Forstmann Little & Co. has figured out how to turn pepper into gold.
The New York investment firm shared its secret with the world yesterday when it announced that it was selling Dr Pepper Co. to Coca-Cola Co.
In a classic leveraged buyout, Forstmann Little purchased Dr Pepper two years ago with $30 million in equity investment. If the Coke deal is successfully completed, the firm will receive 10 times that amount, or $300 million.
The remarkable financial returns provide a classic example of how a leveraged buyout is designed to work. Dr Pepper was acquired using mostly borrowed money, with the debt repaid through a combination of earnings and asset sales.
In addition to benefiting Forstmann Little, a small firm with just seven professionals, the Dr Pepper sale would produce a significant profit for the pension funds of some of the nation's largest corporations, including General Electric Co.'s, that invest in Forstmann Little's buyouts.
"This deal is a great success," said Theodore Forstmann, one of the firm's four general partners. "We thought we had a great deal when we bought Dr Pepper, and we thought we knew what we were doing. It turns out we did. One cannot duplicate this kind of performance over and over again. But if this is the high point and you make four or five times your money on the low point, you're still doing quite well."
Forstmann said Dr Pepper was an ideal candidate for a leveraged buyout because the business had strong consumer loyalty and predictable cash flow. He said another key element was that certain assets on Dr Pepper's books could be sold without damaging the core business. Forstmann said that aggressive management and marketing helped Dr Pepper's operating profit increase from $38.9 million in 1983 to $60.6 million in 1985.
Here's how the Dr Pepper buyout worked:
In February of 1984, Forstmann Little won a bidding war for Dr Pepper, which had been a public company. Forstmann Little agreed to pay $623 million, of which all but $30 million was borrowed.
Wall Street experts criticized the price -- which was more than 24 times reported earnings -- as excessive. Articles in leading newspapers and magazines termed the deal a symbol of the wreckless borrowing and absurdly high prices caused by leveraged buyouts.
The articles were wrong. Within the first 18 months, Forstmann Little sold nine domestic Dr Pepper bottling plants and excess real estate for $285 million. In addition, Forstmann Little sold the Canada Dry soda business, which Dr Pepper owned, to R. J. Reynolds Industries Inc. for $177 million.
Following these sales, the Forstmann Little investment in Dr Pepper's remaining core business -- the manufacturing of soft-drink concentrate -- was about $200 million. Of that $200 million, $30 million was equity, or stock investment, and $170 million was borrowed money.
Coke yesterday agreed to buy Dr Pepper for $470 million, including the $170 million of debt. That leaves $300 million for Forstmann Little and its partners, who include New York investor Derald Ruttenberg, Wall Street arbitrageur Ivan Boesky, California businessman Eli Broad and New York executive Lew Lehrman, who ran unsuccessfully for governor in 1982.
"This deal is really a home run for Forstmann Little," Broad said. "If you go back to when the Dr Pepper deal was done, all of Wall Street said it was a bad deal, that they overpaid. Forstmann Little had the imagination and understanding to know they could restructure the business."
Geoffrey T. Boisi, codirector of investment banking services at Goldman, Sachs & Co., which represented Forstmann Little in the sale of Dr Pepper, said one of the keys to Forstmann Little's success is its disciplined approach to dealmaking.
"The thing that impresses me most about them is their extreme discipline in terms of which deals they get into and how they approach the financing of the deals," Boisi said. "The controversial thing about this deal was that people sensed they overpaid. This deal is a real coup for them. They saw something others didn't."
"We gave them substantial sums of money for this deal, and their initial estimate of what they could get for the core business was not far off," said Rob Morris, who directed the investment of General Electric's pension fund in the deal. "We are delighted."
Forstmann Little recently was an unsuccessful bidder for Revlon Inc., although it received a substantial "break-up fee" from Revlon after Revlon broke its deal with Forstmann Little and was acquired by Pantry Pride Inc.
Most of Forstmann Little's deals have involved companies with much lower profiles than Revlon and Dr Pepper. In 1981, Forstmann Little bought Union Ice Co., California's largest commercial manufacturer of water ice, for $30 million. Following asset sales, the equity investors received 15 times their original investment in three years.