Rich Kinder's bigger slice

The $15.2 billion Kinder Morgan buyout is a model for the times. Top managers and financiers get rich, but conflicts abound. Is it fair to shareholders? Fortune's Adam Lashinsky investigates.

By Adam Lashinsky, Fortune senior writer

(Fortune Magazine) -- Rich Kinder had a secret. In fact, he had just tipped his hand, but it would be weeks before his shareholders picked up on the hint. On a conference call with Wall Street analysts in April 2006, the chief executive of pipeline operator Kinder Morgan was venting his frustration over his laggardly stock price when he let his intentions slip out. "Frankly," he said, "I'd like to own a lot more than 18 percent of the company myself."

Would he ever! For weeks Kinder had been huddling with Goldman Sachs investment bankers and execs at Goldman's private-equity unit. The topic of discussion? A bold bid to take private a portion of the Houston energy empire Kinder had founded ten years earlier.

Rich Kinder
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When the group's $13.5 billion offer was announced in late May, it was then the second-largest leveraged buyout bid in history (it later rose to $15.2 billion, plus $7.2 billion in assumed debt) - the biggest since the RJR Nabisco deal at the peak of the LBO craze of the 1980s. And Kinder's shareholders weren't the only ones who'd been kept in the dark. The offer by Kinder and Goldman took the company's directors - at least the ones the CEO hadn't personally invited to join the deal - completely by surprise.

What was really stunning was what happened next: Kinder's deal turned out to be the first float in a parade of increasingly ambitious gambits. In the months since, corporate America has seen a wave of multibillion-dollar buyouts - from HCA ($32.7 billion including assumed debt) to Equity Office (Charts) ($38.9 billion) to TXU (Charts, Fortune 500) ($43.8 billion).

All told, there were $415 billion worth of private-equity deals in 2006. And PE firms raised a total of $215 billion last year to invest. In sheer dollar amounts, the current takeover frenzy dwarfs the buyout boom of two decades ago.

It's not just the war chests that are bigger this time; the potential conflicts of interest are too. Wall Street investment banks have plunged full force into the private-equity business, further clouding their already compromised judgment as corporate advisors. "Hostile" takeover bids by buyout firms have become far less common, as corporate managers have learned to share in the lucrative paydays that PE firms promise.

And the temptations have only become greater with the proliferation of so-called club deals, in which multiple private-equity firms team up to make bigger and bigger offers, which typically go unchallenged, for companies previously considered too large to devour. In October the Justice Department said it was beginning a preliminary investigation into potentially anticompetitive behavior by private-equity firms in club deals.

Perhaps no deal before or since embodies all these tensions quite the way the Kinder Morgan buyout does. A year after he first made his bid, Rich Kinder and his new partners are on the verge of getting final approval, despite pending shareholder lawsuits (alleging that the purchase price was too low) and a persistent regulatory challenge. While it's too simple to say that Kinder and his buyout mavens are out-and-out fleecing shareholders, the way the deal was carried out raises significant questions about fairness and disclosure.

After some haggling by the board on their behalf, the company's investors eventually got $107.50 for their shares, or a 27 percent premium over the pre-announcement price of $84.41. That sounds like a good deal - at least until you consider what they're leaving on the table.

Last spring Kinder told his board that a restructuring on behalf of the shareholders could get the stock to $163 by 2010. Presumably the buyout group thinks it can do at least as well. When the deal closes, Rich Kinder's personal stake in his company will immediately jump from 18 percent (worth $2.6 billion) to 31 percent ($4.5 billion) without his investing another penny.

Consider the motivation of Kinder's investment-banking advisor Goldman Sachs (Charts, Fortune 500), which stands to be paid for three different roles in the buyout deal. Not only did a Goldman banker, acting as an advisor, connect Kinder with Goldman's private-equity arm, but the venerable Wall Street firm has the lead role in the lending syndicate that's putting up $7.3 billion of debt. In all, Goldman will divvy up $243 million in fees - and that doesn't count the potential profits for the PE unit when Kinder is inevitably sold back to the public.

