Barbarians.

In our previous memo Game of Stones, we discussed Steve Schwarzman’s life, legacy, and most importantly, his lasting impact on the private equity industry.

Schwarzman correctly identified the buyout industry as the perfect sub-sector of finance to focus on due to its high growth potential. In the process of doing so, he built a $150B+ behemoth and solidified himself as the face of private equity.

Henry Kravis walked so that Stephen Schwarzman could run.

Kravis was born to a Jewish family in Tulsa, Oklahoma, known as the oil capital of the world for most of the 20th century.

Raymond Kravis, Henry’s father, forged an extremely successful career with his business partner Joseph P. Kennedy, father of John F. Kennedy.

Oftentimes, we see two people in the exact same situation live two completely different lives.

Exhibit A: two people’s fathers are crippling alcoholics; one of them traverses the same road and struggles with the addiction, while the other never takes a sip of alcohol.

Both would have the same justification for their lifestyle: “my dad was an alcoholic.”

Similarly, those with extremely wealthy parents tend to end up on one of two paths —leading degenerate lives with every pleasure imaginable at their fingertips or possessing relentless ambition, attempting to out-do the success of their predecessors.

Henry Kravis falls into the second bucket.

Despite Kravis’s natural intelligence, he hated the American schooling system and vowed to never pursue further education after graduating from Claremont McKenna.

His father eventually convinced him to enter business school, and he enrolled in Columbia’s MBA program.

After graduating, Kravis and his cousin, George Roberts, joined Bear Sterns in 1969 and were assigned to Jerome Kohlberg in the corporate finance department.

It would be this seemingly lucky placement with the experienced Kohlberg that would change Kravis’s life forever, due to Kohlberg introducing him to a novel asset class: bootstrap investments, also known as leveraged buyouts.

The trio, under the Bear Sterns umbrella, would execute a few of these deals, putting up roughly 10% of the transaction as equity and taking on the rest as debt through high-yield bonds. After a handful of successes, Kravis became a partner at just 31, becoming the youngest in company history to achieve this feat.

Kravis began to think bigger.

His next idea was to raise a fund for these buyouts using the Bear Sterns platform and enter into a 50/50 profit sharing agreement with the company.

To Kravis, it seemed like the ultimate win-win, given the trio could use the company’s established branding to quickly raise funds and provide the firm with passive profits.

Surprisingly, Cy Lewis, a senior partner at the firm, quickly thwarted the proposal.

The issue came down to one thing: creative control.

Cy Lewis’s response went something like this: “you either do exactly what we want you to do or you can see your way out of the door.”

To Lewis’s surprise, Kohlberg, Kravis, and Roberts actually dipped in 1976.

Now that they’d completed the easy task of leaving, now came the difficult task of raising a $25M fund using the new branding of KKR Associates instead of Bear Sterns.

While Schwarzman struggled to raise capital, Kravis was able to quickly close on an anchor investor: Henry Hillman.

Hillman was a billionaire industrialist from Pittsburgh who had previously invested with Kleiner Perkins, one of the trailblazers in the VC space. His existing exposure to alternative investments was a major factor in his willingness to step in and take half of the fund.

Next, they went to Prudential and pitched their idea and they immediately loved it too—they were ready to take the other half.

While there were obviously challenging obstacles that the trio faced in fundraising, relative to other Schwarzman’s story, it seemed to be a relatively smooth and short process.

However, the same problem of creative control re-emerged from the Bear Sterns days, as Prudential was not willing to simply be a passive investor in the fund.

Rather than being a part of the investment committee, Prudential essentially wanted to be the investment committee. They demanded significant control over investment decisions that included veto power.

To Kravis, it was a no-brainer. It didn’t matter how desperate they were for capital; if they said no to Bear Sterns, then they could do the same to Prudential.

Despite the moral victory for sticking to their principles, the team still faced the reality that they still had $12.5M to raise with no real leads.

One night, Roberts and Kravis met at an Italian steakhouse, where Kravis proposed to scrap the original plan of an institutional fund and pivot to a more innovative idea.

Kravis’s layout was this: since they needed roughly $500K a year to cover their overhead, they would raise $50K from eight individuals, including Kravis’s father and Hillman, and, in exchange, show these eight backers every deal they came across for the opportunity to invest with them on a deal-by-deal basis. To cover the remaining $100K, they would simply use the fees generated from the deals.

Roberts loved it, and Kohlberg was all-in after receiving the information.

Using this formula, they invested in three companies that all performed very well: Houdaille Industries, Incom International, and Barrows Company.

During this time, the concept of carried interest was nonexistent in the financial world.

Kravis introduced the idea, borrowing the oil industry’s famous “a third for a quarter” system, where an investor in an oil rig receives a third of the upside in exchange for covering a quarter of the costs.

Using this as the blueprint, Kravis decided on capturing 20% of the upside. He admits that the number was completely arbitrary and chose 20% over 25% because they “didn’t have money” and that demand would be higher for 20%.

Now that they had the performance of their three investments and formalized their unit economics, they were able to raise the institutional fund they’d previously attempted to and closed on $35M in 1978.

As KKR expanded and hired more team members, Kohlberg, Kravis, and Roberts needed to be intentional on how they were going to build the firm’s culture.

At Bear Sterns, Kravis resented the “eat what you kill” mentality that infested the company, as this attitude eventually led him to lock his desk at night after co-workers would attempt to steal his deals.

Kravis oftentimes preferred to use creative interview processes, especially for higher level hires, that placed people in different situations, spanning from lengthy dinners at restaurants to hitting the links.

Once anyone — whether it’s a new CFO or a freshly hired associate — successfully passes the interview process, they are “treated like an owner.”

Kravis is especially proud of this shared ownership model, where everyone — including executive assistants and mailmen — receives a portion of the carried interest, as he would personally hand everyone their checks whenever a liquidity event occurred. Moreover, he rewarded loyalty, handing out larger checks to those who had longer tenure with the company.

As the company headcount expanded, the average deal size, and thus average debt load, was increasing as well, which unsettled the more old-school and conservative Kohlberg.

Kohlberg preferred to keep things simple: acquire mid-sized companies, improve operations, and work collaboratively with management. However, his younger co-founders Roberts and Kravis began to pursue larger mega deals and hostile takeovers like Beatrice ($6B) and Safeway ($5.5B) that became extremely popular in the 1980s.

Eventually Kohlberg’s vision became too separated from his partners’ and left to found Kohlberg & Company in 1987.

Just a year later, KKR would pull off the most notable LBO in history, inspiring one of the most popular financial books, Barbarians at the Gate, of all time.

This deal is so action packed that it deserves its own memo.

Part II coming soon.

Headlines

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• Leeds United, owned by the 49ers group, is heading back to the Premier League. FOS

• Private equity dives into retail investor pool. Axios