In the past several years, a number of managers of private equity funds have themselves gone public and now provide retail investors with an opportunity to get exposure to private equity while retaining liquidity. I have called the companies in the sector "private equity managers" (PEMs) but they have also been called "alternate asset managers" or simply "private equity". For the purpose of this article, I consider the sector to include Blackstone Group (NYSE:BX); Kohlberg, Kravis, Roberts (NYSE:KKR); Oaktree Capital Group (NYSE:OAK); Carlyle Group (NASDAQ:CG); Och-Ziff Capital (NYSE:OZM); Fortress Investment Group (NYSE:FIG); Apollo Global (NYSE:APO); and Ares Management (NYSE:ARES).
The Business - As a broad generalization, these companies manage investments (usually obtained from pension funds, sovereign wealth funds, and wealthy individuals) in "alternate" investments. Private equity funds are usually the largest component of the activity. These funds invest in taking public companies private, providing funding for existing private companies, and taking over private companies. PEMs also invest in distressed debt, real assets (e.g., energy facilities) and real estate. The funds they manage tend to be subject to "lock ups"(restrictions on investor withdrawals) and are generally restricted to institutional and high net worth individual investors. PEMs may also manage hedge funds and public investments, including business development companies (BDCs), real estate investment trusts (REITs), closed end funds and exchange traded funds.
PEMs earn some fees on a straight percentage of assets managed basis. In addition, they earn "performance fees" based on the success of the funds they manage. PEMs generally make an investment of their own in the funds they sponsor and manage on a "side by side" basis with other investors so that buying PEM units provides an investor with an opportunity to profit if those private equity funds appreciate in value. Performance fees are in some cases taken in the form of a "carry" or special percentage of the profits of the fund being managed.
Investors in PEMs are generally getting a "limited partnership" position rather than common stock. As a general matter, this means that the investor will get a K-1 at the end of the year and will have to deal with a more complicated tax situation. It also means that the entity which actually manages the investments described above is one which itself is managed by another outside entity and the PEM retail investor does not have the kind of voting rights common stockholders generally have.
The Companies - I generally include eight companies in the sector. The table below provides Friday's closing price, trailing twelve month distributions, yield, market cap, and the price earnings ratio for each of the companies in the group. Distribution information comes from the company websites, market cap was calculated in billions of dollars based on current share price and most recent share count as disclosed in SEC filings, and earnings are based on current year analyst consensus earnings set forth on Yahoo Finance.
|Price||TTM Distributions||Yield||Market Cap||P/E|
A few points are important. Dividends (actually distributions) vary considerably from year to year so that trailing twelve month dividends do not necessarily portend similar dividends going forward. PEMs seem to be evolving in the direction of more emphasis on regular quarterly dividends rather than large year-end dividends, but there is still likely to be one dividend payment each fiscal year which is larger than the others. Because PEMs manage funds, large dividends may be issued after a fund closes and the final performance fee is received in cash. This will produce lumpiness in dividends from year to year. Thus, the "yield" percentage is not something which can be counted on from year to year. These are not stocks which will pay increasing dividends year after year for 20 or 30 years. Instead, there will be some years with very big dividends followed by declines.
The industry is still in search for the perfect metric. Earnings constitute a reasonably good metric, but presentations by PEMs suggest "economic income" and "distributable earnings" as alternatives. My review of the sector indicates that economic income can be somewhat higher than reported income due to the backing out of non-cash charges against earnings such as amortization of various past expenses. The bottom line is that these stocks are trading at reasonable multiples of earnings and are therefore priced at attractive levels here.
The market caps may seem low (the entire Carlyle organization is worth much, much more than $2 billion), but remember that the PEM you buy into in the open market may own only part of the entity which manages the relevant funds and earns fees.
It is beyond the scope of this article to provide detailed information about all eight companies. Investors should review recent financial statements and corporate presentations available on company websites for more detail. The companies vary considerably in size and focus.
BX is by far the largest of the companies in terms of public market cap; it also has a very well diversified mix of assets under management, including relatively large allocations to hedge funds and real estate. KKR is also large and has a long and very impressive track record in private equity. Indeed, some writers describe Henry Kravis as the inventor of private equity investing.
ARES, APO, OAK and FIG tend to emphasize debt related strategies. In this regard, although debt for companies with access to public bond markets has become very inexpensive, there are still many very solid small companies paying double digit interest rates and recapitalization strategies aimed at this market have enormous potential for return. ARES just went public a few months ago and that is why we don't have TTM yield data. APO and OZM had very large dividends in the past 12 months which are definitely not necessarily indications of the level of future dividends. FIG has a very strong balance sheet with roughly $3 a share in investments and cash so its valuation is quite attractive at these levels. OAK has a very long history of providing high returns on distressed debt, convertible debt and other credit oriented strategies.
OZM emphasizes long/short equity strategies and credit strategies. CG is a very large and well respected entity which has focused on corporate buy out strategies and, within the "real" assets sector, energy assets. It has an impressive track record producing returns at high levels in the funds it manages.
Transparency - I read one analysis of the sector which mentioned "transparency risk" as a factor. In World War 2, General Eisenhower would frequently get reports from local commanders describing the situation as "fluid." He once told an aide that such a report is another way of saying that the local commander doesn't know "what the hell is going on." I suspect that security analysts use "transparency risk" when what they are really saying is that they can't figure the company out based on its public reports.
