KKR - Value At The Gate

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 |  About: KKR (KKR)
by: Yaniv Uliel

KKR (NYSE:KKR) is a leading asset management firm that is mainly known for its private equity fund management. Some people may have read the book Barbarians at the Gate, by Bryan Burrough and John Helyar, that tells the story of the RJR Nabisco LBO, led by KKR. At the current price level, KKR may present a compelling investment opportunity as its earning and distribution power is expected to grow substantially over the coming few years. I conservatively estimate KKR's intrinsic value at $40/unit vs. the current price of $23/unit. As such, there is almost 100% upside.

Company Overview

KKR is a leading global investment firm, mostly renown for its private equity funds, which are its core business. Jerome Kohlberg and cousins Henry Kravis and George Roberts founded the company in 1976, and the latter two still lead the company. Most people know KKR for its role in Barbarians at the Gate, as it took part in the epic leveraged buyout of RJR Nabisco. That was the largest leveraged buyout to that time, and it has held this record for 17 years.

KKR's core business is its private equity (NYSE:PE) funds management. The company has a marvelous track record generating gross IRR of 26.2% on its funds. This track record starts at 1976. Not many investors have such an achievement under their belts. The PE funds draw business-consulting services from KKR Capstone, which is KKR's operations improvement team. Instead of outsourcing the consulting and strategic planning of their portfolio companies to firms like McKinsey or BCG, KKR has its own team to do that job, at a lower price for the portfolio companies than what other consulting firms charge. Capstone recruits only the best and brightest management consultants who have few years of experience with one of the first-tier consulting companies. In addition to Capstone, the capital markets division gives investment-banking services to portfolio companies. This follows the same theme of keeping more value at home.

KKR also manages other types of investments. Readers who are interested can refer to the 10-K for full business description as I intend to keep this write-up at a reasonable length and focused on the PE business.

PE Industry Overview

At the end of 2012, the PE industry had a total of $3 trillion of assets under management, of which about $1 trillion is "dry powder." The term dry powder relates to funds that limited partners (LP, investors in the funds) have committed to invest, but were not called yet. Once called by the PE firm, those funds have to be made available to the PE firm at a very short notice. The largest investors in this asset class are pension funds and funds of funds. In recent years, due to the aging population in the western world and the need of more pension funds to achieve higher returns in order to fund their obligations, the allocation for PE has grown. The AUM in the industry has grown threefold since 2004; the long-term CAGR is 14.5%.

So players in this industry enjoy a tailwind in terms of AUM. This is not all positive, however. Higher allocation to PE means more PE funds chasing the same number of deals (the number of potential targets does not change with AUM) and it may push valuations higher. However, given a choice, a PE fund should favor to operate in an environment where raising new funds is easier. The risk of too much money chasing too few deals can be mitigated by discipline in the investment process.

The business model in the PE industry is that funds are raised for a pre-defined period, usually five to 15 years. During that time frame, the manager has to find targets for investments, invest the money, create value at the portfolio companies and eventually exit in order to return capital to investors. Broadly speaking, a PE firm can create value to its investors in three ways: exit multiple expansion (you buy low and sell high), financing (optimize the balance sheet, re-gear the business, etc.), and improvement in operations. In the industry's early days, most value was created through advanced financing. A simple example would be buying an underleveraged company, loading it with as much debt as it can possibly carry, paying high dividends to the PE fund and then exit the business.

In the 1990s, after the LBO boom of the 1980s, the theme was multiple expansion. PE firms will buy their companies at a low multiple, slightly improve the operations and then sell it at a higher multiple for a willing buyer or through an IPO when times get better. Over the last decade the focus has been more on value creation through operations improvement. The PE funds will buy the targets; improve the corporate governance, the incentive structure, drive operational performance improvement and set a strategy. The next phase is the harvesting, or, exiting in order to return capital to shareholders. An exit can be done in multiple ways; the most common ones are a sale to a strategic buyer and an IPO. Clearly, at times when markets are receptive for IPOs, the exit stage becomes much easier.

The fee structure to the PE firm or, as it's called, the general partner (GP) has the shape of a J-curve. In the first years of the fund, the LPs are paying management fees on uncalled capital while the GP is on the lookout for deals. The management fee on committed capital during that period is in the range of 1.5%-2% per annum. Once the funds are invested, the management fee on those funds drops to 0.75%-1.25%. Once the GP exits, it is entitled to a carry fee (or success fee). This is usually around 20% of the net profits with a hurdle rate that can be anywhere from 0%-8% depends on the fund. Next there are the hidden fees: fees for consulting services, investment-banking services, director fees and so on.

This industry is very complex. Trying to describe it in just few paragraphs does it an injustice; I'm just putting forward some basic information to make the rest of this article easier to read.

