Twenty years after the record-setting buyout of RJR Nabisco, the deal still stands as a prime example of private equity operating at extreme capacity. Will mega-LBOs of 2006 and 2007 be as influential? And will they, like RJR Nabisco, ultimately disappoint? David Snow compares two bygone boom eras

In an early 2007 interview with the Wall Street Journal, Henry Kravis made a comment that could not have been delivered more authoritatively by anyone else. He said,“Any fool can buy a company. You should be congratulated when you sell.”

Kravis and the rest of the partners of Kohlberg Kravis Roberts (KKR) know all too well that celebrated buys don't always lead to sells worthy of congratulation. Most of the celebration around the $31.4 billion buyout of RJR Nabisco happened around the bidding war that commenced in 1989. The exit was barely noted. Shares in RJR Nabisco were used to buy food company Borden in 1995, and Borden was sold to Apollo in 2005.

There was no celebration to mark either transaction, and for good cause. The deals lacked the competitive drama of the original purchase, and in any case the results of the investment were nothing to crow about. Limited partners who participated in the RJR Nabisco buyout saw a net IRR of less than 1 percent, according to an investor source (see p. 66 for more details on the performance of the deal).

In 1995, around the time of the share swap with Borden, KKR co-founder George Roberts stood before the investors gathered at his firm's annual limited partners meeting to explain how it came to be that KKR's massive investment in RJR Nabisco had produced such a paltry return. An investor in the room says that Roberts “told us KKR paid an aggressive price for [RJR Nabisco], and then everything went against them. He said they couldn't have predicted that all these things would go wrong”.

But for its record-breaking size, RJR Nabisco would likely not be remembered beyond the private equity industry; even among the parties to the deal, it would otherwise be remembered as just another deal that went sideways. Many of the things that went wrong with RJR Nabisco under KKR's ownership were historical peculiarities, such as tobacco lawsuits, and terms specific to that market era, such as bonds with interest-rate “reset”provisions designed to ward off sagging bond values. And let's be clear – investors didn't lose money so much as suffer a lot of brain damage and nothing to show for it in the form of returns.

Far from being a prime example of private equity at work, RJR Nabisco was an outlier. But the size of the deal, and its proximity to the collapse of the go-go high-yield bond market at the end of the 1980s, made it iconic. There was no deal anywhere near as large leading up to RJR Nabisco, and for 18 years thereafter there was no LBO deal that surpassed it in size. When in 1988 news reports started to circulate that RJR Nabisco was about to undergo a leveraged buyout, the initial potential value was set at $17 billion. At that point the largest buyout on record had been sponsored two years earlier by KKR, when it acquired Beatrice Companies for $6.1 billion.

The general public was perplexed. “They said, here's a mainstream company, and who the hell are these guys that are buying it?”remembers an LP source who was investing at the time. This, plus the aggressiveness of the bidding war, added to a public image of private equity as being predatory, greed-addled and reckless.

RJR Nabisco made an impression on industry insiders and outsiders alike, and over 20 years those impressions have led to both progress and challenges.

As the 1990s economy gathered steam, theWall Street of the 1980s was the furthest thing on anyone's mind as Internet start-ups became spectacular engines for wealth creation. But the easy credit environment following the tech crash and 11 September created prime conditions for a new LBO market. Deals ballooned and multiplied around the world, and the press and politicians reached for the nearest reference guide to make sense of it all: Barbarians at the Gate. By this point, private equity firms had almost universally adopted friendly approaches to investing. But they couldn't resist the copious, inexpensive and attractively offered debt, which in at least one respect made it seem like RJR Nabisco was happening all over again. The “barbarians”image in the public imagination rose along with the volume of buyout deals. This negative connotation has accompanied private equity wherever it has gone in the world, creating real problems for firms as they attempt to convince lawmakers, regulators and union members that their intentions are not insidious. The image problem has had real consequences from South Korea to Washington DC, where, last year, large buyout firms found it necessary to create a lobbying organisation, the Private Equity Council, to battle proposed legislation designed to further harness and tax private equity firms.

A positive legacy of RJR Nabisco, at least from the point of view of LPs, was a change to partnership terms. The under-performance of RJR Nabisco, coupled with its magnitude, gave LPs the resolve to demand that GPs be paid based on the overall IRR of the fund, not on individual deals, as was the case in the 1987 KKR fund from which the RJR Nabisco equity was drawn. “There was no netting of carry,”says an LP from that fund. “That made it possible to lose money in the fund but still pay carry to KKR.”

Today almost all private equity limited partnerships use fund-as-a whole carried interest terms. The plethora of deal fees charged to RJR Nabisco went entirely to KKR, but today most funds call for half or more of all deal fees to be shared with the LPs. This market term is also partially the result of LP revulsion with the outcome of RJR Nabisco, the investor source says.

The private equity market has grown incredibly since 1989, and the amount of capital at risk in today's private equity funds dwarfs the equity invested through the late 1980s. And although it's difficult to compare sentiment between recessions, the general level of anxiety and pessimism today seems higher than was the case at the outset of the 1990 to 1991 recession.

Given the path of destruction now cutting its way from the US to Europe and beyond, investors are worried that a number of the big, highly leveraged deals to which they are exposed will, in fact, go bankrupt, resulting in total losses. If one or more of the iconic deals of 2006 or 2007 goes belly up, LPs may look back wistfully on RJR Nabisco as a heroic feat of capital preservation.