KKR is one of the top alternative asset managers "ALTs" benefiting from the desperate search for yield of large institutional investors. Given global yields have fallen dramatically over the past 30 years institutions have increased allocation to alternatives. The alternative asset management industry is growing at 11% and KKR, as one of the leading players, is benefiting from that huge tailwind. KKR is growing above industry rates at ~15% thanks to its consolidated brand and global scale. However, the early stage nature of most of KKR's strategies makes the financials look way worse than the underlying economic reality. In addition, the investments through the balance sheet and the capital markets business would accelerate growth and the compounding of earnings. At current share price, double-digit growth and huge underearning are free options. Valuation suggests at least a double in the next five years. The recent corporate transformation from a partnership to a C-corp should help to raise the interest of the investment community.
1. Business model
Alternative asset managers help pensions, endowments and other large institutional investors to deploy capital in illiquid opportunities such as private equity, infrastructure, real estate and credit with the goal of generating attractive long-term returns. Top ALTs are KKR, Blackstone, Brookfield, Apollo or Oaktree (recently acquired by Brookfield). The long-term returns generated by alternative asset managers have been superior to the returns generated by active managers in the public markets. In the last 10 years, private equity returned 16% compared to 9% public equity and private credit returned 11% compared to 8% corporate high yield.
The business model is as follows. ALTs raise a fund from institutional investors "LPs" to invest capital raised and charge a management fee, typically ~1%, and a performance fee. In addition, some ALTs invest alongside their partners with their own balance sheet. Thus, the business model compounds capital through the increase in capital managed and in turn, fee related earnings, and the increase in value of their own investments in the funds in the case of ALTs using their balance sheet. Once all capital raised is almost invested, ALTs raise a new fund. When investments mature, they divest to distribute returns to LPs. If they delivered enough good returns, they will earn an incentive fee or carry and that track record will allow them to raise a larger fund. Capital commitments to alternative investment strategies often have legal commitment periods of over eight years, creating very long streams of highly predictable revenue.
KKR (NYSE:KKR) manages ~US$ 210 bn of which ~US$ 70 bn are in PE and US$ 140 bn in non-PE strategies such as credit, real estate, infrastructure and hedge funds. KKR has been growing AUM at 15% since 2013, the highest rate among the top ALTs. Almost 90% of the AUM is performance fee eligible. However, 25% of the AUM is driving ~90% of the realized carry, which is coming from the three flagship funds in private equity. This is because of the maturity profile of the funds, not because non-PE strategies are not performing well. KKR, through its balance sheet, is the largest investor in the funds.
The asset manager has three forms of revenue and two forms of operating expenses. Revenues come from management fees 35%, transaction fees 25% (advisory fees and capital markets fees) and performance fees 40% (carry and incentive fees). Operating expenses are composed of compensation ~40% of revenues and other expenses ~10% of revenues. Thus, pre-tax margin is about 50%. This could improve in the future due to some operating leverage, given capex in this business model flows through the income statement.
The balance sheet primarily consists of investments in KKR’s funds.
KKR defines its organization not as stock pickers but as active managers of businesses. They drive value creation in companies using multiple different levers. In terms of operating capabilities, they get support from KKR Capstone, a 60-person operating group. However, this team is not a subsidiary of KKR, although works exclusively for the firm.
Since inception KKR PE funds returned 25.6% gross and 18.9% net. Most recent funds delivered gross returns of 19% (Asian fund I), 27% (European fund I), 6% (European fund II), 17% (European fund III), 34% (European fund IV) and 23% (Asian fund II).
Compared to other alternative asset managers, KKR strategically decided to hold a larger balance sheet. To put that in context, its balance sheet is 30% larger than that of Blackstone, Apollo and Carlyle combined. In addition, KKR has developed a capital markets business (KCM) that provides capital markets services, mainly debt and equity financing to portfolio companies (75%) and third parties (25%).
Having a strong balance sheet allows KKR to grow fees and AUM faster. There are several reasons that contribute to this. 1) If you want to seed new strategies you need to do it through your balance sheet. 2) If you want to partner with a strategic player in a new strategy you need to do it through your balance sheet. 3) Investing in your own funds guarantees alignment with your LPs; and 4) You have the ability to opportunistically size up compelling investments.
