Description

Summary

KKR represents an attractive opportunity to invest in a (a) secularly growing, (b) high quality business, with (c) a low valuation that is (d) accretively reinvesting FCF into its enterprise.  These are the hallmarks of a compounder.

At $15/share, net cash and investments account for ~65% of market price ($9.75/share).  The residual $5/share of market price are accounted for by the value of current fee-related earnings.  Thus, an investor receives (a) future carried interest for free, plus (b) growing AUM and fee earnings and (c) the returns accruing to the balance sheet.  Alternatively, KKR is priced at a growing 12+% FCF yield.

Perfunctory Background

Everyone here knows KKR.  Nevertheless . . .

KKR is a leading global investment firm that manages investments across private equity, energy, infrastructure, real estate, credit and hedge funds. KKR holds $131bn AUM with $75bn in private markets and $56bn in public markets. From 1976 inception through 3Q16, KKR’s seasoned private equity funds generated a gross IRR of 26%.  Since 2000, KKR’s private equity funds have generated an estimated 18% gross and 13% net IRR, with the firm’s most recent vintages performing better than the average (North America 2012, 25% gross; Asia 2013, 38% gross).

Investment Case

• Quality business generating attractive returns

• Recurring fee earnings given locked-up capital - 73% of AUM is locked for > 8 years

• Secular growth - large alt managers are growing.  In order to support 7 to 8% ROA assumptions, institutional allocators need returns . . . or even the ability to justify their assumed returns (especially true for public plans who discount their liabilities based on their ROA assumptions, which is a total farce, but I will not digress on that tangent).  An institutional allocator is not going to get fired for hiring KKR.  Great brand; sufficient performance.  Even the relatively more muted returns since 2000 will continue to wave in capital.

• Since 2009, KKR has increased its marketing team from 6 to 80 people.  In 2010, the firm had 340 investors versus 950 currently.

• Beyond garnering new clients, KKR has significant opportunity to penetrate its current LP base.  Since 2010, products per client have grown from 1.5 to 1.7.  While at first not striking, this is notable given the 180% growth of clients since most new clients are only invested in one product.  With KKR’s top 40 largest investors in four or five products, the cross-sell opportunities are material.    

• KKR raised more capital LTM than in any other 12-month period in its history

• Operating leverage with growth

• High-teens to ~20% ROE since 2010 IPO with little leverage

• Sustainable enterprise - culture and alignment

• Alignment of interest - 370 KKR investment professionals and employees owned 45% of the firm

• “One-firm” culture - professional incentive compensation materially tethered to aggregate firm performance.  Tenured leadership, many of whom have ~20 years with the firm.   Kravis and Roberts focus on preservation of KKR’s culture and values,

• Kravis: “Your word is your bond.  If you say something to someone, you’re speaking on behalf of KKR.  Whether you’ve been here six weeks or you’ve been here 30 years, it’s your obligation to stand behind what you say.”

• Kravis: “Bear [Stearns] was very much an eat-what-you-kill culture, and that’s exactly what we didn’t want.  We were big believers in working together.  We wanted everyone to share in everything we did, whether you worked on a deal or not. . . .  Get the best out of everybody and the best out of the firm.  So we started with that 40 years ago, and today our culture remains identical.”

• Kravis: “The one thing we do want is for KKR to outlive us, like a Goldman Sachs.”

• Kravis pitching the business?  Certainly to some extent, but I do believe KKR is distinctive as it relates to its culture and firm focus, leading to a more sustainable enterprise.

• Succession - Kravis and Roberts intend to remain with the firm at least through 2020.  Both 72 years old, they’ve runway left.  Two likely succession candidates, Scott Nuttall and Joseph Bae, are in their mid-40s and each have been with the firm for ~20 years.  Roberts has indicated the leadership transition will likely involve appointing a new CEO(s) with Kravis and Roberts remaining as chairmen.    

• Attractive reinvestment opportunities

• KKR’s large balance sheet is unique amongst alt managers in that it significantly reinvests earnings into its own investments - $0.64/share fixed distribution with remainder reinvested into its own strategies

• Mid- to high-teens IRR since 2010 on balance sheet investments

• Inexpensive investment into KKR funds - sub-2% effective management fee and no carried interest fee

• Chuck Royce: “[The alt managers] are an ideal way to participate in the success of the products. You could even argue that an endowment with long-life assets that is being solicited to buy a private-equity fund would be just as well off buying a piece of the manager. If the products are successful, you participate in the performance fees; if they are unsuccessful, you participate in the management fees. It is a superior way of participating in their success.”  This reasoning holds all the more true for KKR given investor access to its low-fee balance sheet.

• Balance sheet enables KKR to incept new strategies, prove concept with own capital and then ultimately market new strategy to LPs, dropping incepted assets into seeded GP.  Excellent means by which to grow and diversify the business.  

• Real estate is a recent example: seeded in 2011 with $300mm balance sheet capital, and created first fund 2014 totaling $1.2bn, generating a 24% IRR to-date.  KKR now using this real estate foundation to develop collateral real estate strategies - Europe, credit, etc.  

• Continued evolution of balance sheet investments should reduce quarterly volatility while still generating attractive returns

• Reallocation - KKR is raising cash from co-investments and CLOs to refocus on investment into KKR funds ($1bn commitment to North Americas XII fund represents ~10% of NAV)

• Liquidity - cash has increased from $1.3bn at YE2015 to $2.8bn 3Q16 relative to $13.5bn of total assets - KKR has $2.5bn of unfunded commitments to its funds

• Strategic balance sheet monetization - most recently, KKR is selling select assets to LPs that are then placed in separate accounts, generating new AUM and upfront liquidity for KKR, while the firm also retains a carry above a specified preferred return   

Valuation & Related Considerations

I’m not precisely sure how much KKR weighs, but I’m confident it weighs more than $15/share.