KKR's Competitive Advantage

  1. Operational excellence: KKR's portfolio companies have grown revenues and EBITDA at a rate of 10% per annum. in the last two years.
  2. Deal sourcing: 45% of the deals that KKR does are defined as proprietary (deals between 2002 and 2013). That points at KKRs excellent reputation and relationship and frees KKR from having to participate in bids, where prices paid are usually higher. KKR, in many cases, is a partner of choice. Other 40% of the deals are done through what is called "limited process," which refers to three or fewer bidders.
  3. Balance sheet power: As shown in the next section, KKR has the balance sheet power to invest alongside its LPs, which gives it an advantage. Every LP wants the GP to have skin in the game. In addition, it allows KKR to invest without the need to exit. According to talks with few executives, we may see more investments made with permanent capital, similar to what Berkshire Hathaway does.
  4. KKR (and other leading asset management companies) has been achieving high returns on capital over long period of time. This is usually a sign for competitive advantage.
  5. High switching costs: Institutional investors put a lot of efforts and resources into the due diligence process before they choose an asset manager and commit capital. If KKR doesn't disappoint its investors (and its 37-year track record suggests it doesn't) they have very little incentive to switch.

Competition Benchmark

The table below succinctly summarizes the few important data points for the major players who went public. Please notice that due to different balance sheet consolidation practices, not all PE companies break down the operating business balance sheet and the investment balance sheet. However, the main point to deliver here is KKRs balance sheet power, and that is reflected in either way we look at it (consolidated/operating).

KKR

Blackstone (NYSE:BX)

Apollo (NYSE:APO)

Carlyle (NASDAQ:CG)

Year Founded

1976

1985

1990

1987

Business Segments

PE, Credit, Real Assets, Hedge Funds Advisory, Capital Markets

PE, RE, Hedge Funds, Credit, Advisory

PE, Credit, RE, Advisory

PE, Global Market Solutions, Real Assets, Advisory

PE AUM

$54.5bn

$62.6bn

$40.2bn

$55bn

Total AUM

$83.5bn

$240bn

$113bn

$176bn

TTM distribution yield

$1.63

7.15%

$1.33

4.78%

$3.34

10.15%

$1.33

4.27%

Market Cap

$16.3bn

$31.8bn

$13bn

$10bn

Book Value/Unit (total book value)

$9.65 ($6.9bn)

$8.75

($10bn)

$15.77

($6.23bn)

$6.31

($1.99bn)

Total Assets

$8.1bn

$27.74bn

$20.6bn

$5.17bn

Equity/Assets

85.1%

36%

30%

38.5%

P/B

2.36

3.18

2.08

~5

Click to enlarge
  • Apollo: 2013Q2, stock price $32.89
  • KKR: 2013Q2, stock price $22.84, operating book value
  • Carlyle: 2013Q2, stock price $31.57, operating book value
  • Blackstone: 2013Q3, stock price $27.82, book value from Q2

Apollo's stock has done quite a nice run lately due to higher than expected distributions. There are a few issues that make me prefer KKR:

  1. Apollo lost money in 2011 and big chunk of its AUM is not in PE.
  2. The track record is not as long and the company hasn't been through as many cycles as KKR has
  3. Only 65% of PE funds are in carry paying position vs. 84% for KKR.
  4. Apollo has an insurance company that it recently acquired as a "permanent-capital" vehicle. While this may look like a Berkshire-style operation, it complicates the operations, it started in 2009 and there is no evidence that they can work this complicated structure well.
  5. TTM yield is skewed up due to higher-than-normal realization activity ($7bn by mid-2012) that resulted in $1.32/unit distribution in Q2. That suggests $14bn/year in realization, which implies average lifetime per fund of three years (given the PE AUM), which is clearly not the case. This figure also includes non-recurring fees and special dividends from portfolio companies.
  6. It doesn't enjoy some of KKR competitive advantages (e.g., balance sheet power and deal access).

Two things stand out from this benchmark:

  • KKR looks cheap in terms of yield, also considering the underlying qualities of the business (three-year average ROE of 18% with no debt), the longest track record, and 84% of its PE funds in a position to pay carry.
  • KKR has significant balance sheet power than none of the other players enjoys as reflected by its capitalization structure. This will allow it for more permanent capital investments and higher potential balance sheet income.

Valuation

KKR is listed as a limited partnership. As such, it doesn't have shares but participation units ("units" in short). Units can be thought of as shares except for two main differences: units for limited partners does not have voting rights, units are not taxed at the partnership level, but at the individual level (see more in the "Risks" section).