KCM: Capital markets segment
KKR provides capital markets services to its portfolio companies and to third parties. Those are debt and equity arrangements for companies seeking financing and syndication fees. These services, which have traditionally been provided by investment banks. From acquisition to IPO, a significant opportunity exists for KKR to generate fee revenue from transactions that are already occurring at the portfolio company level. In addition, there are several strategic benefits to having an in house capital markets business that extend beyond generating fees. For example, in December 2016, KKR sought to acquire Calvin Capital, a UK gas and electricity meter asset provider, in a transaction that would require £600 million of equity and £400 million of debt. KKR would make the investment from their US$3 billion Infrastructure II fund, which to remain appropriately diversified could only invest US$ 250 million. Many firms would be forced to either call a competitor to complete the deal, or participate in a broader bank-led syndication. Ultimately, having a sizable balance sheet and in house capital markets team allowed KKR to keep the asset from entering a competitive auction process by speaking for the entire deal, syndicate the remaining equity themselves and source attractive debt financing. In addition to earning US$18 million in capital markets fees for this transaction, the equivalent of seven years of management fees, providing the equity syndication in house allowed KKR to maintain control of this investment while investing less than fifty percent of the equity. KCM started in 2007 with US$ 3 mm in fees. In 2018 they earned US$ 631 mm. This compares with US$ 1,200 mm in management fees.
If you add up the balance sheet and the capital markets business you have a model that increases its economics in each transaction compared to the traditional model.
Let say KKR finds an investment that requires US$1 bn of equity to buy the company. KKR’s fund cannot responsibly put US$1 bn investment into a given fund. Assume KKR takes US$ 500 mm and makes 2.5 gross multiple of invested capital. Assume the investment generates US$ 100 mm in capital markets fees over its life. Now lets compare the returns and fees earned with a traditional fund model vs. KKR’s model.
Traditional model: First you have to call a competitor to syndicate the other US$ 500 mm of equity. The US$ 500 mm turns into US$1.25 bn (2.5x money invested) generating US$ 750 mm profit that translates into US$ 150 mm carry for the firm.
KKR model: They will generate that same US$150 mm of carry revenue. But instead of calling a competitor and giving them the opportunity for free, what KKR will do is to use the model of balance sheet and capital markets and monetize the opportunity to a much greater extent. If KKR think the opportunity has a lot of upside, they will invest US$ 100 mm off the balance sheet. That will turn into US$ 150 mm capital gain. The remaining US$ 400 mm. Instead of giving it away, they syndicate it with a 10% carry. That gives KKR US$60 million of incremental carry revenue. In addition, assuming KCM captures 30% of the US$ 100 mm in capital markets fees generated by the investment, provides US$ 30 mm in additional fees. Adding all that up, the same transaction will generate US$ 390 mm for KKR compared to US$ 150 mm to the traditional fund model.
There are some strategic benefits to the model as well. KKR can get access to larger deals while maintaining control of the transaction and the company’s board. Moreover KKR becomes more valuable to their LPs because they get this direct co-invest call.
Inflection point and an underearning platform
It takes time to scale the business. Before reaching the inflection point, you have to incur in up front expenses as you built the platforms, hired the people, opened the new offices and load the G&A costs. It takes up to 5 years to raise the first fund. After you invest the capital, you have to wait for those investments to season. Depending on the fund, it takes over three to seven years to season. The underlying income lagging the process is the carry and the performance fees.
The inflection point is around year ten. Until that date, the fund specific strategy is underearning. And after the first fund, the second tends to be way larger and does not require to build its investment infrastructure again and managing larger funds, increase management fees and so on.
Most of KKR’s strategies other than private equity have not reached that inflection point. 18 strategies out of 22 are less than 10 years old, thus below the inflection point. The private equity strategy is about 37% of the AUM and non-PE 63%. Over 90% of carry has been coming from private equity, meaning that KKR is underearning as a firm meaningfully. Management believes that the underlying performance income should reach ~US$ 2 bn in the near future compared to current US$ 1.2 bn.
2. Industry Overview
The alternative asset management industry is growing at 11%. Currently there are ~US$ 12 trillion allocated to alternatives and it is expected that by 2025 that figure would reach ~US$ 25 trillion. The main driver supporting this trend is that global yields have fallen dramatically over the past 30 years and are very low or negative in US, Europe and Japan. Alternatives are one of the few places returns exist. Both credit and equity alternatives outperformed traditional investments. In addition, institutions are continuing to increase allocation to alternatives. And ~25% of the capital raised was by the top 10 largest asset managers, including KKR.
Limited partners, which are typically large institutional investors and pension funds, are in search of yield and return today. The emergence of large sovereign wealth funds who have not been allocating to private equity and alternatives for the past 35 years, like many US pension funds have, but who are just starting to enter the market in the last five years. Insurance companies and high net worth investors also start allocating meaningfully to private equity and alternatives.
