RJR-case

HarvardBusinessSchool9-290-021Rev.August7,1995ResearchAssociateJoelBarberpreparedthiscaseunderthesupervisionofProfessorAndréF.Peroldasthebasisforclassdiscussionratherthattoillustrateeithereffectiveorineffectivehandlingofanadministrativesituation.Copyright©1990bythePresidentandFellowsofHarvardCollege.Toordercopies,call(617)495-6117orwritethePublishingDivision,HarvardBusinessSchool,Boston,MA02163.Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,usedinaspreadsheet,ortransmittedinanyformorbyanymeans—electronic,mechanical,photocopying,recording,orotherwise—withoutthepermissionofHarvardBusinessSchool.1RJRNabisco-1990Inthespringof1990,thefirmofKohlbergKravisRoberts&Co.(KKR)wasinnegotiationwithlendersregardingtherefinancingofa$1.2billionbridgeloanduetoberepaidinfullbyFebruary,1991.Thebridgeloanwaspartofthe$24billionfinancingofKKR'sleveragedbuyoutofRJRNabiscoinearly1989.Originally,KKRhadplannedtoretiretheloanwiththeproceedsofa$1.25billionpublicofferingofseniordebt.However,inDecember,1989,Moody'sfailedtogivetheissueaninvestment-graderating.Moody'salsodown-gradedRJR'sotherdebt,amovethattriggeredsubstantialdeclinesinthemarketpricesofRJR'ssecurities.Facedwithanunreceptivepublicmarket,KKRwithdrewthedebtofferingandbegandiscussionswithRJR'slendingbanks.Forthebanks,amajorconcernwastheuncertaintysurroundingtheupcominginterestratereseton$7billionofRJR'spay-in-kind(PIK)bonds.IndenturesrequiredthatonorbeforeApril28,1991,RJRresettheratesothatthebondswouldtradeatpar(seeExhibit1).Inthespringof1990,thebondsweresellingatsteepdiscountstopar(Exhibit3).Themarketobviouslysawsubstantialriskthattheresetwouldfail,whichwouldputRJRinviolationofitsbondcovenants.Theresetbondscameintobeingasthecram-downsecuritiesintheRJRbuyout.Thedistinctivefeatureofthesebondswastheresetprovision,whichatthetimeofthebuyoutwasakeyfactorinKKR'svictoryoveramanagementgroupledbythen-RJRNabiscoCEO,F.RossJohnson.1Weeksofescalatingbidding,whichhadbegunwitha$75pershareall-cashbidbythemanagementgroup,endedwiththeRJRboardofdirectorshavingtochoosebetweentwofinalbids:KKR'sofferof$81pershareincashplusPIKresetbondsitvaluedat$28pershareversusthemanagementgroup'sofferof$84pershareincashplusPIKbondsitvaluedat$28pershare.ThelatterPIKbondsdidnothavearesetfeature,however.Theboard'sfinancialadvisors,Dillon,ReadandLazardFrères,concludedthatthetwooffersweresubstantiallyequivalent,ineffectvaluingthemanagementgroup'sPIKbondsatonly$25pershare.2TheyreasonedthattheKKRbondswereeffectivelyguaranteed.Ifthemarketdidn'tjudgethesecuritiestobeworth$28,theinterestratewouldberesettomakethemworth$28.KKRhadputitsmoneywhereitsmouthwas,somethingthemanagementgrouphadbeenunwillingtodo.Withasubstantiallyequivalentopinionfromitsfinancialadvisors,theboardfeltfreetoevaluatetheoffersbasedonotherconsiderations.TheboarddeclaredKKRthewinneronthebasisofthefirm'spledgenottoeffectlargelayoffsandinviewofthefactthatKKR1Burrough,Bryan,andHelyar,John,BarbariansattheGate,1990,Harper&Row,NewYork,pp.441–442,485,493,497–498.2Burrough,Bryan,andHelyar,John,HowUnderdogKKRwonRJRNabiscoWithoutHighestBid,TheWallStreetJournal,12/2/88.290-021RJRNabisco-19902offeredstockholderstheoptiontoacquireupto25%ofthenewcompanyatapointinthefuture,whereasthemanagementgroupofferedthemanoptionforonly15%.3Asaconsequenceofthebuyout,RJR'stotaldebtballoonedto$29billion.KKR'sstrategyforservicingthisdebtrestedonassetsalesandimprovedinternalcashflow.ExceptforthestumblingblockcreatedbyMoody'sdowngrade,theplanhadproceededasforecast:throughMarch31,1990,assetsales(Exhibit2)andcashflowmetorexceededtargetsandallrequireddebtpaymentsweremade.TherewasconsiderablespeculationastohowKKRmighttrytodealwiththeresetproblem,theresolutionofwhichhadnowbecomeintertwinedwiththebridgeloanrefinancing.Withrespecttothelatter,covenantseffectivelypreventedanycourseofactionotherthantheraisingofexternalfundstoretiretheloan.Withrespecttotheresetprovisionhowever,KKRfacedaricherarrayofalternatives,althoughjustaboutanyfinancialrestructuringwouldrequiretheconsentofthebanksinviewofthetightrestrictionsimposedbytheCreditAgreement(discussedbelow).First,thefirmcouldtrytoraiseexternalfundsandrepurchasealloraportionofthePIKresetbonds.Inrecenttimes,manycompanieshadbeenrepurchasingtheirjunksecurities:$2.5billionaloneinthefirstquarterof1990,versus$5.5billionin1987,1988,and1989combined.4Potentially,thefundsforabondbuy-backcouldcomefromadditionalbankborrowingsand/orthesaleofequity,preferredstock,orothersecurities.AnoftenmentionedsourceofmoneywasKKR'sLBOfund,whichstillhadseveralbilliondollarsavailableforinvestments(describedmorefullybelow).Howmanyoftheresetbondswouldhavetoberepurchasedwasnotobvious.Conceivably,withanexternalfundsinfusion,itmightnotevenbenecessarytorepurchaseanyofthebonds,sinceastrengthenedbalancesheetmightgivesufficientboosttotheirvalues.Asecondalternativewastoraiseinternalfundsforabondbuybackthroughthesaleofadditionalassets—themostmarketableofwhichwerebelievedtobeRJR'sU.S.foodbusinesses,estimatedtobeworthover$12billion(seeExhibit3).However,thiswason