Units Offer 8% Distribution Yield, Trade at Significant Discount to Peers, Offer Solid 12-Month Capital Appreciation Potential
Kohlberg, Kravis Roberts & Co. (NYSE: KKR) is the world’s leading private equity (PE) firm and is largely credited with pioneering the private equity industry, which today is an integral component of global capital flows, value creation and economic growth. KKR has significant insider ownership and a strong focus on distribution growth with an 8% distribution yield that is well above its peers. At $22.55 (as of 9/19/2014), units appear under-valued and offer up to 70% upside over the next 12 months with 13 Wall Street analysts rating units a Buy or Strong Buy.
Since its founding, KKR has participated in private equity deals worth over $400 billion including the $45 billion leveraged buyout (LBO) of electric utility TXU Corporation, the largest LBO in history. KKR has offices across the globe with headquarters in New York City, and has three business segments – Private Markets, Public Markets and Capital Markets and Principal Activities.
Today, KKR’s margins exceed 60% with over 20% Return on Equity (ROE), a Distribution Payout Ratio of about 70%, a global presence and the ability to do the biggest deals. Looking forward, KKR plans to double cash flow by scaling its businesses, limiting equity dilution, maintaining minimal leverage and continuing to generate 20%+ ROE. KKR will also use a multiplier effect to generate transaction and syndication fees and investment income, in addition to management fees and carry.
Looking ahead, KKR plans to focus on growth in China, natural resources, infrastructure, real estate, special situations, direct lending and mezzanine financing.
8.0% Distribution Yield, Strong Focus on Distribution Growth since 2010 IPO;
KKR paid its first distribution in March 2010 for its fourth quarter of FY2009. Since then, the company has steadily paid quarterly distributions based on quarterly earnings and cash flow so distribution amounts vary from quarter-to-quarter.
KKR most recently paid a cash distribution of $0.67 on 08/19/2014 and has paid a total of $1.81 in distributions over the past four quarters (as of 9/19/2014) for a handsome distribution yield of 8.0%, well above its peer average distribution yield of 3.1%. The $0.67 distribution included realized cash carry (of $0.41) for the 17th sequential quarter, $0.12 from net realized investment income and $0.05 from KFN’s May-June contribution of net realized investment income.
KKR units are mostly held by management insiders who see distributions as an excellent way of rewarding unitholders so KKR is a classic case of heavy management ownership that allows distribution-oriented public unitholders to securely ride along with management on distribution income.
Annual distributions have grown from $0.39 in 2010 to $1.81 over the last four quarters on a gradual increase in the distribution payout ratio, and reflect a strong growth orientation because of heavy management ownership.
The illustrative graph below shows 111% distribution growth from 2011 to LTM Q1 2014 with contributions from fee-based income, realized cash carry and cash on balance sheet.
Since its July 2010 IPO, KKR units have delivered total annualized returns of 30% (including distributions), well above the 16.7% return of the S&P 500 index.
At $22.55, Units Trade below Peer Valuations, Offer 70% Upside Potential
KKR trades at $22.55 per unit (as of 9/19/2014) with a rather low price-to-earnings ratio of 8.6x and a market capitalization of $18.1 billion with 801.4 million units outstanding. Units are down 8.6% year-to-date and present a strong buying opportunity at current levels.
Wall Street has an average 12-month price target of $29.50 which represents a 31% premium over current levels, with high/low price targets of $33/$24 and 13 analysts rating KKR a Buy or Strong Buy.
Fastgraphs projects units could rise to near $40 over the next twelve months for a 70% gain. While no one can accurately forecast what units might be worth, most analysts are unanimous that units offer upside over current levels.
Company Overview – Three Complementary Segments
KKR Private Markets has a global PE portfolio with over 90 companies across a wide range of sectors such as technology, media and communications, industrials, consumer products, financial services, healthcare and retail. The company primarily invests in growth opportunities and in industry-leading companies. Its Energy and Infrastructure platform focuses on utility and infrastructure development financings in developed and developing markets. Its Real Estate platform too is spread across the globe and finances attractive real estate opportunities through deep resources and a global network of professional relationships that makes KKR a preferred partner in innovative and high growth real estate ventures.
The company’s Public Markets segment has three divisions – KKR Asset Management (KAM), KKR Prisma and Avoca Capital. KKR Asset Management focuses on leveraged credit strategies, high yield bonds, mezzanine debt and direct senior lending through a number of investment funds, structured finance vehicles and managed accounts. KKR Prisma advises clients on developing customized hedge fund portfolios with uncorrelated risk – diversified by sector, investing style, strategy and geography – using quantitative techniques. Avoca Capital focuses on Europe with five different credit investment strategies – global convertible bonds, senior secured loans, structured illiquid credit, long/ short credit, and credit opportunities – with capital preservation and value investing.
