In the pressure cooker atmosphere to get financing lined up, KKR had made a serious oversight. Through a communication error with one of their bankers, they issued $6 billion of debt with a “reset” feature. The notes carried a 14.07% interest rate, and their buyers feared that as low-quality junk bonds even that interest rate might be too low to keep them trading at face value, 100 cents on the dollar. To guard against this, the notes came with the promise that by April 1991, RJR would, if necessary, “reset” their interest rate to force their market price toward full value. But months before that due date, the market for such risky bonds collapsed, and they were selling for as little as 60% of their face value. To meet its obligation, RJR would need to reset its interest rate perhaps to 25%.
Compounding this problem, these bonds were also known as “pay-in-kind” or PIKs. They had an added wrinkle. Rather than paying interest in cash, the notes issued more of the same kind of notes, and the debt piled up. Their 14% interest rate was bad enough, but if it got reset to 25%, then holders would get, not cash, but “baby PIKs” and in only two years the principle would grow from $100 to $156. In only three years, the $6 billion in debt would have increased another $5.7 billion. This compounding debt would surely force RJR into bankruptcy. However, if RJR could secure the money, it could call the bonds and retire them at something like $125.
KKR now faced its worst crisis ever. If the giant LBO went bankrupt, their reputation would be destroyed. They would never again be able to tempt investors to join them in a buyout. Weeks of study and number crunching to find a solution followed. The best legal minds in the bankruptcy area told them there was no way out. They met with the current bondholders who were uniformly angry and uncharacteristically disrespectful to the KKR men, something they were not used to.
Finally, hat in hand, with unaccustomed humility, KKR people petitioned their buyout fund limited partners to allow KKR to put a $1.7 billion cash infusion into RJR. This would allow them to go back to bankers and ask for new loans to retire some of the troublesome reset bonds. The partners agreed. Then the bankers agreed, but at a staggering price.
The banks had always been happy to raise money for KKR. It was a good income at fees of 1.5 – 3.0% of the bond money raised. They had fallen over themselves to court KKR. But now, shockingly, the shoe was on the other foot. The bankers let KKR know how much they had resented all the money that KKR had made on previous deals. Now was the time for the bankers to extract their pound of flesh. They demanded and got a $200 million fee for raising $3.5 billion, a stunning 5.3% payment. But that wasn’t all. The legal, printing and other fees tallied $50 million more, for an unheard-of cost of 6.7%. This new $5.45 billion could retire enough debt to make RJR a viable company. This meant that KKR’s prospective returns on the RJR investment had been cut in half, but the partners breathed a sigh of relief. Their company had been saved.
The debt negotiations were conducted well out of public view and only became widely known after the fact.
At our investment firm, we were sure we knew RJR well and believed the bonds to be a real bargain, so we naively bought them for our fund at around $80. Little did we know that the brightest and the best in the world at valuing bonds were convinced that RJR would go bankrupt and were paying as little as 60% of face value for them.
When KKR negotiated a favorable outcome, our bonds soared to the “call” price and RJR bought them at $125. Our investment of $80 in the few months we held them, including one PIK payment of $7 more bonds, brought $135, a 67% return. The reality was that our $80 investment had a much higher probability of going to $30 with an RJR bankruptcy. (Fools rush in where angels fear to tread.)
Anders, George. Merchants of Debt. New York, InkWell Publishing, 2013.