Rich Kinder's bigger slice (cont.)

By Adam Lashinsky, Fortune senior writer

Goldman forms a club

As a banker in Goldman Sachs's natural resources group, Scott Gieselman had been calling on Rich Kinder for years. On Feb. 16, 2006, Gieselman met with Kinder's right-hand man, company president Park Shaper, to discuss Kinder Morgan's stranded stock. The conversation focused on "various alternatives," including a stock buyback "ranging from small amounts to all of the outstanding shares," according to a proxy statement the company later filed with the Securities and Exchange Commission.

Gieselman and Shaper kept talking over the next several weeks, and on April 5, Gieselman dangled a tantalizing offer. Gieselman's own colleagues at the private-equity arm of Goldman Sachs would be "interested in exploring with management the possibility of a going-private transaction."

For the next two months, Kinder and his sidekick Shaper continued to quietly work out the details of his deal with Goldman. On May 5 Kinder invited co-founder William Morgan and his son Michael, a company director, into the buyout group. On May 9, the day of Kinder Morgan's annual meeting in Houston, Kinder tapped Houston money manager Fayez Sarofim, a longtime Kinder Morgan director and major shareholder, as well.

The next day Shaper met in New York with the two major credit-rating agencies, Standard & Poor's and Moody's. The S&P analyst in particular frowned on a leveraged buyout for KMI. To pay off shareholders, it would have to borrow heavily. And the highly indebted company would still be tied closely to KMP, potentially undermining the partnership's investment-grade debt.

Although Kinder Morgan's management informed the board on May 13 that it was continuing to evaluate "a variety of restructuring alternatives," according to its SEC filing it remained focused on a buyout - even in the face of S&P's disapproval. As these conversations continued, Goldman was busy assembling the club that would kick in the balance of the cash for the deal.

Goldman bankers contacted private-equity firms and by May 18 had narrowed the list to three candidates, in addition to its own private-equity arm: Carlyle Group, which has an investment in a similar pipeline company called Magellan; Riverstone Partners, a Carlyle affiliate whose founders, Pierre Lapeyre and David Leuschen, are former energy bankers at Goldman Sachs; and the private-equity arm of insurance giant AIG. The firms all declined to comment for this article, citing Kinder Morgan's wishes. For its part, Kinder Morgan agreed only to clarify factual matters.

The board gets an ultimatum

On May 28, Rich Kinder finally presented his board with a shocker. Despite weeks of telling them Kinder Morgan was merely considering its options, he said he wanted to buy the company for $100 a share. Judge Joseph Walsh, the retired Delaware jurist, would later chastise Kinder for the way he and Shaper put the deal together.

"While Kinder advised the KMI board on May 13 that they [management] 'were not there yet' on the formulation of a definite plan, he did not disclose that management, in the previous month, had worked on such a plan with the assistance of KMI employees," Walsh wrote in a preliminary ruling in a still-active suit. "When the [management buyout] plan, complete with price, was announced to the KMI board on May 28, it is fair to say that the independent directors were taken by surprise." (Despite his criticism, the judge ruled in favor of management in the procedural matter he was asked to decide.)

The startled directors at least had a tried-and-true game plan to follow. When management springs a buyout offer on a board, the independent directors form a special committee to review the deal, which in turn hires advisors, typically an investment bank with a discrete advisory practice. The Kinder Morgan special committee chose two advisors, Morgan Stanley and Blackstone Group. Both firms have major buyout arms that weren't involved in this deal, so their services were available to Kinder Morgan's board.

In a situation like this, the advisors have two tasks: to try to scare up competing bids and to evaluate whether the offer is fair. Morgan Stanley and Blackstone contacted 35 potential bidders, which included 16 pipeline companies, seven major oil companies, 11 private-equity firms and General Electric (Charts, Fortune 500). The bankers came up empty. For all the discussions they held, not one of the 35 entities even agreed to sign a confidentiality agreement, the first step in showing true interest in a bid.

In reality, there wasn't much Morgan Stanley and Blackstone could do, because they had essentially joined a game already in progress. The two firms were hired June 12, more than two months after Kinder Morgan's management began talks with the Goldman Sachs buyout unit. Goldman already had approached the biggest and most logical buyers to join their team. And who would realistically be willing to bid against such a well-financed proposal that already included the company's founders, especially the alpha financial genius occupying the corner office?