In this regard, here is a quote from the latest quarterly filing of KKR:
"KKR & Co LP was formed as a Delaware limited partnership on June 25, 2007 and its general partner is KKR Management LLC (the "Managing Partner"). KKR & Co LP is the parent company of KKR Group Limited which is the non-economic general partner of KKR Group Holdings L.P. ("Group Holdings") and KKR & Co LP is the sole limited partner of Group Holdings. Group Holdings holds a controlling economic interest in each of (NYSE:I) KKR Management Holdings ("Management Holdings") and (ii) KKR Fund Holdings L.P. ("Fund Holdings") directly and through KKR Fund Holdings G.P. Limited a Cayman Island company..... Group Holdings also owns certain economic interests in Management Holdings through a wholly owned Delaware subsidiary of KKR Management Holdings and certain economic interests in Fund Holdings through a Delaware partnership of which Group Holdings is the general partner with a 99% economic interest and KKR Management Holdings Corp is a limited partner with a 1% economic interest........."
Now, I have something to read and reflect upon whenever I have trouble getting to sleep. I read this 18 or 19 times and still don't really understand it, but when you read it again and again, it starts to develop a beat so that KKR has a hidden value in the copyright to this piece which, when put to music, could become the theme song of a musical comedy. On a serious note, the complexity of some of these companies creates a downside. The problem is that, if the insiders really put their minds to it, they could probably figure a way to minimize the cash flow going in the direction of the entity in which public investors participate. On the other hand, by going public, these entities have subjected themselves to SEC regulation. In addition, in many cases, top management owns large positions in the public entity. Most importantly, the companies in the sector have enthusiastically embraced the concept of going public and generating investor interest in their companies so that mistreatment of public investors would really be contrary to their business strategy.
Plus Factors - Private equity strategies have generally had higher returns than public equity market performance. This may be partly due to the fact that private equity investors have to sacrifice liquidity (they are unable to withdraw funds at will) so that there is less money devoted to these strategies. Unit holders in PEMs can get the best of both worlds by participating in high private equity returns while preserving liquidity.
PEMs tend to have "sticky" relationships with investors in their funds so that assets under management are more stable than in the world of open end mutual funds. Investors in private equity funds commit the funds for a length of time and there are restrictions on withdrawals. In addition, the pension fund and other institutional investors in private equity and hedge funds develop long-term relationships with the managers of these funds so that investments tend to be "rolled over" into new funds after old funds mature and distribute profits.
PEMs are likely to be substantial dividend payers and, while the dividends may be "lumpy" and vary from quarter and year to year, in the long run it is very likely that dividends from the sector as currently priced will generate better yield than almost anything available in the public fixed income market. At current prices, PEMs are priced attractively for appreciation with nice yield on original cost.
PEMs are managed by some of the most savvy people in finance and they are always on the look out for new strategies. Five years from now, it is likely that the mix of new investments will be quite different from the current mix. Investors in PEMs will experience this reallocation automatically simply by owning units.
Negatives - Transparency is a problem. I believe it is not due to any intentional effort to confuse investors, but is simply the result of corporate complexity and the complexity of some of the strategies PEMs pursue. Many PEMs have put out corporate presentations which provide valuable information in more understandable form than in the SEC filings.
These are not stocks which will meet the "dividend champion" test of smoothly increasing dividends for 20 or 30 years. There will be years in which dividends are very large but they may be followed by declines.
As more money is directed at various investment strategies pursued by PEMs, it is likely that the premium returns realized in the past may decline. There are already signs that opportunities for some of the "low hanging fruit" profits in the private equity sector through recapitalization are waning and more attention is being focused on improving the corporate operations of buy out targets. This is, of course, a more complex undertaking and may require more time and management resources.
Retail investors are probably surprised that debt oriented strategies can generate large profits. I think that one reason for this is that there is a tremendous disparity in corporate debt markets which favors large companies with access to public debt markets. There are many small companies paying onerous interest rates and this creates enormous opportunities for savvy debt investors. On the other hand, these opportunities may not last forever.
The sector's performance will likely vary considerably over the economic cycle and is likely to take a nasty hit in an economic downturn. On the other hand, investors in PEMs may actually fare better than investors in funds being managed by PEMs.
Investors will generally receive K-1s with the attendant tax complexity. Some dividends will be treated as a return on capital and will reduce the tax basis of the investment in the PEM so that taxes will be deferred and this may be an advantage in a taxable account. It is beyond the scope of this article to provide detailed tax advice so that investors should consult their accountants in this area. Unfortunately, as far as I have been able to discern, we do not yet have a closed end fund specializing in PEMs so that the avoidance of K-1s available to MLP investors through the closed end fund window (as described here) is not available for PEM investors.
Conclusion - I am generally bullish on the group. I own BX, KKR, OZM, FIG, OAK and CG, and I am kicking the tires on the others. For a yield oriented retail investor with a long term horizon, an allocation of 5-10% of the portfolio to this group with an overweighting on the larger names (BX and KKR) is a reasonable part of a strategy aimed at increasing yield over time and achieving long term portfolio price appreciation.
Disclosure: The author is long BX, KKR, OAK, FIG, CG, OZM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.