(2002–2005)
Back in the early 1970s, when Charles Koch took over the Pine Bend refinery, Koch Industries’ habit of buying and selling other companies was still something of a rarity in corporate America. Koch was an outlier, a quirky family-owned firm willing to spend huge sums of cash to buy out other companies and take them private. By 2003, however, the rest of corporate America had followed suit. There was a growing wave of so-called private equity firms that were on the march across the American economic landscape, searching for companies to buy and take private.
To the private equity world, America’s entire business community was a game board, a financial market where companies could be bought and sold like oil futures. Private equity deals became a defining feature of American economic life during the 2000s. There were $91 billion in private deals at the dawn of the century. The deal flow rose to $133 billion in 2003, and to $197 billion in 2004. Thousands of companies were taken private each year. Dozens of new private equity funds sprang up in New York, Chicago, and San Francisco. Some of these private equity firms were run by nameplate financial firms like Lehman Brothers and Barclays Capital. Others were little-known start-ups with names like Oaktree Capital Management. One of the better-known private equity firms, Cerberus Capital Management, named itself after the mythical three-headed dog that guarded the gates of hell, for reasons that were not entirely clear.
Koch Industries, although it had almost zero name recognition, put itself aggressively into the hunt, competing directly with the largest firms on Wall Street. Koch had an edge over the competition. The company was flush with cash, had only two shareholders to answer to, and was willing to close deals that scared away other companies. In a matter of just a few years, Koch Industries would execute some of the largest private equity deals in America, with acquisitions worth nearly $30 billion.
Charles Koch made it abundantly clear to his team that they would work toward one goal: to maximize Koch’s long-term return on investment. The firm wasn’t looking for quick returns. Koch would press the advantage of Charles Koch’s patience, looking for deals that other investors might avoid because the payouts wouldn’t come for years. Charles Koch institutionalized the company’s “trading mentality” by embedding it in a new, secretive group that was formed on the third floor of the Tower, near Charles Koch’s office. This group rivaled any private equity firm in the nation. It was called the Corporate Development Board.
Charles Koch sat on the Corporate Development Board, and directed it. He was joined by a small cadre of his top leaders. This small group of men would direct a series of acquisitions between 2002 and 2006 that would fundamentally transform Koch Industries, while also more than doubling its size. In 2001, Koch’s annual sales were about $40.7 billion. By 2006, they would be $90 billion.
The Corporate Development Board was essentially a reincarnation of the development group that Brad Hall had led in the late 1990s. Hall was replaced as head of the group in 2002 by Ron Vaupel, who had been president of the Koch Hydrocarbon Division. But Vaupel was not working alone. In its new incarnation, the Corporate Development Board was closely controlled by the company’s most senior executives. The board included Joe Moeller, the president of Koch Industries, and Steven Feilmeier, who had recently been named as Koch’s chief financial officer. Sam Soliman, the previous CFO, who now led a massive trading operation at Koch’s Houston office, also sat on the development board. The final board member was John Pittenger, the Harvard MBA graduate who helped drive Koch’s Value Creation Strategies back in the 1990s.
The board didn’t tend to meet in a formal manner. It didn’t gather every month in Koch’s boardroom and hold a meeting where minutes were kept, as did Koch’s formal board of directors. Sometimes the board met in a smaller conference room on the third floor, near Charles Koch’s office, with some members calling in and participating over speakerphone. The timing was improvisational and reactive to conditions in the market. There was a time sensitivity to the meetings; the board often considered acquisition deals that were the subject of intense competitive bidding. There wasn’t time to pay heed to formality and scheduling.
By 2002, the board had access to multiple, ultra-high-value flows of information that fed into it from every arm of the company. The board sat at the center of Koch’s black box. Charles Koch, for example, was privy to detailed updates from every major division in Koch Industries because the division leaders came to Wichita quarterly to report their results. He had the chance, at those meetings, to quiz them on whatever topic he wished. The board could also draw on the vast pools of data and analysis being generated every minute on the company’s trading floors in Houston.
The development board drew on other important sources of information. It was constructed as the center hub that had spokes reaching out to smaller development groups that were embedded in Koch’s various divisions. For example, divisions like Koch Minerals and Flint Hills Resources had development groups analyzing potential deals in their respective industries at a ground level. They fed important information and bid ideas back to the Corporate Development Board.
When employees in one of Koch’s various development groups saw a potential acquisition that was large enough, they were called in front of the board to present it. This was not pleasant. Everyone knew that there was a profound asymmetry between what the development board knew and what anyone else at the company knew. An ambitious Koch employee who thought they had a good idea never knew how it might be received by the board.