Compounding the perception of unfairness is the fact that by the time shareholders learned of the deal last spring, they were essentially powerless to stop it. A respected, retired Delaware judge who was appointed to rule on one stage of the shareholder suits against Kinder and his partners criticized the CEO last year for his "stealthy" ways and the "flawed process" he oversaw.

Shortly after the bid was disclosed, one sizable investor, retired Fidelity and Neuberger Berman executive Michael Kassen, sent a letter to Rich Kinder suggesting an alternative structure that would allow existing shareholders to get the same deal Kinder was grabbing for himself. The CEO didn't respond. "It's just fundamentally wrong, what they did," says Kassen, still fuming nearly a year later.

In fact, what Rich Kinder and Goldman Sachs have done is quickly becoming standard operating procedure in this new age of private equity. A careful examination of the process, after interviews with more than a dozen people familiar with the inner workings of the deal, sheds light on a situation in which managers are looking out for themselves, and their advisors don't just offer advice, they want to get in on the action. So who is minding the interests of shareholders? That's a good question.

Rich Kinder gets ticked off

Rich Kinder, 62, is no ordinary CEO - in his own eyes or in the opinion of most of the investment community. He's the guy, after all, who walked away from the presidency of Enron in 1996, plunked down $40 million for a couple of the doomed company's unwanted pipelines, and built the business into a pair of publicly traded entities (both bearing his name) together worth some $27 billion. When he tells investors he's going to make them money, in other words, he makes them money. And in early 2006 he felt that Wall Street wasn't adequately appreciating his handiwork. He became determined to do something about it.

Kinder (pronounced like the beginning of "kindergarten") was trained as a corporate attorney. In the 1980s he joined Enron, where his University of Missouri pal Ken Lay had been acquiring energy assets. Kinder quickly became the glue that held Enron together, the operations guru to the glad-handing Lay.

He rose to the No. 2 job and ran a famously tight and disciplined ship, presciently favoring a hard-asset strategy - focusing on the company's pipelines - over the fanciful trading schemes Enron was beginning to embrace. But, fed up waiting for Lay to name him CEO as promised, Kinder left Enron and teamed up with another college friend, William Morgan, to launch Kinder Morgan Energy Partners (Charts).

The assets they bought from Enron were organized as a master limited partnership, which Kinder made a selling point for his cash-rich business. MLPs are required to pay out most of their profits to shareholders each year and avoid paying corporate income tax in the same way real estate investment trusts do.

That arrangement brought in plenty of investors seeking high yield. But it wasn't attractive to such tax-exempt investors as pension funds and endowments. Kinder's solution? Create a corporation to attract those investors. Thus was born a second pipeline company, Kinder Morgan Inc., (Charts, Fortune 500) which has a large interest in KMP and pays out the cash distribution it gets in the form of a dividend. It is Kinder Morgan Inc. that he is now taking private.

The KMI structure has worked well for Rich Kinder personally. Fond of bragging that he's a dollar-a-year man - "I'd try to negotiate a salary increase, but nobody would listen to me," he deadpanned at a January investor meeting - Kinder is less loquacious about his tax-efficient dividend income. Because he owns 18 percent of the corporation's stock, Kinder received $84 million in dividends last year. Dividends are taxed at 15 percent, far less than the rate he'd pay on $84 million in salary or bonuses. "Obviously he knows his way around the tax law very well," says Robert Willens, an accounting analyst at Lehman Brothers.

But there's more to life than tax-advantaged income. By early 2006, Kinder was convinced that his companies were undervalued by billions of dollars. And the shares kept moving sideways, despite what seemed to be good news. In February, Kinder had personally informed investors that a planned megaproject, the $4.4 billion Rockies Express pipeline under construction in Colorado and Wyoming, was fully booked for customers. That meant the Kinder Morgan empire was virtually assured of fat profits from the project. Still, investors yawned, and the weak response was all an aggressive investment banker needed to set the buyout wheels in motion.