Kohlberg Kravis Roberts (KKR) – New York City “Influencer”

KKR and the Art of the Steal Shareholder Theory and Buyback Programs
Introduction
Kohlberg Kravis Roberts (KKR) is an investment firm that acquires influence in a company by purchasing a controlling amount of shares or else a significant amount of shares that enable it to put pressure on the company’s board. KKR has made a number of large-scale investments and leveraged buyouts (LBOs) over the years, including the LBO of RJR Nabisco by KKR in the 1990s. In that instance, the firm anticipated a higher return on investment (ROI) than it ended up receiving, and KKR went back on its promise to keep RJR Nabisco’s assets intact, liquidating them so as to be able to move on to other investment projects (Leveraged Buyouts, n.d.). By using its capital to influence the way a company is managed, KKR has been able to influence outcomes for various firms in which it heavily invests. Like any other activist investor, from Nelson Peltz, who famously battled the board of P&G for control after taking a significant stake in the company through purchases of public shares, to Bill Ackman and Carl Icahn, KKR looks to influence the companies in which it invests so that it can reap a large ROI (Brunsman, 2019; Huddleston, 2014). The problem is that in some cases there can arise a conflict of interest with respect to governance. The conflict of shareholder vs. stakeholder theory becomes evident and one must answer whether it is within reasonable ethical guidelines for a company to manage another firm for the purpose of increasing shareholder value at the expense of stakeholder value. Additionally, the issue of auditing comes into play, as external auditors are awarded large contracts to audit a firm but those firms often want a glowing review rather than one in which numerous red flags are found: in fact, that was the problem Andersen eventually ran into and that in the end led to the fall of the most famous and respected auditing firm in America (Neuman). This paper will analyze the problem of conflict of interests with respect to KKR and discuss how influencers deal with this issue and how they manage to make the right call.
How KKR Influences a Firm’s Board
KKR is able to influence a firm’s board by buying a controlling stake in the company or by having enough of the stake in the company that it can demand a seat on the board, much the way Peltz did with P&G. Peltz went on to advocate for certain changes in the company’s direction, which led to the company’s stock price rising substantially. KKR typically seeks to do the same thing. If it does not have a controlling stake it becomes like BlackRock, which has a massive stake in many of the top companies all over the world. Whenever an investment firm like KKR or BlackRock has such a large stake, it is able to influence the board by making demands that must be met lest the investment firm decide to punish the company by dumping its stock into a weak market and causing the share price to crash. As many board members and executives count on shares for compensation, they want the share price to remain high—thus they tend to give in to the influence of firms like KKR.
KKR is then able to change the corporate culture of the firm by focusing its governance on increasing shareholder value. Shareholder theory is the idea that a company’s duty is to increase the value of shares so that investors see a good ROI. One of the ways that companies today implement shareholder theory is by authorizing share buybacks on the open market. Companies will often take on cheap debt (i.e., debt at low interest rates) and buyback shares—and by creating demand for shares the price of the shares goes up, benefiting shareholders (Light, 2019).
This creates a problem because as Zhao (2010) puts it, “the essence of corporate governance in U.S. public corporations lies in the separation of ownership and control” (p. 495). When the owners of shares end up in control of the firm, the idea of corporate governance becomes conflicted. However, it is actually much more complicated than just one investor buying up stock, as KKR does, because in the US corporate governance is the result of the integration of various entities and parties: from executives to shareholders to institutional investors to agencies like the Securities and Exchange Commission to consulting firms to stock exchanges themselves (Ewmi, 2005). However, when the shareholder is large enough, that shareholder can wield influence with the board, just as KKR often does in its investments and just as Ackman did with JC Penney in his attempt to alter that firm’s direction (Guinto, 2013).
Conflict of Interest
When the shareholder is calling the shots in the company, the idea of corporate governance becomes muddied and polluted. The board should be concerned with transparency, accountability and security. But when an activist investor like KKR influences the board, the question of transparency and accountability arises: just to whom is the board now accountable—this single powerful shareholder?—or other shareholders and stakeholders? Corporate governance is supposed to focus on the long-term success of the company—but as KKR showed with RJR Nabisco, the firm was really just interested in a short-term positive ROI, and it dumped the investment when the ROI did not become manifest.
Big investors like KKR want the ROI to be big and fast—and they are more interested in that than in the long-term success of the company. They can thus influence the board to do something as self-serving as engage in share buybacks by taking advantage of low interest rates, borrowing billions of dollars and using those dollars to purchase shares in itself so as to create artificial demand in the marketplace. This has nothing to do with corporate strategy or production or research and development; instead, it is all about creating an illusion of demand by acting as a buyer of its own shares; other investors see that the company is doing buybacks and the price of shares goes soaring, benefiting KKR and of course board members who allow themselves to be easily influenced by activist investors looking for an ROI—because after all a good ROI for KKR is a good ROI for them as well, since they typically receive large options contracts for sitting on the board. BlackRock is an example of a potential activist investor who can use their shares to influence decisions of the Board regarding firm direction or policies. KKR does this, too; and Peltz did it with P&G: they all can criticize the board’s corporate governance strategy until the board conforms to the will of the activist investor; and of course the activist investor is interested primarily in the ROI.
