Future of the KKR 'Barbarians': the world's most famous buyout duo has adapted more slowly than their rivals.

From a conference room near his office overlooking New York's Central Park, Henry Kravis offers an appropriately expansive insight into how he views his place in Wall Street history. People have long "bought assets by putting up a dollar and borrowing money," he says during a joint interview with George Roberts, his cousin and business partner. "People bought homes and small businesses this way. But we created something to enable this process to achieve a much larger scale."

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Kohlberg Kravis Roberts, the investment firm the men founded nearly 30 years ago, acquired RJR Nabisco, the food and tobacco company, for $30 billion--a buyout of still unsurpassed magnitude, immortalized in a best-selling book and film Barbarians at the Gate. Since then, KKR has continued to plow billions of dollars into companies around the world, generating gross profits of nearly $40 billion for investors and the firm's partners.

From self-imposed "outsider" status on Wall Street, Kravis and Roberts have become part of the establishment. The technique they devised, which involves buying a company, loading it up with debt and selling it for a profit, has become an industry of its own, called private equity. And the two men, aged 61 and 62, respectively, say they are not even close to contemplating an exit. "Everyone has a clear understanding that George and I will continue to oversee the firm with the benefit of critical input from KKR senior executives," says Kravis.

This determination to remain in control comes as KKR seeks to expand both in size and geographic scope. It will soon attempt to raise a fund that could be as large as $12 billion, roughly the same size as the pool of money brought together last year by Steve Schwarzman's Blackstone Group, its nearest rival. At the same time, KKR will be pursuing the next step in its global expansion: Asia.

Kravis and Roberts had shied away from a region where a number of Western investors--Carlyle, Warburg Pincus, and Ripplewood Holdings--have planted flags. KKR now hopes to prove that it has not arrived too late to the Pacific party.

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Meanwhile, Kravis and Roberts will have to demonstrate that KKR's model has the flexibility to endure. Have they found the right balance between maintaining control and making room for a new generation of dealmakers? Is it enough for KKR to excel at its core buyouts business while its competitors are branching out into new products, such as hedge funds? The answers could determine whether KKR will maintain its reputation as a private equity big gun, or languish, leaving a legacy of a powerful pioneer rather than a lasting Wall Street institution.

While the environment for private-equity firms has never been better, there are doubts about sustain-ability, as higher interest rates reduce the availability of cheap financing for acquisitions. There are also fears, which Kravis and Roberts reject, that deals of the past may have been too debt-laden, threatening a spate of bankruptcies.

The chemistry between the founding duo is flawless despite differences in character between the more reserved Roberts and the effortlessly charming Kravis. Over the course of almost two hours, the men--natives of Texas and Oklahoma who attended university in California together before starting careers in finance at Bear Stearns--often finish each other's sentences, embellishing and adding to each other's thoughts.

Many people close to the firm share their belief that KKR will remain successful. The group "is in as good a shape today as it has ever been," says Casey Cogut, a long-time lawyer for KKR at Simpson Thacher & Bartlett. "Henry and George have built a terrific organization," says Lloyd Blankfein, president of Goldman Sachs. "They are part of the rarefied atmosphere at the top of the private-equity community and represent the kind of continuity and brand that anyone would envy."

Wall Street has not always been so bullish about KKR's prospects. During the late 1990s, a number of private-equity firms suffered but KKR was exceptionally hard hit after a few bad telecommunications investments and a disastrous foray into U.S. cinemas. But rather than inflicting permanent damage, that period appears to have allowed the firm a rethink.

"That's when George and I sat down and said we've got to change the way we are doing business," says Kravis. KKR put into action a plan to reinvigorate Capstone, its consulting arm, which worked on the 2005 acquisition of Toys 'R' Us and 2004 purchase of Sealy. In addition, KKR started hiring people from industry. The most recent is Michael Marks, former CEO of Flextronics, the Singapore-based contract electronics manufacturer, to oversee technology investments.

The focus on operational expertise reflects a belief by Kravis and Roberts that as competition increases, the best returns will be achieved by firms with a more hands-on approach to the companies they own.

Beyond that, the duo also undertook a radical shake-up of KKR's internal structure. Kravis and Roberts relinquished their near-total control of decision-making and set up an investment committee of six KKR partners to ratify investment decisions and a 13-member portfolio committee to monitor how investments perform. "That has been a massive change in our culture," says Johannes Huth, a European-based partner who sits on the investment committee. "The business is becoming more formalized and more institutionalized. We are trying to identify what makes a good transaction and replicate that across the firm."

The economic structure of KKR has evolved over the years, as Kravis and Roberts have had to allow younger partners to share the spoils. The two men's share of the profits is thought to have fallen under 50 percent, in part reflecting the rising number of KKR partners, which recently expanded from 14 to 23. (Roberts says only: "Henry and I have never had an increase in our ownership since we started 30 years ago.") "KKR has clearly widened the net and brought in a new group of managers--some of the most talented people in American business," says John Mack, Morgan Stanley's chief executive.

While pushing through these changes, KKR was helped by successful deals in its current fund. Launched in 2000, the $6.1 billion Millennium Fund has so far produced an unusually high gross return of 71 percent on investments that include PanAmSat, the satellite operator, and utility Texas Genco. These gains add to the staggering amounts KKR has generated: By last September, the firm had invested $22.5 billion, converting it into $61.3 billion. Of the resulting $38.8 billion gross profits (calculated before the billions that KKR partners have taken), $10.6 billion is unrealized, reflecting shareholdings in companies KKR still controls or part-owns. "The bottom line is that they have made a lot of money for us over a long period of time," says Joseph Dear, executive director at Washington State Investment Board, one of the world's biggest private-equity investors.

Too Little Change?

Questions remain, however. Last September, fears that KKR had done too little to motivate younger staff surfaced publicly when Scott Stuart and Ned Gilhuly, two long-time partners and favorites to succeed the founding duo, left to set up their own fund for public-equity investments, just as Jerome Kohlberg, the other co-founder, had done in 1987.

But Roberts rejects suggestions that they should have tried harder to keep Stuart and Gilhuly, saying: "Ned and Scott want to run their own business and make investments in midcap companies and bring their private-equity experience to those companies. That's not what we do."

Unlike peers such as Blackstone and Carlyle, which branched out into hedge funds, KKR has been reluctant to expand beyond its traditional business of buyouts. Last year, it carried out an initial public offering of KKR Financial, a small real estate investment fund. So far, that is the extent of Kravis' and Roberts' flirtation with other businesses, and this is not expected to change. "For the immediate future, our focus is on our core competency, which is making good long-term investments in attractive companies," says Kravis.

The new expansion into Asia follows KKR's establishment of a London office only in 1999--a move seen as tardy because a number of its rivals had already crossed the Atlantic. Nonetheless, the European expansion generated a string of lucrative deals.

For its Asia push, KKR sent Joseph Bae, an up-and-coming dealmaker, to set up offices in Hong Kong and Tokyo, and hired Sir Deryck Maughan, a former Citigroup executive, to help navigate the region's political waters.

More than anything, the most famous duo in private equity say they will continue to rely on their combination of instinct, energy and experience. "We've seen every cycle imaginable. We've seen inflation, deflation, high rates and low rates," says Kravis. "If you get the proper financing, create the proper capital structure and understand how an industry works, you have the ability to withstand just about any kind of shock."

As KKR faces stiff new challenges, its founding fathers must hope those words prove not hubris but prophecy.

Reprinted with permission from the Financial Times