Credit Suisse analysts met with KKR management recently. CS has some insights into both company specifics and the private equity industry in general
KKR report via CS
Last week, we had the opportunity to travel with KKR & Co. L.P. (NYSE:KKR) Chief Financial Officer Bill Janetschek and Head of Investor Relations Craig Larson. Management reinforced many of the key themes from KKR’s recent Investor Day (disciplined growth/expansion across KKR’s Private, Public and Capital Markets businesses, LP expansion, flexing of the balance sheet as a competitive advantage), spoke to the still constructive operating backdrop and addressed recent investor concerns of higher interest rates and potential fee pressures. We came away from the meetings with the view that the KKR story continues to progress quite well over recent years—at the firm’s core, favorable investment returns have helped on myriad fronts (bolstering fundraising, incubating new growth opportunities and closing netting holes & positioning the vast majority of KKR’s fee earnings assets to paying carry).
KKR Capital Markets Operations:
KKR: Firm Strategy at a High Level. Almost forty years after KKR & Co. L.P. (NYSE:KKR) was founded, management continues along their efforts to selectively expand and grow. Private equity remains KKR’s one scale business (KKR has an estimated 5-7% global share), while the firm remains in the early stages of incubating 7-10 newer-to-firm businesses (most notably Real Estate, Infrastructure and Public Markets) that, if successful, should provide an opportunity for successor funds that are upwards of 2-3 times larger. Real Estate will be a major proof point of that concept, as the firm prepares a drop-down fund for the strategy. KKR’s balance sheet and capital markets operations are key strategic differentiators and competitive advantages. Over time, the output of all this should be reflected in a more balanced mix towards non-PE businesses (now 32% of fee earning AuM and 15-20% of the balance sheet). On top of that strong organic growth profile should be the benefit of select fill-in acquisitions—last year, KKR completed its first acquisition in history of hedge fund of funds Prisma; early returns since deal closing (AuM growth, LP expansion) have been quite favorable.
Some Thoughts on the Current Environment. KKR & Co. L.P. (NYSE:KKR) is seeing good opportunities to both buy and sell across the current operating backdrop. Unlike some of the firm’s major peers, management is more constructive on current valuations than peers (we attribute a portion of this to differing investment styles). Broadly, activity levels at the investment committee remain very, very busy with particular areas of focus being energy/infrastructure, industrials and healthcare. Despite the recent backup in interest rates (more thoughts on that below), the funding environment remains quite positive. Portfolio company performance remains favorable—as of the first quarter, LTM revenues grew 9% across KKR’s 82 portfolio companies, augmented with operating margin expansion (LTM EBITDA grew 11% yr/yr during the same period). On the realization front, KKR & Co. L.P. (NYSE:KKR) remains active (YTD, KKR has realized over $4 Bn, on track for the largest or second largest year) but with that said, there admittedly has been less M&A activity than anticipated. With respect to the Public Markets business, management continues to see healthy demand for products and select places to put money to work (more Europe than U.S., direct lending).
The Potential Impact of Higher Rates. A common theme among our investor meetings was the concern and debate regarding the impact of higher interest rates on KKR & Co. L.P. (NYSE:KKR) and alternative asset management peers. At various levels of the conversation, management does not view higher rates as that material of a concern, and in some instances, should provide a tailwind. First and foremost, if higher interest rates are a signal of firmer economic growth, then that should be a positive for core fundamentals and valuations for KKR’s base of portfolio companies.
At a portfolio company level, KKR has favorably utilized the near zero-interest policies over the past few years to amend and extend debt profiles; over the past six months, management took the view that there was more upside than downside to interest rates and hedged out approximately 75% of portfolio company floating rate exposure. Finally, from a deployment perspective, while certainly higher rates would represent a potentially higher weighted cost of capital for new acquisitions, the impact should be modest— historically, the vast majority of historical value creation has been generated via operational enhancements rather than initial deal price/cost of capital. Additionally, the financing markets actually remain quite accommodative relative to historical standards. From a Public Markets perspective, KKR & Co. L.P. (NYSE:KKR) continues to see long-term demand for yield products from LPs though there is some skewing towards loan products with some exposure to floating rates. On the Public Markets deployment front, Europe remains particularly active for the firm, and the U.S. less so.
