A Lecture You Don’t Often Hear: How Smart People Lose MoneyPublished: April 24, 2002 in Knowledge@Wharton
Perry Golkin didn’t come to brag.
Wall Street financiers who seek to raise hundreds of millions of dollars annually in investment capital typically focus on their success stories. But when Kohlberg Kravis Roberts & Co. partner Perry Golkin delivered the Institute of Law and Economics’ annual "Law and Entrepreneurship Lecture" in Philadelphia recently, he only described KKR investments that lost money.
"Pension funds, banks, and rich people" that entrust millions of dollars and pay huge fees to private equity firms such as KKR do so in the belief they are run by "smart people" who know which investments will bring the greatest return, said Golkin, who titled his lecture "Smart People Making and Losing Money: Some Recent Examples."
But "smart people don’t always get it right." KKR didn’t it get it right, he said, when it invested in the movie exhibition business and reinsurance business."
Although Golkin didn’t name the companies involved, the facts he presented fit KKR’s purchase of the Regal Theater Chain, in which KKR is said to have lost its entire $500 million-plus investment, and its Alea Group Holdings venture which lately has cost KKR additional capital rather than producing profits. Indeed, last August the New York Times reported that today KKR is "just one of dozens of buyout firms," and not even one of the most successful. The Times cited the Regal investment as one that has "dragged down" KKR’s returns.
Kohlberg Kravis Roberts & Co., of course, is the investment firm that became famous - and in some quarters, infamous - in the 1980s for its leveraged buyouts - the use of huge amounts of debt, including junk bonds and bank loans, to buy public firms and take them private. KKR’s acquisition of RJR Nabisco in 1989 for $31 billion, including the assumption of debt, remains the largest buyout in history.
"Before buying a company," said Golkin, "we in the private equity business investigate that company’s management. We know the risks. We learn stuff they won’t tell anybody else. We have the information that should enable us to make a good decision. We’re supposed to able to beat that guy in the Wall Street Journal who picks stocks by throwing darts. And once the company is bought, we can be proactive in managing the business. When you own, you control the situation."
That, at least, is the theory. However, Golkin noted, as Warren Buffet once said, "a good management team will always lose the battle with a bad business."
The movie theater industry, according to Golkin, looked like a money machine in 1998. "It was amazingly profitable. It had experienced pure growth for 20 years. Attendance had been growing. The concession stands [provide] a stream of money. They sell Pepsi for which they pay virtually nothing and sometimes they are even paid by Pepsi to get customers to try it. They sell popcorn and Raisinettes at huge margins.
"They are adopting modern management techniques. The multiplexes contain both little theaters and big theaters. There’s a single ticket office for all the theaters and just one guy selling popcorn for all the theaters.
"If a film flops, that’s not your [the theater owner’s] problem. It’s the movie studios that take the risk. You can get whatever films you want. Theaters aren’t going to be displaced by home video or on-line transmission," said Golkin, "because the initial ticket sale at the box office determines non-theater sales, so movie companies need box office sales and they will promote the film for the theaters."
On top of everything else, he added, investors thought investing in the theater business was sexy. "They liked the idea of going to the movies, of being able to walk on red carpets with film stars."
And so it was that the smart people at KKR and other investment firms bought theater companies which "all went bankrupt."
According to Golkin, the theater companies explained this by saying: "We overbuilt after we bought. Regal built in AMC’s territory and AMC built in Sony’s territory. We cannibalized each other. It was too easy to build. Interest was cheap. Developers were building malls and malls need theaters. But theaters got more expensive. Each new theater had better seating and sound systems. Debt went up, taking away profitability."
But all that, he added, "misses the most important point. What the investment firms had failed to recognize was simply that movie theaters are not a good business. A theater is a commodity. It’s a room with a screen. There are no barriers to entry. No brand loyalty. The consumer decides which theater to patronize based on ’what movie do I want to see, where and when.’ The smart people never stepped back and asked: ’What am I buying?’"
Reinsurance would seem to be as unlike movie theaters as you can get, but according to Golkin, the businesses turn out to have much in common. Reinsurance, he explained, is insurance that insurance companies or self-insured companies buy to limit their risk in the event of a costly catastrophe. "It’s the largest industry in the world but also the most regulated industry in the world. The amount of revenue you can make depends on how much equity you put in, because regulators insist you be able to pay claims - not a wrong position to take," he said.
"You make money by taking the premium money and investing it," said Golkin. "Also by getting your estimates of costs right and there are a lot of ways to do that. If you know that Turkey has earthquakes, you limit your risks in Turkey.
"This is a hard industry to understand," he pointed out, "but you look at it and say: ’The product is needed and although it has recently been in decline, historically it has made a lot of money. It’s worth looking at.’ So KKR invested in reinsurance and the decline began to turn around and we said: ’Boy, are we smart.’
And then the World Trade Center catastrophe happened. Golkin said he thinks all estimates of what that will finally cost the insurance industry are low, but those losses aren’t what turned reinsurance into a - so far - poor investment for KKR.
"After September 11, demand for insurance skyrocketed, the price of insurance skyrocketed. And every smart investor wanted to be in the business. Twelve billion in new capital flooded in, but not to existing businesses. No, they said: ’Let’s go to Bermuda and start a new company.’ Here again, despite all the regulation, we found we were dealing with a commodity." Too much competition, too little customer loyalty.
Golkin said he hasn’t completely lost hope that KKR’s reinsurance venture will pay off. He thinks the new companies may fail, which would drive business back to the established companies. But, for now, the reinsurance investment isn’t looking "smart."
In his lecture, Golkin didn’t mention KKR’s RJR Nabisco acquisition, the subject of the best-selling book Barbarians at the Gate. But when a questioner in the audience asked if KKR had it to do over, would it buy RJR Nabisco again, Golkin flatly replied: No.
The New York Times article as well had noted the "disappointing performance of the RJR buyout …. The deal that cemented the firm’s reputation as one that could tackle deals of any size continues to hurt its track record."
"Parts of that deal worked out," Golkin said. "We needed to sell assets to get the debt down. We expected to get $5 billion and got $6 billion. Nabisco’s manager said he could improve profitability and did." What didn’t work out, he added, was that in the early 1990s the market for high yield debt shut down because of the bankruptcy of junk-bond king Michael Milken’s firm, Drexel Burnham Lambert and the [ongoing] government investigation of the savings and loan industry. "We had to sell high yield securities quickly and we hadn’t expected that."
The tobacco part of RJR Nabisco became an unexpected drag as well, Golkin said. KKR hadn’t expected the Philip Morris Co. to reduce the price of Marlboro cigarettes. "They trashed their own product in a price war with other cigarette companies." And, too, he said, "when we bought the company, tobacco was winning 100% of the court cases filed against it. But then the whole litigation landscape changed. "
Despite his emphasis on what can go wrong, Golkin ended his lecture on an upbeat note. Other KKR investments that he hadn’t described, he told his audience, "are going well."