Another important trend in the industry is that LPs are looking for consolidated or one-stop shop GPs. They want a GP that offers them the core alternative investment strategies: Private equity, real estate, infrastructure and credit. That is one of the reasons why Brookfield acquired Oaktree (mainly credit) and why KKR launched real estate and infrastructure. Clearly KKR will benefit from this trend. The main reason is that LPs do not want to deal with several GPs. There is a lot of administrative and internal work and they prefer to deal with one or two GPs instead of 10.
3. Competitive Advantage
Asset managers can benefit from competitive advantages derived from its brand, reputation and scale.
Brand and reputation: Alternative asset managers like KKR benefit from their brand and reputation created throughout decades of consistently delivering above average returns. It is very hard to build a brand in the asset management business since it essentially takes decades and a successful track record. Brand not only attracts capital but also talent. It creates a “flywheel” effect in which consistent returns build the brand that attracts capital, which in turn allows the firm to pay higher salaries and hire the best talents in the space. However, it is not only money what attracts talent but the brand. In the case of KKR, its top executives aside from the founders, have been working more than 10 years for the firm. Actually, the two co-CEOs started their careers as investment analysts in KKR back in 1996. Moreover, brand and reputation help to create long-term relationships with clients. The firm's 10 largest investors have remained with KKR for almost two decades as 50%-70% of new capital tends to come from existing KKR investors. For an LP it is way more attractive in terms of reputation to invest alongside KKR compare to invest alongside “XYZ” fund. This translates into the top ALTs like KKR getting most of the capital raised in the industry as per Prequin Alternatives in 2019 report notes "Capital remains concentrated. ~24% of the capital raised was by the top 10 largest asset managers"
Scale: Scale advantage comes in the form of 1) Access to opportunities across the globe, 2) Ticket size and 3) Invest across the entire capital structure
1) It takes a lot of time and capital to have the ability to invest globally and across multiple strategies. You need the upfront investment required to seed the strategies in different countries, find talent, open offices, raise funds and build a lengthy track record. Knowing how to do business in China versus India versus Japan and building relationships with the entrepreneurs in each of these markets takes a tremendous amount of time and capital. For example, KKR did not make an investment in Japan in the first seven years on the ground. Nowadays is a busy market for the firm. It does not happen overnight. However, once in place, it creates a huge opportunity since there is always a market to deploy capital at very attractive returns. KKR has more investment professionals outside US than in the US and in 2019 they deployed 2.5x the capital deployed in US in Asia and Europe.
2) Larger deals are less crowded. First because of the reduced number of funds that can deploy a large sum in a single transaction and second because of the above average complexity of large deals. Complexity comes in the form of dealing with different jurisdictions, complicated capital structures and transactions, complex business models etc.
An example in which scale and complexity played together was the acquisition of Bayer Diabetes Care. KKR identified the opportunity. Bayer was selling a diabetes care business which was going to fit very well with Panasonic Healthcare, controlled by KKR. The European team worked together with the Japanese team and were able to get the Japanese bank to finance that business. There was not a lot of competition there since it was not a simple transaction from a business model, jurisdiction, size and financing structure standpoint.
3) Example of investing on the entire capital structure though the credit team. The Americas PE team considered an investment in Virgin Pulse and Redbrick Health. They decided not to invest on the PE side but pivot the deal and create a financing opportunity out of it. Ultimately KKR committed to a several-hundred million-dollar first lien term loan via the credit investing pools of capital instead of giving a pass to the opportunity and the work already done.
Industry tailwinds: The industry is growing AUM at low double digits and will keep growing for the reasons mentioned above. KKR is growing above industry rates. Since 2005, the firm grew its assets under management at an annual compounded annual growth rate of 19% (at 16% in 2018).
New strategies reaching inflection point: Most of the AUM is still not earning carry since more than half of the funds have not reached inflection point. There is also a lag between the upfront costs and the AUM for non-mature strategies. 18 strategies out of 22 are less than 10 years old, thus below the inflection point. Additional capital flowing through those strategies will not require more employees nor additional selling and general expenses. For example, the Asian PE strategy went from 16 employees in 2006 prior to closing the first fund to 72 in 2013 before the closure of the second fund. In 2006 there were US$ 4bn in AUM. In 2013 US$ 12 bn. However, headcount increased by two from 72 in 2013 to 74 in 2018 but AUM increased from US$ 12 bn to US$ 18 bn. In terms of revenues, 74 employees were making ~US$ 300 mm compared to ~US$ 100 mm in 2012 with 62 employees. The same applies to the infrastructure strategy and other non-mature strategies. KKR’s non-PE strategies have a lot of room to grow. For example: In infrastructure, the market leader has US$ 130 bn in AUM (KKR has US$ 13 bn). In real estate, the market leader has US$ 120 bn in AUM (KKR has US$ 6 bn).