The board is supposed to be accountable to all shareholders, and, according to stakeholder theory, it should be accountable to all stakeholders as well. By altering corporate governance to fit the needs of those who benefit from higher share prices, the board is demonstrating a conflict of interest. However, there are ways a firm can deal with this conflict of interest, and Chinese Walls are one way.
Chinese Walls
Chinese Walls is a term used in business to refer to the way in which information is protected by preventing it from being shared or distributed to those who might stand to profit from that information. It is a way of maintaining confidentiality so that one group does not have access to information that all other groups do not have. Activist investors like KKR seek to have control over the flow of information by influencing the board, but in doing so they can become privy to insider information and that might affect how they trade or profit. This is unethical, as insider trading is illegal since it means that one group has access to information not made public to all other investors.
An investment firm like KKR is going to have access to information for companies that might make an initial public offering (IPO), for example. Yet it has to erect Chinese Walls to prevent information about that IPO from getting into the hands of other departments that might base trades on the knowledge before the knowledge is actually made public. Yet, as Seyhun (2008) argues, a porous Chinese Wall is actually beneficial in that it can reduce the conflict of interest that results in insider trading because it actually leads to the reduction of volatility as more investors seek positions on the board. In other words, if the board is going to be open to influence from one investor, it should be open to all investors, and this changes the nature of the game of corporate governance completely. Chinese Walls can thus help, but auditing is also a strategy to consider.
Auditing
Another way of addressing the conflict of interest issue is through auditing. External auditors are meant to be impartial and objective. They should be able to view a company’s approach and see whether it is in the company’s long-term interests or not. However, there are challenges here as well. For example, an audit for a publicly held firm by one of the "Big Four" accounting firms will easily run into the eight figure range (McDonald's for instance, paid EY about $14 million for their audit last year), and this creates a major conflict of interest since the firm should want to do a correct audit but at the same time it does not want to offend the company that hires it, as offense would endanger a contract of that size.
Thus, the "influencer" deals with the conflict of interest by working with the accounting firm doing the auditing and helping focusing the company on new strategies. At the same time, the firm puts pressure on the board to make the "right" judgment call that would please the large shareholder. KKR as an influencer thus complicates what should be a simple process of corporate governance by bringing the matter of chasing the ROI into the matter. The external auditor that should be focused on helping the company to chase down any problems in accounting or record keeping is instead twisted around into doing the bidding of the influencer because the prospect of not being hired back is one the auditor cannot risk.
Conclusion
Influencers and activist investors like KKR and others pose a significant ethical risk to the issue of corporate governance. They represent a shareholder first mentality that not only flies in the face of stakeholder theory but that also flies in the face of shareholder theory if one is going to take a long-term vision. The fact that KKR and other activists and influencers will put pressure on a board to authorize share buybacks by taking on more debt so as to inflate the price of the stock is evidence enough that a serious conflict of interest exists. The corporate governance system of the US does not place many strict regulations on this type of activity; on the contrary, it encourages it and has done so since 1982 when share buybacks (once illegal) were permitted and public companies were essentially allowed to manipulate the market.
References
Brunsman, B. (2019). P&G CEO Taylor, activist investor Peltz laugh off proxy battle as stock soars. Retrieved from https://www.bizjournals.com/cincinnati/news/2019/09/20/p-g-ceo-taylor-activist-investor-peltz-laugh-off.html
Ewmi, P. F. (2005). Three models of Corporate Governance from developed capital markets. Lectures on Corporate Governance, December, 1-14.
Guinto, J. (2013). Who wrecked j.c. penney? D Magazine. Retrieved from http://www.dmagazine.com/publications/d-ceo/2013/november/who-wrecked-jc-penney
Huddleston, T. (2014). A look at how some of the top investors, hedge funds spent the second quarter. Retrieved from https://fortune.com/2014/08/14/hedge-funds-quarterly-disclosure/
Leveraged Buyouts. (n.d.). RJR Nabisco—Case Study.
Light, L. (2019). More than Half of All Stock Buybacks are Now Financed by Debt. Here’s Why That’s a Problem. Retrieved from https://fortune.com/2019/08/20/stock-buybacks-debt-financed/
Neuman, E. J. (2005). The Impact of The Enron Accounting Scandal On Impressions Of Managerial Control. Academy Of Management Annual Meeting Proceedings, S1-S6.
Seyhun, H. N. (2008). Insider trading and the effectiveness of Chinese Walls in securities firms. JL Econ. & Pol'y, 4, 369.
Zhao, J. (2010). Comparative Study of US and German Corporate Governance: Suggestions on the Relationship Between Independent Directors and the Supervisory Board of Listed Companies in China. Michigan State International Law Review, 18(3), 9.