As for whether the offer was fair, Morgan Stanley and Blackstone used ten different methodologies to analyze what Kinder Morgan was worth. They came up with values ranging from $74 to $128 per share vs. the $100 bid. As is standard in situations like this, the two firms relied completely on data they received from Kinder Morgan rather than doing an independent audit. (For their trouble, each firm will collect fees of $10 million after the deal closes; both declined to comment.)

The chairman and CEO of a company negotiating with his own board is like a card shark playing poker while wearing X-ray specs. The senior managers and their buyout partners effectively have all the information, including how they will run the company after the deal is done.

Judge Walsh was bothered by the behavior of the buyout group, writing that it was "less than forthcoming and cooperative in providing information to the special committee." For example, it took management about a month, until June 27, to provide the special committee with the incentive package executives would be awarded. When they saw it, they learned it was doozy. Fully 20 percent of any profit from selling KMI or taking it public again would go to Rich Kinder's management group. Kinder himself would get 40 percent of that amount.

In the end, the special committee determined that $100 per share was insufficient. During late July and early August the committee told Rich Kinder several times that the offer would be rejected, a common face-saving technique.

"They want to come back with something to show they've been diligent, and management is very likely to raise its offer to show the special committee has been effective," explains Jeffrey Williams, a buyout veteran who runs the New York advisory firm that bears his name. On Aug. 21, the buyout group raised its offer to $107.50 per share. After consulting again with their advisors, the special committee accepted Kinder's offer on Aug. 27 and announced it the next day. Shareholders ultimately approved it overwhelmingly.

Kinder forges ahead

Nearly nine months later, the deal still hasn't closed, the result of an unexpectedly contentious regulatory challenge in California. A group of oil companies, including Chevron and BP, has for years been disputing a payment between its subsidiaries and a Kinder-owned pipeline. That group seized on the buyout as an opportunity to take its grievances to the California Public Utility Commission. On April 24, the commission issued a preliminary order approving the deal. It's expected to give final approval in late May.

The buyout is not without financial risk to the club group, including the CEO. They'll assume a heavy debt load, and their success will depend in part on the ability to sell some assets quickly at a good price to pay it down. And ultimately, of course, to cash out, they'll want to persuade the public markets to buy the company again at a much higher price.

But by taking advantage of the $5 billion of equity that Goldman and its partners are contributing, Kinder himself may well be getting a whale of a deal. Investors appear to be coming around to Kinder's point of view that his assets were severely undervalued - either on their own or because Kinder's bid opened some eyes.

Consider that the stock of Kinder Morgan Energy Partners (KMP) - not frozen by an agreed-upon purchase price - has jumped 24 percent since the KMI buyout was approved by its board last August (a gain of $1.9 billion in market value).

At a financial analysts' meeting in Houston for KMP in late January, Rich Kinder assured investors that the buyout of KMI would mean "business as usual" for KMP. He said that any attempt to strangle the "golden goose" - that is, KMP - would be foolish. "We are not brilliant people," said Kinder, in one of his down-home lines people find charming but unconvincing. "We are just trying to hit singles and doubles. We are not trying to hit grand slams." If this deal works, at the very least Rich Kinder will have gotten a big hit off a pitch that hardly anyone else saw coming.

_______________

Letter to the Editor:

While I understand the job of the media is to probe and be provocative, I also believe they have a responsibility to be fair and objective. Such was not the case with the May 28 Fortune article, which attempted to describe the deal to take Kinder Morgan, Inc. (KMI) private.

I was personally offended by this article because the author insinuated wrongdoing by the management team and others. Nothing could be further from the truth. We took extraordinary measures to ensure the process was transparent, appropriate and fair, virtually all of which is detailed in a 200+ page proxy.

