This past weekend the Wall Street Journal reported that KKR (NYSE:KKR) is teaming up with NASDAQ (NASDAQ:NDAQ) to create a second market enabling institutional investors to sell portions of their stakes in KKR private equity funds to high net worth individual investors. This is the latest step in a strategy that will eventually bring institutional product to "Main Street's" retail investors. At first glance this appears is a good move for KKR and their limited partners (LP), but it remains to be seen how well the retail buyers will fare.
KKR has long been an innovator in the private equity world. Founded in 1976, the firm has been a pioneer in forming what is today a multi trillion-dollar market for private equity. In 2010 the firm continued to innovate becoming one of the first private equity managers to go pubic. This enabled retail (and institutional) investors to own a piece of the rich management and incentive fees earned from funds under management.
More recently KKR and their competitors have created mutual funds managed by the same teams that run private equity funds for institutional investors. This move is not surprising considering registered investment advisors (RIAs) manage an estimated $2 trillion for high net worth individuals and the market for mutual funds and ETFs is likely to reach $13 trillion by 2015, according to Forbes Magazine.
A key driver of this strategy has to do with the changing landscape for fundraising. Historically most of KKR's LPs are pension funds that in the future will control less assets as companies move from defined benefit to defined contribution and employee managed programs. In order for KKR to grow assets going forward they will have to tap new sources of capital.
Earlier this year I had the pleasure of attending an event hosted by Artivest with the team from the KKR Energy Income and Growth fund. Artivest is an investment platform that provides individual accredited investors with access to elite alternative investments funds below the typical minimums. The company is backed by Silicon Valley elites including Paypal co-founder Peter Thiel.
At the Artivest event I asked the KKR team why they were interested in working with a startup like Artivest. Clearly a small $5-10 million allocation in a $2 billion fund wasn't the main driver. Rather the marketing executive said that KKR sees the high net worth investors that Artivest targets as a key player in the future of fundraising. With this latest move it appears that KKR is moving one big step closer to that long-term goal of broadening their capital source from institutions down to high net worth and eventually retail investors.
Historically securities laws restricted alternative investments like private equity funds to ultra high net worth investors and institutions but the recently passed Jumpstart Our Business Startups Act or JOBS Act now makes it possible for asset managers to now tap this market. Already platforms like AngelList enable retail investors to invest alongside institutional investors in early stage technology companies. My own company Energy Access Capital offers investment opportunities in oil and gas development to accredited investors with relatively small minimum investment amounts.
With their secondary marketplace, KKR has created a new source of liquidity for their LPs. Typically KKR private equity funds have a 10-year life and generally investors do not begin receiving distributions until well into the fourth or fifth year. For most LPs this isn't a problem as they have massive portfolios and are able to manage the illiquid nature of these investments.
In fact one reason private equity has performed well over the years is because of this long lock up period. Unlike hedge funds, private equity managers do not need to concern themselves with redemptions. Many hedge funds have been forced to temporarily freeze redemptions or close altogether due to liquidity issues. This lockup is great for KKR's bottom line as it virtually guarantees fee income for many years regardless of performance.
Since KKR LPs tend to have a very long investment horizons it remains to be seen who will actually utilize this new marketplace. One reason an LP might choose to sell their position in a fund is because they are concerned about future performance. Presumably this "smart money" is in a better position to make this evaluation than the typical high net worth investor (never mind the retail investor). If that's the case then this doesn't bode well for the buyer of these positions.
I suspect a better opportunity will exist for investors who wait to repurchase positions from other retail investors in the future. Retail investors are more likely to sell their stakes for reasons other than performance. Perhaps they have a temporary liquidity crisis and need access to cash. Since these assets are difficult to price and given the expected limited liquidity of the marketplace, there will likely be many bargains to be had.
While this latest innovation by KKR represents an important evolution in the firm's capital raising strategy it will have a negligible effect on near term earnings. However it brings the firm one step closer to eventually tapping the Holy Grail that is the trillions of dollars managed by individual investors in their 401(k) retirement plans. In the medium term, savvy investors that avoid the temptation to purchase early stakes on the new KKR platform will likely find bargains as those early stakes are eventually resold.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
Additional disclosure: I am founder and managing partner of Energy Access Capital, a private company mentioned in this article.