The company’s Capital Markets & Principal Activities division helps portfolio companies and clients with underwriting, capital markets advice and services, debt and equity financing and structuring of new investment products. KKR Capital Markets is a registered broker-dealer in the countries that it operates in.
Steady Growth in All Business Segments
KKR is focused on growing its capabilities, competitive strengths, deal sourcing and preferred partner status. Over the past four years, the company has grown fee-paying assets under management (FPAUM) by 83% from $46 billion in 2011 to $84 billion in Q1 2014.
The table below (as of Q1 2014) illustrates steady growth in fees, carry (based on beating benchmarks) and balance sheet, with total segment revenues up from $713 million in 2004 to $3.4 billion for the 12-months ended March 31, 2014. Over the same period, KKR’s FPAUM, Book Value and Market Cap expanded substantially. KKR is a unique, high quality franchise, capable of bringing big money into deals, so this growth will likely continue over the next several decades as demand and size for innovative financing rises.
Since its July 2010 IPO, KKR has steadily ramped up Cash Carry per Unit to approximately 95% of remaining PE fair value.
A snapshot of month-to-date news (below) reflects the strong pace of KKR’s ongoing deal flow, with a seat virtually assured at the negotiation table on every major deal, often with an exclusive non-competitive invitation.
KKR’s Unique Approach Delivers 2.5x Higher Returns, Enables Bigger Deals
As the illustrative comparison below shows, KKR’s approach to deal structuring can hypothetically generate about 2.5x higher Total Distributable Earnings impact with associated Book Value growth using half of the assets under management (AUM) – even with the same assumptions on carry, gross internal rate of return (IRR) and holding period as the traditional model.
A $1 billion investment under the traditional model generates $21 million in after-tax Economic Net Income (ENI), $21 million in Distribution Impact and no gain in Book Value. KKR’s approach, for the same $1 billion investment, hypothetically generates $54 million in after-tax ENI (2.5x traditional model), $32 million in Distribution Impact (50% higher) and $23 million in Book Value Impact.
KFN Acquisition Will Boost Distributable Cash
On April 30, 2014, KKR closed its acquisition of 100% of KFN in an all-stock transaction. KFN is a specialty finance company with $3.2 billion in assets that are externally managed by KKR. Assets span a range of complementary classes for current income and capital appreciation. KFN’s notes (S&P: BBB credit ratings) and perpetual preferred shares will remain outstanding without recourse to any other KKR entity.
The table below shows KFN’s balance sheet as of March 31, 2014, with $185 million in cash, $3 billion in portfolio holdings (including 45% in Collateralized Loan Obligations (CLOs), 16% in Natural Resources and 14% in Special Situations).
Prior to the acquisition, KFN’s results were reported based on “bank accounting” where balance sheet and income/loss results reflected assets held in CLOs (vs. assets actually owned by KFN), loans were carried at amortized cost with corresponding reserves for credit losses, and bonds were carried at fair value with changes in value reflected in shareholders’ equity, causing significant differences between cash earnings and GAAP results.
Post acquisition, KKR’s results will reflect KFN’s actual assets owned and reported at fair value with changes reflected in segment P&L and distributable cash earnings consistent with KFN’s results, excluding unrealized gains and losses.
KFN brings in long-dated, low-cost liabilities with a sizable cash-yielding portfolio that meaningfully increases the recurring portion of KKR’s distributions; KFN’s CLOs provide attractive cash-yielding investments that are insulated from the market value of assets, benefit from a significant increase in short-term rates and are financed with long-dated non mark-to-market debt. And 100% of KFN’s cash earnings will be included in Q2 distributions.
Company Still Led by Co-Founders, Backed By Influential Global Advisors
KKR was founded in May 1976 by Jerome Kohlberg, Henry Kravis and George R. Roberts when they left investment bank Bear Stearns and formed KKR to focus on leveraged buyouts (LBOs) and management buyouts (MBOs) through private equity investments. Kohlberg left KKR in 1987 over differences in strategy and later formed his own company to focus on LBOs of small and medium companies while Kravis and Roberts were hungry to do the biggest deals.
Today, KKR continues to be led by two of its original founders – Henry Kravis and George Roberts – who hold Co-CEO and Co-Chairman titles. Todd A. Fisher serves as Member
Chief Administrative Officer, William J. Janetschek serves as Member &
Chief Financial Officer the David J. Sorkin serves as Member & General Counsel and Secretary. Management is assisted by a team of 250 senior professionals across the globe in the 1,000-strong company and a group of highly-influential senior advisors that held leadership positions at major corporations, financial institutions and governments in the countries that KKR has investments in.
Strong Equity Incentives Align Management with Investors
KKR typically invests its own capital along with third-party equity dollars and borrowed funds (balance sheet) to pursue friendly acquisitions of solid businesses with strong growth or turnaround potential. From the outset, the firm’s focus has been on nurturing partnerships with managers and investors who have deep industry expertise and knowledge of significant investment opportunities.