Asian market: The alternative investment industry is growing at rates above ~20% in Asia. KKR started the first PE fund in the region back in 2006 with US$ 4 bn. Today is investing the third fund, manages ~US$ 20 bn, has 150 investment executives in the ground located in Greater China, Korea, Japan, India, Australia and Southeast Asia and has developed relationships and deep local expertise since the beginning of the century through 20 generalist executives. The PE strategy delivered 15% net returns compared to 5% of the MSCI Asia Pacific. To put in context potential growth in Asia, AUM is 35% PE and 65 non-PE. However, Asia is 100% PE. KKR is about to launch three new strategies in Asia: infrastructure, real estate and alternative credit. KKR is very well positioned to benefit from the higher rates of growth in the region.
Margin growth: Since there is a lot of upfront capex in the form of opex costs flowing through the income statement, KKR should benefit over time from incremental margins.
Dry powder: One additional source of potential upside not reflected in the financials is the dry powder. Of the US$ 60 bn in dry powder, US$ 25 bn is what is called “shadow fee paying AUM”. That is capital not earning management fees because is pending to be invested. Assuming that the US$ 25 bn will be invested at a run rate of 100 basis points, we get to US$ 250 in management fees, or a ~25% increase in management fees, that is not considered in the financials. Assuming they deploy the shadow AUM in the next 3 years, management fees will grow at 6%.
All in all, it seems to be conservative to assume that fee revenues (management, capital markets and carry) will grow at double digit rates at least in the next five years. Management guidance is to at least double earnings in the next five years. Scott Nutall (Co-CEO):
5. Capital Allocation
KKR has been using its balance sheet to build and grow faster in different strategies where they had no presence. In the same way Brookfield strategically acquired Oaktree to accelerate exposure to credit strategy, in which they were not involved, KKR has partnered with other asset managers. In late 2015, KKR acquired a 25% stake in MW, a global hedge fund manager, with the option to increase its ownership over time. KKR currently holds a 35% stake. By the time of the acquisition MW had US$ 22 bn in AUM. Today it almost doubled and has US$ 40 bn. Having a strong balance sheet allowed KKR to execute this strategic movement and participate in the hedge fund business combining its platform with that of MW’s. They also have a JV with Franklin Square, an expert at delivering alternative investment products to the true retail client (US$ 25,000 to US$ 35,000 average ticket size). KKR combines its franchise in this space with FS’s. Scale allows KKR to narrow the competitive universe in private credit. By having scale, they narrow the competitive universe and now compete with only three, or four firms that can write US$ 300 mm to even US$1 bn checks.
Dividend policy: From 2010 to 2015, KKR was paying out about 70% of the cash flow in dividends. Since then they changed the dividend policy to a fixed distribution with the aim to compound the balance sheet. They realized the importance of having a balance sheet support to help accelerate growth. They currently distribute quarterly dividends of US$ 0.125 per share which represents an annual dividend yield of 1.7%
Buybacks: They are committed to avoid dilution of shareholders as it relates to compensation of employees. They have used US$ 1bn to repurchase shares since 2016 to date. In the first 9 months of 2019 they repurchased US$ 120 mm worth of stock at an average price of US$ 20 per share (33% discount to current price).
6. Management Team
Jerome Kohlberg, Henry Kravis, and George Roberts, founded KKR in the late 1970s, with Kravis and Roberts continuing to lead the company today. Insiders own about 40% of KKR's shares (founders own ~35%).
The current co-presidents and co-CEOs have worked at the firm for over 20 years. In fact, they joined the firm within a few months of each other and they joined in the private equity business in 1996. They joined KKR back in 1996 as analysts at the age of 24. So they spent the last 23 years working at KKR, from bottom to top. This is not unusual. They key executives have been working for the firm 10,15 or 20 years. They have manage to build a strong culture at the firm.
KKR, through its balance sheet is the biggest investor in the funds. In addition more than US$2 bn of the capital in KKR funds come from its employees.
When you buy KKR you are effectively buying 1) the asset manager business and 2) the book value.