Fundraising & Client Partner Expansion Efforts. Further evolving KKR’s fundraising capabilities and depth remains a key strategy priority for management. The backdrop for fundraising has improved over recent years—management views it as a good time to be raising money (as evidenced by the success of Asia II and NAXI), though admittedly raising first time funds remains a challenge. From a long-term perspective, management still sees a meaningful opportunity to expand their limited partner base (over 600 today from 275 when KKR went public); this is still meaningfully behind the 1200-1600 LPs reported by some peers. While KKR feels very well positioned in US pension plans, firm efforts continue to broaden exposure to sovereign wealth funds (who as a client segment still have only nominal allocations to alternative investments) and high net worth/retail channels. On the latter, NAXI is KKR’s first flagship fund represented through multiple high net worth channels.
Thoughts on Fee Pressure. Management does not worry much about fee compression—management is seeing very minimal pressure on management fees and carry fees but has added a preferred return in the latest vintages of its private market flagship funds. Where there is some pressure is on transaction/monitoring fees—currently, KKR LPs receive 80% of those fees. In some instances where KKR is seeing demand/desire for a fuller rebate, KKR & Co. L.P. (NYSE:KKR) is receiving some offset in terms of improved management fees.
The Capital Markets Opportunity. KKR & Co. L.P. (NYSE:KKR) still sees a significantly meaningful opportunity set for its growing capital markets efforts. Begun six years ago as an extension of the firm’s own capital markets operations, KKR Capital Markets has expanded into participating in portfolio company operations, and more recently, a third party financial sponsor capital markets facilitation business. While the first quarter’s performance was weaker here, the business has begun to really hit its stride in the past 12-18 months. A longer-term opportunity here remains to be more global. What about the risks? While LPs were at first skeptical when KKR went down the path of creating the business, they have seen the longer-term opportunity to garner better deal economics and further boost portfolio returns.
The Distribution From Here. Over the past two years, distributable earnings have doubled for KKR & Co. L.P. (NYSE:KKR)—total distributions in 2012 of $8 Bn were a record for the firm, and 2013 is continuing along a similar trajectory. Management remains quite confident in the team’s ability to further boost distributable earnings and ultimately unit holder distributions—this should be achieved by strong operational improvements at a portfolio company level, certain private investments entering their maturity/harvesting phase, and further build out and payoff from Public Markets/Capital Markets activities. On the private market franchise, approximately 84% of Private Equity’s fair value is now carry eligible (25% of it resides in publicly traded securities) with the major netting holes filled—management estimated this could drive upwards of $4.50-$7.00 per unit of distribution over time (with no further dry powder deployed or fundraising). Critical to achieving this is continued positive fund returns, accommodative equity markets and some pickup in getting dialogues with strategic buyers to the finish lines as there remains some hesitancy. Relating to Public Markets, an important of the output of success over time should drive a more sustainable distribution given the yield oriented, counterbalancing facets of a credit business.
Successful Balance Sheet Investing Can Accelerate The Timeframe
The Balance Sheet. One of the unique aspects to KKR & Co. L.P. (NYSE:KKR) is the firm’s balance sheet investment and expansion efforts—over recent years, we believe management has done a solid job of both flexing the balance sheet’s capability and clearing up any confusion regarding unitholder participation in its success. Originating from the ~$5 Bn permanent capital KPE vehicle, management has progressed and evolved the KKR balance sheet strategy to both incubate growth initiatives and consider strategic acquisitions. On the growth initiative front, top of mind to us are Real Estate and Infrastructure—management hopes that successful balance sheet investing can accelerate the timeframe from a first time strategy to a successor fund. Drilling into the real estate business, other important facets here include offering potential investors a good selection of deals to complete due diligence while also providing a potentially shorter J-Curve. Currently, 80-85% of the balance sheet is related to private equity investments—over time, we expect that figure to migrate closer to the 60% level as KKR & Co. L.P. (NYSE:KKR) remixes/reallocates assets.
Estimates/Target Price. Our 2013-2015 dividends estimates are $1.35, $1.30 and $1.25—this implies a 6.4% distribution yield over the next 12 months. Our target price is $22.