If going before the board was intimidating to business leaders at Koch, it might have been doubly intimidating to Steve Packebush. He was a thirty-eight-year-old marketing guy who grew up on a Kansas farm. He attended K-State and joined Koch Industries straight out of college, in 1987. He had never worked anywhere else. In 2003, Packebush was a marketing guy with Koch’s small fertilizer division, called Koch Nitrogen.
If all of Koch Industries’ business units were a professional sports league, then the Koch Nitrogen team would be in last place. The division was small, losing money and cutting production at its primary fertilizer plant in Louisiana, where it had laid off about half its workforce. Koch Nitrogen had sold off its ammonia pipeline network and seemed to be a caretaking unit whose main job was to babysit a handful of assets that were left behind after the now-legendary collapse of Koch Agriculture back in 1999. If an up-and-comer at Koch Industries was looking to make a name for himself, he would have stayed away from Koch Nitrogen.
But in 2003, Steve Packebush and a team from Koch Nitrogen made an appointment to appear before Charles Koch and senior executives at the Corporate Development Board. The nitrogen team wanted to convince Charles Koch to give them hundreds of millions of dollars to buy a group of money-losing fertilizer plants.
As it turned out, this would be one of the first deals considered under Koch’s new acquisition regime. It would also be a test. It would determine how well Koch could export its trading mentality into the real world.
The Koch Nitrogen team filed into the boardroom in Wichita and took their places. The team included Steve Packebush and his boss, Jeff Walker. They had prepared their case, and this was their moment to pitch it directly to Charles Koch.
During such meetings, Charles Koch sat and listened to the presentations, statue-like. He let the presenters talk, often without interjecting. When it came time for him to ask questions, Koch was, almost invariably, soft-spoken and utterly unsentimental. He looked for weak spots. He tried to smoke out any executives who were inflating the prospects of a deal, or, conversely, those who might be too timid to realize the upside of taking a bigger risk.
Packebush’s investment thesis might have seemed ripe for puncturing. The thesis was first developed around the year 2000, when natural gas prices spiked. This volatile surge had exposed the terrible weakness of many high-cost fertilizer producers in the fertilizer business. Natural gas was the primary ingredient of nitrogen fertilizer, accounting for roughly 80 percent of its production cost. One of the fertilizer plants that was punished by the spike in gas prices was Koch’s plant, in Louisiana. All of the US fertilizer plants, in fact, were exposed as being the weakest animals of the global herd. Natural gas wells were relatively scarce and unproductive in the United States. Other countries, with more plentiful gas supplies, could make fertilizer much cheaper. Imported fertilizer had an edge that seemed like it would be permanent.
Packebush and his colleagues responded to the crisis in a very Koch way—rather than panic, they launched an in-depth study of their situation. When they studied the fertilizer markets, Packebush’s team confirmed that Koch’s Louisiana plant was a permanent loser. But that didn’t mean that all fertilizer factories were permanent losers. His team believed that the bloodletting would only go so far, and then the market would stabilize. When that happened, a small island of winners would be left behind. These winners would be supported by strong local demand for their product. Modern US farmers were a lot like modern motorists: they had become utterly dependent on fossil fuels. Without nitrogen-based fertilizers, US food production would decrease substantially, maybe as much as 40 percent. There was no plausible future wherein nitrogen fertilizer demand would drop to zero, or anywhere near zero.
Packebush and his team began mapping out what the postapocalyptic fertilizer industry might look like. They figured that after half the US fertilizer production was wiped out, then the remaining plants would be in the best competitive position. The Koch Nitrogen team believed it would be smart to buy any fertilizer plants in the United States that went up for sale, but only if Koch could pay the price of replacement value—meaning the amount of money that it would take to rebuild the plant if it were destroyed. In other words, it would be smart to buy the plants for the cost of their physical equipment and not much more. At that price, the plants could stay in business for years, even if they didn’t exactly thrive.
The Koch Nitrogen team had to figure out which plants to buy. They settled on an unlikely target: one of the largest fertilizer producers in the United States and a powerhouse of modern agriculture, a gigantic, farmer-owned co-op based in Kansas City called Farmland Industries.
Koch Industries had been closely scrutinizing Farmland Industries since at least the 1990s. This was only natural for Koch—Farmland was a big competitor in fertilizer, grain, and other markets. Koch didn’t just want to compete against Farmland—it wanted to understand Farmland better than Farmland understood itself. Koch put together a small team that X-rayed Farmland’s business. A team at Koch studied every piece of publicly available data about Farmland and then reverse engineered the data to figure out what was happening inside the giant cooperative. Koch used the data to figure out Farmland’s cost structure, profit margins, and cash flows.
