KKR & Co. L.P. (NYSE:KKR)’s deal to acquire KKR Financial Holdings LLC (NYSE:KFN) will bolster KKR’s distribution and enhance its balance sheet composition, notes Citi.

William R Katz and Citi Research’s team of analysts also point out the deal would, however, throw a few complexities to grapple with.

KKR’s announcement to acquire KFN

Yesterday, KKR made its surprise announcement that it will purchase KKR Financial Holdings LLC (NYSE:KFN), a specialty focused company, in an all-stock deal, and anticipate the transaction would close in 1H14, likely in 2Q14. The deal involves KKR issuing 0.51 units for each KFN share, issuing 104 million units, for a total deal consideration of $2.6 billion or about 35% premium over Monday’s closing price.

Also see: KKR To Acquire Landscaping Company Brickman For $1.6B

Citi analysts anticipate the deal will bolster KKR & Co. L.P. (NYSE:KKR)’s distribution, raising the 2014 pro forma payment from $1.36 to $1.46 based on Street estimates. This is depicted in the following graph:

Bolstering KKR's distribution KFN

KKR’s distribution rise expectation

According to Citi analysts’ estimates, they anticipate the distribution rising to $1.06 from $1.11 prior based on an approximate half-year impact on 2014. The analysts anticipate the deal will bolster the recurring element of the distribution to $0.64 as against $0.50 earlier.

Also see: KKR & Co. Crushes Earnings Estimates

Another positive that KKR & Co. L.P. (NYSE:KKR) would derive from the deal would be that the deal will diversify the pro forma Balance Sheet, reducing PE from 68% to 44%, increasing the liquidity of the Balance Sheet to 33% compared to about 19% recently. This is evidenced from the following graphs:

KKR's combined portfolio

KFN acquisition: Complexities to grapple with

According to Citi analysts, the proposed deal also throws some complexities which need to be grappled with. For instance, the deal is about 2% dilutive to 2014 ENI despite KKR issuing stock at 2.5 times its book value to purchase KKR Financial Holdings LLC (NYSE:KFN) at about 1.15x book value. The analysts point out that the timing of cash flow will prove crucial to the ultimate dilution/ accretion.

Also see: KKR To Acquire Avoca Capital, European Credit Firm

Citi analysts believe the deal seems an exercise in yield arbitrage as the transaction doesn’t offer immediate new business opportunities. However, the analysts anticipate significant LT strategic value, as management adds about $2.6 billion in essentially permanent capital that can be used to fund FPAUM and / or drive acquisitions, though such lift may take some time to fully evolve.

William R Katz and team at Citi Research anticipate some trading volatility as they suspect event-driven investors may look to play this deal.

Also see: KKR To Acquire Panasonic Healthcare For $1.67B

Citi analysts have lifted their 12-month target price of KKR & Co. L.P. (NYSE:KKR) by $1 to $29 to reflect accretive pickup in yield and SOTP valuation dynamics, net of lower FRE valuation contribution. The following table captures Citi’s estimates on KKR:

KKR estimates

Though Citi analysts consider the deal initially dilutes the arbitrage of shifting cash flows from the Balance Sheet to FPAUM, they anticipate greater flexibility to drive FPAUM growth as management adds familiar AUM and a permanent capital base.