One of KKR’s most significant innovations was co-opting business managers as equity owners rather than professional managers. With heavy equity incentives, management worked to boost unitholder returns as true owners of the business, with performance measured over the long term, not just a few quarters. KKR also prudently uses leverage against underlying assets to manage cash flow and enhance long-term unitholder value.
Well Positioned for Future Growth
Over the years, KKR has expanded the creativity, complexity, scope and diversity of its business, and entered into regulated industries such as utilities, insurance and banking. KKR’s investment professionals are industry experts with deep sector knowledge and fully capable of determining capital and operational needs, and how KKR could boost business value. The company’s KKR Capstone subsidiary focuses purely on improving operations through new product development, sales force effectiveness and manufacturing excellence within portfolio companies.
KKR has offices in Europe and fast-growing global markets in Asia and South America, and has recruited experienced teams of local investors and operators, and coupled them with experienced KKR executives from other offices, to deliver best-in-class results.
KKR invests in esoteric debt instruments through wholly-owned subsidiary KKR Asset Management (KAM). The company developed its Capital Markets business in 2007 to ensure that its corporate partners had access to the best finance terms, maintained optimal capital structures and carefully approached IPOs and liquidity events.
Today, six key principles guide the company’s investing philosophy: a partnership based alignment of interests with each player in the ecosystem having a vested equity interest in outcomes; creativity and flexibility in capital deployment and structure to optimally meet the needs of portfolio companies and investors; investments across the entire spectrum of the company’s capital structure such as debt, convertibles, equity and warrants; a strong focus on deep industry expertise, capital requirements, operations and global opportunities; building and nurturing a global network of advisers and leaders for expertise and deal-sourcing; and investing for the long-term.
Q2 2014 Results – Record Distributable Earnings on Successful Exits
KKR has three forms of revenue – fees, carry and balance sheet – and two major buckets of expenses – compensation and operating costs. The company defines Economic Net Income as Total Segment Revenues less Total Segment Expenses (primarily compensation, allocation to carry pool and other operating expenses).
For its second quarter ended June 30, 2013, KKR reported net income of $178.2 million on a GAAP basis, 11.8x net income of $15.1 million in the year-ago quarter on higher income from investments, transaction fees and a larger ownership stake in KKR businesses. Total distributable earnings hit a record $701 million, up 73.6% from $403.8 million a year-ago, with distributions of $0.67 per unit, up from $0.42 in Q2 2013.
KKR reported $501.6 million in quarterly Economic Net Income, up 247% (with all comparison relative to the year-ago quarter), with after-tax ENI per unit of $0.62, up 240% from $0.18.
Private Markets’ AUM dropped $1.1 billion from Q1 2014 to $59.4 billion due to distributions made to limited partners of PE funds on liquidity events in the quarter, partly offset by new capital and an increase in fair value of the PE portfolio. Private Markets’ FPAUM dropped $2 billion to $46.2 billion, primarily on Energy Future Holdings’ bankruptcy. This segment reported a strong $445.1 million jump in revenue to $642.9 million on higher capital appreciation on the company’s PE portfolio and higher carried interest, with ENI of $376.2 million, up $297.7 million.
Public Markets’ AUM dropped $3.3 billion from Q1 2014 to $38.5 billion and FPAUM dropped $1.9 billion to $33.5 billion due to the KFN acquisition. Public Markets reported a $76.6 million increase in segment revenue to $157.2 million due to investment income contributions from KFN, with segment ENI of $105.6 million, up $62.4 million from the year-ago quarter on contributions from KFN.
Capital Markets generated segment revenues of $34 million, up $1.5 million over Q2 2013, on higher transactions, with ENI of $19.8 million, a drop of $3 million due to higher compensation costs.
Additionally, the company closed the KFN acquisition in the quarter (on 4/30/2014, as previously mentioned) and added to recurring corporate earnings with low-risk capital to grow the company.
As of June 30, 2014, the company had $3.4 billion in cash and $2.5 billion in consolidated segment debt, and ended the quarter with $10.4 billion in Book Value ($12.52 per adjusted unit), $98 billion in AUM and $79.7 billion in fee-paying AUM (FPAUM). The company delivered a 29% return on equity from strong investment performance, cash flow and balance sheet income.
KKR is an undisputed leader in the PE segment it pioneered back in 1976 when it was formed. The company has deep insider ownership and a strong commitment to growing unitholder distributions. KKR units trade at valuation multiples that lag peer multiples, and appear attractive at current levels of about $22.55. The company has a strong franchise and has buttressed its position through complementary growth in public markets, capital markets and related services to boost ENI. Units offer compelling value to income- and growth-oriented investors with little downside and up to 70% upside should they rally to $40 over the next 12 months.