It didn’t take long for Koch to grasp a truth that was well known to Farmland executives, which was that nitrogen fertilizer sales were pivotal to the company’s business model in 1995. Koch also detected a weakness in Farmland’s business model. Farmland was a co-op, meaning that it was owned by thousands of members who also sold their products through the firm. It was a uniquely midwestern form of capitalism that blended community control with industrial scale. In this way, Farmland was the opposite of Koch Industries, which was tightly held by Charles and David Koch. Farmland was owned by thousands of farm families and small business owners who shared in Farmland’s annual profits and voted on its actions. But it also hindered Farmland—decisions were influenced by its member-owners, who considered factors beyond the simple return on investment.
“It was Socialism,” as Koch Agriculture president Dean Watson put it. And Koch’s traders believed that Socialism was always destined to fail.
Farmland would, in fact, collapse. And the company’s fertilizer plants were the catalyst that destroyed it. During the 1990s, Farmland’s fertilizer plants were immensely profitable, dispensing waves of cash. Farmland’s member-owners used this money to expand, buying pork processing plants, grain elevators, and even an oil refinery. Free cash flow from nitrogen fertilizer helped fund it all. This was possible because natural gas was cheap. By the end of the 1990s, Farmland was one of the largest purchasers of natural gas in the United States; it was buying all the supplies it could get to stoke the fertilizer money machine. In doing so, Farmland had become an energy company without even realizing it. Farmland had gotten deeply entrenched with a commodities business during an upcycle, without thinking too hard about what life might look like during the inevitable down cycle.
When the crash came, it decimated the profits in Farmland’s nitrogen division. This sapped the cash flow to every other division. The whole co-op machine began to falter. Farmland couldn’t pay its debt obligations, which increased its debt obligations as creditors demanded repayment. In 2002, Farmland was trying to raise as much capital as possible by selling off its businesses. Bankruptcy looked imminent.
Packebush and his team studied Farmland’s network of fertilizer plants, and they identified something that no one else saw. Farmland owned a constellation of plants that zigzagged through the Corn Belt in a crooked line that looked a little bit like the Big Dipper turned on its side. The long handle of the Dipper started up in Fort Dodge, Iowa, and ran in a long slope down through some of the most fertile cropland on earth, down through the town of Beatrice, Nebraska, where there was a large nitrogen plant, and then bending to meet Dodge City, Kansas. At the edge of the Dipper’s cup was Farmland’s crown jewel—the company’s massive fertilizer plant in Enid, Oklahoma.
Farmland’s plants had a key advantage: they were located right next door to their customers—the farmers. This gave them an edge on transportation costs. If these plants closed, there would be a dramatic fertilizer shortage. It would be simply impossible to import all the fertilizer that midwestern farmers needed.
The Farmland plants were similar to Koch’s oil refinery in Pine Bend. They were perched on exclusive real estate, giving them an advantage over their competitors. Demand wasn’t going to disappear, and it wasn’t feasible for new competitors to set up shop nearby.
Perhaps most important, nobody else in the marketplace attributed this value to the Farmland plants. When Farmland put the plants up for sale, the co-op got very little interest. There were two big, publicly traded fertilizer companies that seemed like natural buyers, called Agrium and CF Industries. But these companies were also embroiled in the natural gas crisis and seemed obsessed with their quarterly losses and the near-term economics of the fertilizer business. These companies had to explain themselves to investors every quarter and focused on the losses that were likely to occur this year and next.
The Koch Nitrogen team made its pitch to Charles Koch and the development board. The team wanted Koch to spend somewhere in the neighborhood of $270 million for a group of fertilizer plants—that could produce about 1.8 million metric tons of fertilizer a year—at the very moment when those plants were delivering absolutely gruesome quarterly reports to their current owner.
The plan seemed preposterous in many ways, and Charles Koch wasn’t convinced at first. As he and the development board considered the plan, they applied a set of rules that would help usher in years of future growth:
1. The Target Company Had to Be Distressed
Koch was only interested in buying companies or assets that had fallen on hard times. Part of the logic behind this was simple: distressed companies were cheaper. They could be purchased at a discount. But the company had to be distressed in the right kind of way. Ideally, the firm should to be distressed because of managerial negligence or poor decision-making. That way, Koch could reverse the poor strategies when it was the owner. The goal was to improve operations and profits at the distressed firm to boost its value. When that happened, Koch could hold on to its new profit-making machine or sell it.
