Why was Ross Johnson resistant to a leveraged buyout of RJR Nabisco? Why did he eventually cave in?
In the 1980s, many LBO consultants were pursuing the idea of buying out RJR Nabisco, but CEO Ross Johnson was hesitant. Eventually, he agreed to try an LBO, which would later become the biggest in history.
Learn more about RJR Nabisco’s LBO below.
How and Why Ross Johnson Initiated an LBO
According to Barbarians at the Gate by Bryan Burrough and John Helyar, LBO consultants repeatedly contacted Johnson, asking him to consider a leveraged buyout and offering their services. Initially, Johnson was resistant to the idea because he feared that RJR Nabisco’s LBO would force him to adopt a restrictive budget in order to pay off bank loans. Also, he didn’t want to trade his amicable board of directors for a group of finance-consultant partners who might be less inclined to let him run the company as he saw fit.
(Shortform note: Many financial advisers would likely feel that Johnson’s concerns about the pitfalls of debt were justified. Dave Ramsey in Total Money Makeover, David Bach in Automatic Millionaire, and Scott Pape in The Barefoot Investor argue that if you have debts, you should brutally cut every nonessential expense to pay them down. They believe that until you’re debt-free, your budget for luxuries should basically be zero, and Johnson enjoyed having luxuries like corporate jets at his disposal.)
However, Burrough and Helyar speculate that Johnson grew restless, not finding enough avenues for continued change and improvement. He also became obsessed with the company’s stock price, which dropped to around $45 per share in an economic downturn and failed to come back up. In the end, Johnson agreed to try an LBO, seeing it as the only way to address the low stock price: If Johnson and his partners bought the company, the stockholders would get a big payout and then there would be no more publicly traded stock to worry about.
According to Burrough and Helyar, Johnson partnered with the finance firm Shearson Lehman because Shearson was willing to give his executive team more generous terms for their partnership than other consulting firms. Specifically, the new board of directors would be structured such that Johnson’s team had veto power. And Johnson’s team would get 18.5% of the company’s dividends (almost twice the going rate), even though Shearson would put up all the money for the LBO (most of which they would borrow from banks or raise by selling junk bonds).
Burrough and Helyar explain that Shearson Lehman was willing to accommodate Johnson’s terms because they felt they needed the LBO to establish themselves in the LBO consulting business. They were a relatively new company that had started out facilitating wire transfers, bought out the Lehman Brothers investment bank, and was now trying to get started in the LBO consulting business. Because of the size and value of RJR Nabisco, doing an LBO for Johnson would have propelled Shearson immediately to the top of the LBO-services market.
Shearson’s motive for working with Ross Johnson on unusually generous terms illustrates the concept of “positioning,” which marketing consultants Al Ries and Jack Trout discuss in The 22 Immutable Laws of Marketing. As they explain, a company’s “position” in the market is simply how prospective customers perceive the company. For example, is it the market leader? Is it the alternative to the market leader? Is it an option that caters to a specific niche?
They assert that as markets mature, eventually every sector becomes a two-rung ladder, with one clear market leader and one clear rival to the leader, while the rest of the companies in that sector are relatively obscure and compete for just a tiny fraction of the overall market share.
Based on Burrough and Helyar’s account, it appears that at the time of the RJR Nabisco LBO, Shearson wanted to be one of the top two in the LBO consulting market, but they weren’t, and they knew it. They believed that handling the largest LBO in history would provide a step-change in their market position, raising them from relative obscurity to one of the top few LBO companies in the minds of prospective customers. If they could establish a position on one of the top two rungs of the two-rung ladder, then in the long run, their increased market share would likely more than make up for lower profits on the RJR Nabisco LBO itself.
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- The history of the RJR Nabisco buyout that caused drama and intrigue
- Inside information on many of the people and companies involved
- How leveraged buyouts and junk bonds work