The distributions that KKR makes comprised of few components:

  1. Balance sheet gains and fee-related income: KKR invests its own cash in its funds. Last quarter the distribution that was related to balance sheet gains and fee income was $0.19/unit. The portion that is related to balance sheet gain is $0.09. If we annualize that we get at $0.36/unit. Note that his is a very conservative number. KKR has about $4.7bn invested. At an IRR of 15% (one could argue for a higher figure, because this is KKRs capital so carry and fees are not applicable on it so we could use the gross IRR here) this could translate into $0.975/unit from balance sheet gains alone. So we get a range of $0.4 (no balance sheet gains) and $1.375 ($0.975 for balance sheet gains + $0.4 for fees). Let's use $1.1/unit for balance sheet gains and fees.
  2. Moving on to the cream: carried interest. On slide No. 47 of the investor day the company estimates the carried interest generated from its current funds to be between $4.5-$7. Let's use the $5 as a number at the low-end of this range figure and be conservative again by estimating that this income will be spread over 10 years, which is a longer period than the lifetime of the average fund and it assumes that no new funds will be raised during that time. This brings us at another $0.5/unit.
  3. Excluding the PE portion, KKR has $5.3bn in its energy and infrastructure funds. It plans to more than double the size of those funds but lets ignore that plan for now. There is another $28bn managed under the public markets segment, out of which $12.3bn is fee-paying AUM. Also, there is the RE segment that is picking up. All these segments are high growth segments. To keep things simple, lets assume that we have another $20bn of fee-paying AUM and they pay only 1.5% of assets. Most of these pay more and some significantly more (e.g. hedge fund that pay incentive fees). We get another $0.4/unit. Again, conservatively estimated.

So far we get $1.1 from balance sheet gains and fees, another $0.5 from carried interest and another $0.4 from fees related to the public markets segment. We get at $2/unit of distributable earnings. I can't stress enough how conservative this figure is. It assumes KKR will not raise new PE funds, no growth in public market fee-paying assets (which has been growing organically at a CAGR of 22% and 56% as a total CAGR figure), low-end performance estimates for the existing PE funds -- well, you get the point.

Should market price these $2/unit at a yield of 5% we are looking at a $40 fair value for the stock, under very conservative assumptions. This figure can easily be much higher. Just to get a feeling of where we may get an optimistic scenario we can take $1.2 from balance sheet gain and fees, add that to $1.07 from carry (assuming total of $7.5/unit from carry over 7 years) and another $0.6 from fees from public markets activities and get at a stock price of almost $57.4/unit under a 5% yield assumption.

Conservative Case

Optimistic Case

Balance Sheet gains and fees

$1.1

$1.2

Carried Interest

$0.50

$1.07

Fees from public markets segment

$0.40

$0.60

Years for Carry

10

7

Target Price at 5% yield

$40

$57.4

Click to enlarge

Some may question where did the 5% yield figure come from. After all, this implies a PE of 20; similar to the PE ration of Coca-Cola (NYSE:KO). However, one must remember, that Coke can't return all the profit to investors as it have to spend on growth wherein KKR can raise another fund without increasing its headcount and it requires marginal additional expenses. In addition, Coke's balance shows almost 40% debt/assets while KKR has no net debt. Also, KKR can grow, and has grown, much faster than Coke.

Summary

KKR seems to offer an interesting investing opportunity at current price levels (~$20/unit). The upcoming carry fees and strong growth will be reflected in the near-future distribution and performance. Also, at this price, the investor almost does not pay for the strong growth that both KKR and the industry experiences due to higher allocation to PE in investors portfolios. On top of that, we get best-in-class management with a proven track record of success, the balance sheet power to co-invest and operational capabilities that a few players in the industry posses.

Risks

  1. There is a lot of dry powder in the industry and that may push potential targets' price higher.
  2. A new $6bn Asia fund was raised; it may be difficult to generate high IRR due to the looming crisis in China. However, the investments made so far in that fund (Panasonic Healthcare, Diary producer in China, Haier) seem quite resilient.
  3. KKR is traded not as a common stock but as limited partnership units. The taxation around this structure, and around the structure of the KKR group is not clear and many new suggested rules were brought up. I urge readers to refer to the relevant section under the "Risk Factors" in the 10-K (linked to above). From my understanding, even if the most adverse option will take place, it will be 10 years after being enacted.
  4. Cyclicality in the business: "For example, as of March 31, 2009, the date of the lowest aggregate valuation of our private equity funds during the most recent downturn, the investments in our contributed private equity funds were marked down to 67% of original cost." (taken from the 10-K). This gives us a good proxy for what could happen should we experience another GFC. Given the magnitude of the GFC, a 33% markdown does not seem exceptionally high.
  5. Henry Kravis and George Roberts are the founders and are still heavily involved in the business. Should that change, the impact may be adverse as leadership transition in such situations is not easy. Both are 70 years old and seem to have enough time to stay in their positions.

Catalysts

  1. 84% of the PE AUM is already position to pay carry vs. 33% two years ago.
  2. PE AUM has grown by a 19% CAGR since 2004 and KKR is expected to grow its AUM as the industry enjoys investments inflows.
  3. Growth and fees from the real-assets funds.
  4. Higher distributions in the near future may make the market more enthusiastic about the units.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KKR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.