Asset manager: Revenues from the different fees (management fees, transaction fees and carry) have not the same underlying value. Management fees are very predictable, recurring and do not suffer in a downturn since fees are charged based on invested capital. Transaction fees are very recurring in nature although more erratic. This business segment is clearly inferior to management fees business but I would say superior to performance fees business. Transaction fees have been growing at 22% since 2013 and it make sense to think growth will keep up with AUM growth since more AUM implies more deals, which in turn means more companies entering the portfolio and more deals to be syndicated. Finally, carry and incentive fees are way more erratic by definition although again, recurring. KKR reported performance fees in the last 36 quarters and since 2014 performance fees have been well above US$ 1bn, considering that there is huge underlying performance fee potential not reflected due to the early stage AUM.
Source: Image by author, using data from company filings and his own estimates
Source: Image by author, using data from company filings and his own estimates
After tax margins for management and transaction fees are ~35% (40% compensation, 15% opex and 21% tax) and ~47% for performance fees since opex is not imputable to this fee stream. Those margins are the lowest of since 2013. In this business all capex flows through the income statement so there is room to grow those margins over time and that is actually what the company guides. However, let’s do not count on that. Assuming a 25x, 20x and 15x multiple respectively seems to be even conservative considering the 2013-18 CAGR growth of those three streams (10%, 22% and 12% respectively) and the potential growth ahead. Particularly, management fees grew 50% in less than three years. With the multiples assumed, total valuation for the asset manager would be US$ 24.5 bn or US$ 28.2 per share.
Source: Image by author, using data from company filings and his own estimates
As for the book value, it is worth US$ 15.4 bn or US$ 17.7 per share. However, if we only consider cash, investments and unrealized carried interest, leaving tax assets, corporate real estate and other assets aside, we get to an “adjusted” book value of US$ 11.6 bn or US$ 13.4 per share. It seems fair to pay 1x for that adjusted book value.
Source: Image by author, using data from company filings and his own estimates
Adding all that up, we get to US$ 42 per share which implies a 40% upside compared to current share price of US$ 30 per share. Basically, this current share price implies paying 15x, 15x and 8x for the fees respectively and 0.8x for the adjusted book value.
Downturn: Given the “antifragile” nature of the business, the US$ 60 bn of dry powder and the stickiness of the management fees, a downturn in the US economy will actually improve the long-term business performance. Why? Management fees are locked-up so at least will remain flat. Transaction fees would increase since KKR would put to work US$ 60 bn which comes with deals to get executed. Finally, performance fees would drop in the short-term but the benefit of deploying capital at depressed prices is huge in the long-term. The business would not suffer from operating leverage since compensation would get decreased alongside performance fees.
In addition, KKR has US$ 60 bn in credit and US$ 40 bn in hedge fund strategies out of US$ 210 bn in AUM, both of which are strategies that should protect capital on a relative basis in a drawdown.
Reputation risk: This is a real risk since the firm depends on its reputation to keep raising capital. With a track record of more than 40 years and being led by its founders, it seems a low probability risk.
Balance sheet risk: KKR is in the business of allocating capital. Thus, given their historical returns its investments through balance sheet should help to compound capital faster. Also, worth noting that there is no "underwriting" risk in any deal coming from the capital markets business. This is not their business. Before "underwriting" any deal they get money secured from their LPs. They work closely with more than 100 LPs that are eager to invest alongside KKR.
Lower returns from funds given “Too much money chasing too few deals”: The narrative says that since alternatives are growing very fast and a lot of capital is coming to the industry they will not be able to keep delivering past results. Two comments to this narrative: 1) KKR it is not an average PE in the sense that it does not compete for typical and easy to structure deals. Those are crowded deals. 2) KKR’s scale, global reach and operating capabilities allow them to participate in less crowded deals and to deliver value by creating it within the company. I believe that returns will be lower, however, given the desperate search for yield in a very low interest rate world global alternatives will still deliver very attractive relative returns.
Pricing pressure in management fees: With the advent of passive funds, fees have moved down for active asset managers. Alternatives could suffer a similar structural trend. However, given the strength of KKR’s brand, the potential impact will be limited.
Leverage nature of PE returns: Although it is true returns on the PE strategy are levered and this could be an issue for potential returns in a downturn, some points: 1) PE is 35% of AUM, 2) Credit and hedge fund strategies are 45% of AUM. 3) There are US$ 60 bn of dry powder on top of the AUM that if deployed in a downturn will provide above average returns.
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Disclosure: I am/we are long KKR. 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.