKR agreed to sell these warrants for the nominal sum of $10 million, but Milken called at the last minute and said that actually it would be nicer if they gave them away free. Ammon balked, and they settled for $5 million. The owners of those warrants got an awfully sweet deal. KKR and its investors had paid $221 million for 51% of the company. The warrant holders , were paying $5 million for 32%. (As it turned out, the company did well, and Storer was sold three years later, reaping KKR's equity investors an annual return of around 50%.) Asked several years later why KKR would have given Drexel total discretion over the disbursement of such an important piece of the company, Ammon acknowledged that the priority was to get the deal done. Most observers assumed that the financial reward that Milken and Drexel received for their hard work came solely from investment banking and underwriting fees. But beginning in late 1987 it became clear that their remuneration was much more complicated. Several SEC disclosure documents filed then and in 1988 showed that most of the high-octane warrants that had been issued to induce bond buyers to finance Storer, and subsequently Beatrice, had ended up in the hands of Drexel executives and, more particularly, Michael Milken. When the news of the warrants' whereabouts first broke, KKR executives let reporters know they were furious with Drexel's behavior. Their dismay was certainly not surprising. In keeping most of the valuable warrants for themselves instead of distributing them to buyers of the company's hard-to- sell securities, it appeared that Milken and other Drexel employees had taken KKR on a very expensive ride. Since Drexel did not seem to need the warrants to sell the Storer securities, KKR and its investors could have kept that 32% of Storer for themselves and been about $225 million richer. That was the amount that Drexel executives were estimated to have garnered in profits from the Storer warrants. Even now, George Roberts appears to become enraged when asked if he feels betrayed. ''You're damn right we do,'' he exclaims. ''It's unforgivable!'' IF KKR executives were mad at Milken and other Drexel employees for having received $500 million in profits from Storer and Beatrice warrants that might instead have gone to them and to their own investors, they did not seem to act on it. Long after the revelations, KKR continued to use Drexel Burnham for its financings -- indeed it insisted that Drexel be used in RJR Nabisco, over other investors' strenuous objections. ''We continued to use Drexel because they were the best at what they did. There was nobody that could come close to them,'' said George. KKR also continued to pay Drexel hefty underwriting fees for its services. But most important, Ammon confirmed in his testimony that KKR continued to give Drexel large equity interests, sometimes in the form of warrants, in the companies KKR was acquiring: 5% of Jim Walter, 7% of the recapitalization of the Marley Co., and 25% of a company called IDEX, of which Drexel kept 6.5%. When Jerry Kohlberg finally returned to work on a full-time basis in early 1985, it was a strange and different world that he encountered. CEOs who once regarded KKR as an ally in reinvigorating their companies now were beginning to regard KKR's advances with suspicion. The firm's financing partners were no longer stodgy insurance companies but the aggressive Michael Milken and Drexel Burnham Lambert. KKR was making money hand over fist from investment-banking fees, a complete departure from Jerry's original intention. And Henry was no longer under his control but seemed to represent the social-climbing nouveaux riches Jerry despised. Kohlberg was appalled by the fees the firm was charging. Even though he could see that it was getting away with them, he thought big fees completely violated the firm's founding principle: that they would make money with their partners. Of course, George and Henry still had some incentive to invest prudently: Their reputations were at stake, not to mention the fact that they would get 20% of any profits on their deals. But what bothered Kohlberg was that they also got handsomely rewarded even if they made bad investment decisions. And that, he felt, could distort their judgment. Previous reports have speculated that it was the hostility KKR displayed toward Beatrice's management that finally pushed Kohlberg over the edge. But Kohlberg says the breaking point had more to do with the fees that KKR was charging, first the $45 million for Beatrice and then the $60 million investment-banking fee they charged for buying Safeway. ''I was starting to urge that we take lesser fees as a percentage,'' he says, because he felt that the standard 1% of a transaction no longer made sense once KKR's deals grew to the multibillion-dollar level. ''I looked ridiculous,'' he says. ''I was the old fogey. I was always the one that said we should charge less. It's a very difficult position to defend when you've got happy investors.'' On March 13, 1987, after nearly two years of emotional wrangling and months of intense negotiation, Jerry Kohlberg signed an agreement in which he withdrew as a general partner of Kohlberg Kravis Roberts and ceased to have any decision-making role. The agreement, which became effective on May 7, stated that he would continue to hold his shares of companies KKR had already acquired, and that he would have the option of investing in future deals for the next nine years, but that his interest in future deals would steadily decline. Thus, in 1987, Kohlberg would be entitled to a 20.5% stake of KKR's interest in any new companies that the firm acquired. The following year that figure would decline to 17.6%. By 1990 it would be only 12.6%, and it would go down to 7% in 1995. About two weeks after the agreement went into effect, Kohlberg announced his withdrawal at KKR's third annual investment conference. Standing at a podium looking out over the 120-some of the firm's investors who had gathered for the meeting in the luxurious Versailles Room at the Helmsley Palace Hotel, Kohlberg took the opportunity to deliver a rousing defense of business ethics, a speech that some in the room might have interpreted as a veiled critique of his younger partners. ''Twenty-two years ago,'' he told the group, ''I had a small dream -- that companies could be bought, and investments made, in undervalued businesses where we, as financiers, would put our money, time, and effort right alongside management's. We would do everything in our power to ensure that our investment and theirs turned out well. We would both risk a great deal -- capital and reputation.'' What held these financial principles together and created KKR's success, he said, were the precepts of integrity and ethics. ''I chose to mention this today because all around us there is a breakdown of these values -- in business and government . . . It is not just the overweening, overpowering greed that pervades our business life. It is the fact that we are not willing to sacrifice for the ethics and values we profess. For an ethic is not an ethic, and a value not a value, without some sacrifice for it. Something given up, something not taken, something not gained. We do it in exchange for a greater good, for something worth more than just money and power and position . . . We must all insist on ethical behavior, or we will kill the golden goose.'' With that, Kohlberg said that he was turning over active management of the firm to George and Henry, and he sat down. It was an emotional moment for everyone. The renunciation of a dream for Jerry, freedom for Henry and George, and a perplexing end to an era from the standpoint of KKR's investors. Henry and George, who had not known what the unpredictable and intransigent Kohlberg would say in his farewell speech, were . reportedly stunned by his references to greed and a general moral breakdown. But all three tried to put the best face on it. Despite the hurt feelings, none of them had any interest in seeing KKR undone by the breakup.