2. The Deal Had to Be a Long-Term Play
Koch wasn’t looking to buy and flip companies. The deal needed to make sense over the five-, ten-, or even twenty-year time frame. This played to Koch’s advantage as a private firm. It could hold an asset through the stormy weather of commodities cycles, improving the underlying investments along the way until they were worth much more. This long-term strategy would open the door to a raft of acquisitions that other firms would not consider. Publicly traded firms, and even private hedge funds, looked for deals that showed a return within one to two years. Koch would face far less competition for the deals that paid off over many years later.
3. The Target Company Had to Fit with Koch’s Core Capabilities
In the new era, Koch would stick to its knitting. It would expand into new industries only if the new line of business closely resembled something Koch already did. If Koch didn’t know how to do a certain business process better than its competitors, then it would stay out of that business. New acquisitions had to build on Koch’s expertise and had to branch out from the company’s current strength.
The development board eventually decided that the Koch Nitrogen plan fit all three of these criteria. Packebush and his team were given authority to spend hundreds of millions of dollars to execute it, and they did so before their competitors were prepared to act. The timing was perfect. Farmland’s CEO, Bob Terry, was frantically working to dismantle the co-op and put its biggest assets up for sale. He was hoping to get as much money as possible from the fertilizer plants. He was puzzled when he was contacted by a little-known energy company in Wichita.
The delegation from Koch Industries arrived at Farmland’s headquarters building on a mild spring day, March 27, 2003. Farmland’s headquarters were located in a new office tower just north of Kansas City, another relic of the co-op’s recent profits. The Koch team arrived at the appointed time, walking through the glass doors and into the spacious lobby. Koch Industries employees, around this time, wore a uniform of button-down shirts and blazers. They were soft spoken, unfailingly polite, and single-mindedly focused on the task at hand.
Steve Packebush was with the team, and as he walked through the lobby, he passed by an enormous mural that Farmland had installed on the wall. The mural was itself a piece of history, and a testament to Farmland’s former greatness. It was painted by a student of artist Thomas Hart Benton and was a symbolic history of Farmland’s rise to greatness. The mural also told a story about what was happening in corporate America, and the broader meaning of Farmland’s collapse.
The mural depicted how Farmland came to be, back in the 1920s. It showed a group of men and women, dressed in Depression-era clothing, sitting next to a tree and a bale of hay. They are watching a pitchman, who waves his arms out to a horizon of fertile fields and a skyline of grain elevators. He is selling them on the promise of a co-op and the prosperity that could be realized by banding together. Just behind him, two men are slouched below a tree, one of them idly chewing a stalk of wheat. These two men are the “skeptics,” doubtful that the co-op structure would work. Over the next seventy-four years, Farmland proved the skeptics wrong. In 2003, the co-op was owned by roughly five hundred thousand farmers. They shared the profits that Farmland generated from more than $12 billion in annual revenue a year. These farmers had a real say in how Farmland conducted business and they shared in its success.
It would not be entirely fair to consider Packebush one of the “skeptics.” His father, in fact, had been a Farmland owner and member. He wasn’t quick to criticize the co-op model. But he wasn’t going to be sentimental about it, either. The model had failed, at least in Farmland’s case. The American economy in 2003 was a private equity economy. Even up until the 1960s, US companies operated under something that could be called the “managerial theory” of capitalism, meaning that the interests of shareholders took a backseat to the decisions of managers. Even CEOs at big, publicly traded companies did what they thought was best for the long-term health of the firm. The wealth of shareholders was only one factor among many in their decision-making. A typical CEO thought about rewarding employees, supporting the community that their company called home, and reinvesting profits to invent future products. This arrangement fell apart during the 1970s, when price shocks, inflation, and recession meant that public shareholders got a terrible deal for their money. The rate of return on capital was 12 percent in 1965, but only a meager 6 percent by 1979. This malaise laid the groundwork for a revolution in corporate management.
A group of academics devised a new way to think about corporations, called the “agency theory.” Under this new way of thinking, a company’s CEO wasn’t in the driver’s seat—he or she would simply be the “agent” of the shareholders. The balance of power was flipped. Now the shareholders would have the upper hand, and they would essentially tell the CEO what to do. Within this framework, the CEO’s only real job was maximizing the return for shareholders. Everything else, from employee pay to civic commitments, even long-term company value, took a backseat to maximizing return to the owners.
The rise of private equity firms intensified this transformation. Private equity firms bought existing companies and ran them in the best interests of the new owners. Between 2000 and 2012, private equity firms would invest a total of $3.4 trillion as they took companies private. More than eighteen thousand companies were thrust into an extreme form of agency-theory management. Labor costs were slashed, headquarters were moved, and expenses were cut across the board.
