Originally published in Nikkei Asia's “Henry Kravis: My Personal History"
Chapter 5
Awestruck and inspired by an innovative method of buying companies
When I graduated from Columbia Business School in 1969, George (Roberts, KKR co-founder) was already working for Bear Stearns. He was in the investment bank's corporate finance department, which was led by Jerry Kohlberg, who was co-head of the section.
After he had his first child, George wanted to be transferred to San Francisco, which he knew well from his law school years. George recommended me to Jerry as his successor in the department. But it was not the first time that I was offered a job at Bear Stearns. Previously, I declined Jerry's offer of a job and joined a venture capital company, but I quit the venture capital company after only a short time. "Are you sure you're coming this time?" Jerry said to confirm my intention.
Jerry, George and I worked as a team. We were in the business of bootstrap acquisitions, a new formula for buying a company. This type of corporate acquisition later came to be called, successively, a management buyout, a leveraged buyout and now, private equity.
It's a lot like buying a house. Let's say you buy a house, but don't mow the lawn or fix problems with the roof. You will never be able to sell it later at a decent price if it is a completely rundown property.
The same applies to businesses in private equity; you need to nurture and grow them through investment.
One of the keys for increasing a company's value is for management to own shares. This is the difference between being an owner and being a renter of a company. When you rent an automobile, you don't really care as much if it gets dirty or scratched. If it is your own automobile, however, you try hard to keep it clean, wash it by hand and try hard not to dent it or scratch it.
The discipline of debt is also important. If a business has debt obligations, you pay attention to its cash flow and take care not to make unwise investments. Because if your company fails to service the debt, it can be forced out of business. Like a house, you must keep paying your mortgage so you can stay in your house and protect your equity.
Jerry was the first to use this formula, in acquiring a company called Stern Metals. The company was managed by a friend of his in New York. The man had a son who he did not think was equipped to run the business and asked Jerry what he should do with the company. "I don't want to sell to a large company. I want to keep the company independent if I can, but I don't want to go public. What do I do?"
Jerry had this idea of forming a group of investors involving financial institutions to buy the company from Stern in a deal that allowed his friend to keep a 25% stake in his company while the group would own 75%. This way, they were able to stay involved and benefit as investors while transferring ownership and governance. This whole idea, a new way of buying and investing in companies, was fascinating.
In the 1970s and 1980s, most U.S. companies were poorly managed and had lax governance. Board members, including the top executives, would serve on each other's boards without asking too many questions. Businesses simply were not that well run. The bootstrap acquisition changed the mindset of CEOs by creating more incentive and accountability. Managers had to put their money into the company so they were "aligned" with other investors who were putting valuable equity into the company. When they did that, they looked after the company differently.
We purchased a number of companies while at Bear Stearns through the buyout approach. The first deal I was involved in at Bear Stearns was the acquisition of Vapor Corporation, a subsidiary of Singer, the sewing machine maker, in 1972. George did corporate finance work as well as working on buyouts while at Bear Stearns. George and I became partners at Bear Stearns before we turned 30, but the company was not interested in this new way of doing business.
Bear Stearns was a trading firm with a trading mentality focused only on short-term profits. We wanted to create value in these companies and hold them longer. We were enchanted by this new art of acquiring and working with companies. The ember of entrepreneurship had started burning -- and that fire never went out -- for George or for me. If we couldn't do it at Bear Stearns, we were going to find another way to do it.