In a deal of this size, the process is complicated and the involved players are always going to be subject to scrutiny. Scrutiny is fair, but inaccurate and biased reporting is not. Inaccuracies in the article included:

  • In the April 2006 analyst call, I did not let my intentions "slip out." I purposely stated in my prepared remarks that I did not believe that the markets were fully valuing the future benefits of the slate of projects that the Kinder Morgan companies were undertaking. We had previously disclosed the expected financial impact of these projects. I reiterated, in response to a question, that I believed that our shares offered a very attractive value -- there was nothing unintentional about any of these statements.
  • My stake in the company will not "immediately jump" in value. In fact, I (along with other members of management) agreed to take a discount on the value of my shares so that the price paid to all other shareholders could be raised. My stake, rather than being worth $2.6 billion (24 million shares times $107.50 per share), will be valued at $2.4 billion ($101 per share) in the new private company. My relative interest in the company will increase to 31% because there will be less equity in the company (slightly more than $2.4 billion divided by $7.9 billion of total equity equals 31%).
  • The shareholders were not "essentially powerless to stop" the deal when it was announced last spring. The transaction could not happen without the approval of shareholders. In a December 2006 vote the shareholders overwhelmingly approved the transaction (97% of those shares voting voted in favor of the merger agreement).
  • The board never received an "ultimatum." In fact, our process was specifically designed to give the board and the special committee more freedom and flexibility than many other buyout transactions. As soon as we made an offer to the board, we publicized it so that everyone would know that the company was in play. At that time, there was no break-up fee and no time limit as to how long the board could consider its options and solicit other bids. In fact, the board had not even agreed that there would be a transaction. The board and the special committee had complete freedom and control -- hardly an "ultimatum."

There also are certain facts of which your reporter was aware, but chose to exclude or diminish. I can only assume that he made this choice because these facts were not consistent with the picture that he wanted to paint. These facts include:

  • Actions speak louder than words. If shareholders believed that $100 or $107.50 per share was an insufficient price, why weren't they backing up the truck to buy the shares when they traded for $84.41 immediately prior to the offer? An equal number of shares must have been sold at $84.41 as purchased, or else that would not have been the market clearing price. If shareholders believed that $107.50 was insufficient, why did they overwhelmingly approve the transaction? And, why did all of the independent shareholder advisory services recommend a vote in favor of the transaction?
  • Companies and private equity firms are economic beasts. If these firms believed that they could earn an attractive return by purchasing KMI at a price higher than $100 per share (the price on the table when they were contacted), then they would have made an offer for the company. Ours is an asset-based business, not a people-intensive business. While we like to think that we operate our assets well, we are not foolish enough to believe that the assets do not have value without us.
  • Plaintiffs attempted to prevent the shareholders from voting on the offer by seeking an injunction, which we opposed. Justice Walsh ruled in our favor. While it is certainly possible to search through his order and pull out the few statements in which he criticized us, the vast majority of his order and certainly his conclusions were favorable to us. Far from ruling on a narrow "procedural matter" as implied by the article, Justice Walsh explicitly held on the preliminary injunction motion: (1) that the special committee functioned effectively, was well informed and made its recommendation in good faith; (2) that the proxy statement contained a full description of the events leading up to the formulation of the MBO, the work of the special committee, the negotiation of the final price, and that it was replete with financial information sufficient to permit the shareholders to make an informed choice as to whether to vote in favor of the offer or to reject the offer; and (3) that, based upon his review of the facts and the law, the plaintiffs failed to demonstrate a probability of ultimate success on the merits of their claims in the pending litigation.
  • The new investors are taking on a significant amount of risk. This includes financial risk in the form of additional debt and execution risk on the projects that the Kinder Morgan companies have underway. The magnitude of this risk is once again evidenced by the fact that neither our current shareholders in the aggregate nor any other potential buyers valued the company at $100 per share or higher. Indeed the project execution risks were prominently noted by several of the analysts' reports following the April call as the justification for their target prices, which were well below the potential values cited in the article.

I am not perfect, nor is my management team or our employees. But we have worked very hard to be open and honest in building our company, which I believe is one of the finest energy companies in North America, and it would be negligent of me to allow an inappropriate shot at our credibility and reputation go unanswered. Fortune has published an inaccurate and biased article. Do you have a problem with that?

Richard D. Kinder

Editor's note: Rich Kinder declined many times to be interviewed for this story. He is correct that the value of his equity in Kinder Morgan Inc. hasn't increased immediately, from $2.6 billion to $4.5 billion as estimated in the article. While the deal will raise his equity stake to 31% (up from 18% before the deal), Kinder's stake is initally worth $2.4 billion. Fortune regrets the error; otherwise, we stand by the story. Top of page

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