Koch Industries had been operating under the agency theory for years—the primary interest of managers was to increase the return on investment for the primary shareholders, Charles and David Koch. Packebush and his team were agents for Koch’s shareholders. They were hoping to buy the most valuable pieces from the wreckage of Farmland and reshape them to deliver the highest profit.
There was a large table inside the conference room at Farmland headquarters. Next to the table, a series of tripods were arranged, each holding a large, poster-sized photo of Farmland’s fertilizer plants. The glossy photos were designed as an enticement, showing off the plants’ big tanks and tall towers. If the Farmland executives believed that the posters might excite more bidding at the auction, they had reason to be disappointed. Only two companies showed up that day: Koch Industries and the Canadian fertilizer company Agrium.
The delegation from Koch took their seats along one side of the table. The representatives from Agrium sat down on the opposite side of the table, facing Packebush. The teams from Agrium and Koch were joined by Farmland’s lawyers and bankers, who led the auction.
Agrium was the largest publicly traded nitrogen fertilizer producer in the United States, with about $2.1 billion in annual sales. Agrium was worth billions, so it had the money to spend on Farmland’s plants. But more importantly, buying the plants would have been a good strategic fit for Agrium—it was already the industry leader. Koch was a nobody in the nitrogen business, having been forced to close down its plant in Louisiana when gas prices spiked.
But Agrium had reason to be a hesitant bidder that day. The glossy photos couldn’t hide the fact that Farmland’s fertilizer plants were losing about $50 million a year. It seemed possible that Agrium was at the table only because Koch Industries had arrived. Koch and Farmland had already announced a preemptive agreement for Koch to buy the facilities. Agrium might very well have showed up just to nip a competitor in the bud.
Koch had a key advantage over Agrium. Koch’s shareholders could fit around a small kitchen table. The Agrium team had to answer to a multitudinous crowd of shareholders on Wall Street. If they made the wrong decision, Agrium’s stock price could fall within minutes. Farmland’s plants would likely drag down Agrium’s profits for years to come. Charles Koch had come to peace with this fact. Agrium’s shareholders had not.
Before the auction, Koch had offered Farmland around $270 million. Agrium forced Koch to sweeten its bid to just more than $290 million. But Agrium wouldn’t go further than that. After a relatively short and desultory auction, Packebush and his team stood up from the table as victors. The glossy photos of the fertilizer plants were taken down and tossed in a dumpster. Eventually the mural in Farmland’s lobby was disassembled and shipped off to the National Agricultural Center and Hall of Fame, a tourist attraction in Bonner Springs, Kansas. The mural sat behind a velvet rope and was scrutinized as a relic of the long-forgotten past.
After it acquired Farmland’s fertilizer plants, Koch Nitrogen was renamed Koch Fertilizer and moved to a huge office on the fourth floor of Koch’s headquarters tower, just above Charles Koch’s office. Koch instantly started pouring money into the plants. Over the next ten years, it spent roughly $500 million to outfit the plants with new technology while streamlining production. Koch Fertilizer abandoned the co-op sales model and began trading supplies to the highest bidder (rather than giving preference to the farmer-owners) throughout the Corn Belt.
Koch installed a team of fertilizer traders in the office, including Melissa Beckett, the star trader who’d once specialized in trading megawatt-hours. The traders bought and sold supplies around the globe, learning more about fertilizer markets each day. Within a few years, Koch Fertilizer built a global distribution network. Koch founded a new company, called Koch Energy Services, which bought and sold natural gas supplies to keep the fertilizer plants stocked. The energy traders sat on the fourth floor, just next to their counterparts trading fertilizer.
Steve Packebush was named CEO of Koch Fertilizer in 2003. Being part of the Koch Nitrogen team had paid off nicely. He lived in a very large house, by Wichita standards, and ran a division that would become one of Koch’s largest and most profitable. It wasn’t bad for a Kansas farm kid with a degree from K-State.
Shortly after the bankruptcy auction, a former Farmland employee approached Packebush. He said he had something that Packebush might want. It was one of the glossy poster boards that Farmland printed up for the auction. The Farmland employee had fished it out of the dumpster.
Many years later, that poster hung on the wall in Packebush’s office. He could gaze at it while the traders outside his door haggled for natural gas supplies and bargained over the price of nitrogen in China. As it turned out, the poster, and the fertilizer plants, would be one of the smaller trophies Koch Industries acquired.