Below I’ll describe several means by which I try to triangulate value here.  Importantly, undergirding this entire exercise is my view that that KKR is a quality, growing business priced at a discount to its current value, which value is increasing.  Moreover, the stock price has moved inversely to to the underlying development of the business over the past two years.  KKR’s recent commentary and presentation at the September Barclay’s conference well-highlighted this disconnect between price and business progress / value.  I include three of the more salient slides:

More broadly, it’s worth considering the positive, diversifying overall evolution and development of the firm since it’s 2010 IPO:

As noted above, I believe the transformation of KKR’s balance sheet investments is important.  The firm is diversifying its investment profile, reducing concentrated co-investment assets and lower-returning CLO holdings, with a mix shift toward investment into its own funds.  The past few Qs have seen monetization via secondaries (Walgreens, Zimmer, etc.); these will continue and ultimately First Data too as valuation/deleveraging progresses.  KKR’s $1bn commitment to North Americas XII PE fund is emblematic of the shift.  This portfolio repositioning should reduce quarterly noise in the reported numbers without a significant net effect on returns.  

One last point to color the discussion.  The amount of carried interest KKR generates is volatile, but consistently generated.  Valuing this cash flow stream is imprecise, but it’s valuable.  KKR has produced 25 sequential Qs of realized carry.  Additionally, as the firm continues to diversify its investment funds and strategies, the consistency of carry should only increase; 80% of third-party capital is subject to carry or incentive fees.  And again, at current pricing, an investor is paying $0 for KKR’s carried interest.

So what’s the business worth?  I’m not exactly sure, but it’s more than $15 and the value is growing.  

As a starting point, KKR is cheap on some traditional valuation metrics.

On an EV of $4.3bn against $1.27bn of 2016 EBITDA (excluding balance sheet income), KKR is priced ~3.4x EBITDA.  Alternatively, on FCF of around $1.85 to $2.10 annually over the next couple of years, the company is priced at a > 12% FCF yield.

In terms of an investor receiving future carry for free:

The balance sheet value and fee earnings (FRE) suggest $16 of current value.  The carry valuation is a stab, but supports current value of at least $20/share.  All these metrics are growing (e.g., FRE should grow ~20% as North Americas XII fund turns on its fees).  In terms for estmated current FRE, I take reported FRE (~$600mm) and reduce it by 50% of stock comp and 50% of principal activities expenses.  This is admittedly imprecise, but I want to ding FRE for some portion of these expenses.  With respect to valuation multiple, I would pay 12x pre-tax for a growing, leverageable, recurring earnings stream with little capital intensity (73% of AUM locked for > 8 years).

I have also tried to think about current valuation on an EV/AUM basis, a methodology that has been previously discussed on VIC.

Assuming 10% as a normalized EV/AUM valuation metric, suggests current value ~$20/share.  Again, the value driver here is growing: KKR has $20bn AUM that is not yet earning fees (1.3% blended rate plus carried interest) and has demonstrated consistent AUM growth over the past six years.

Another approach tracks the way management discusses the firm’s earning power: ROE as comprised of (a) balance sheet investment returns and (b) 5% to 10% ROE from fees and carry.  These two components have aggregated to high-teens to ~20% ROE since 2010 with little leverage.  KKR’s related performance targets are double-digit returns off the balance sheet investments combined with fees and carry to generated a mid- to high-teens ROE.  I visualize as such:

In terms of supporting management’s framework/assumptions for the returns-based valuation:

Again, this view of the business suggests ~$20/share or more of current value with all the relevant valuation drivers growing.  With respect to the compounding potential of current value, Nuttall framed it well in the 3Q15 call:

In short, KKR trades at a discount to a reasonable estimate of its current value.  An investor today receives KKR’s future carried interest and AUM/fee growth for free.  Intrinsic value will continue to accrue upwards.  While there is inherent cyclicality to the investment business, the enterprise is quality, generates attractive returns and is growing.  An investor willing to look through the intermittent ups and downs should accrue an attractive high-teens to 20% return over time.  

Lastly, I would also note that federal tax reform has been an issue overhanging KKR and the alt managers.  Clarity on this front could offer catalysis and revaluation.  To begin, taxation of carried interest as ordinary income would not affect the reported earnings numbers of the alt managers.  Whether the markets correct for net returns to the investor is a worthy debate (same effect occurred in 2013 with cap gains increasing 9% for top brackets).  Specific to KKR, I believe the full host of potential tax policy changes could significantly benefit KKR’s valuation.  The likely reality is KKR management (who owns 45% of the firm) will pursue whatever tact creates the most net value.  In this vein, because KKR is already effectively retaining 100% of net earnings (dividend covers taxes), KKR is unique amongst the alt managers in terms of the calculus to convert to a C-corp, which conversion would significantly expand the potential shareholder base and perhaps lead to index ownership; a dynamic likely to increase valuation.  My view on this issue is informed by the following tax analysis.  I am confident this analysis is not completely accurate (I am not a tax expert, and I welcome feedback to correct where I am astray), but my goal was directional correctness.  Moreover, this isn’t integral to the thesis.  

My assessment of KKR’s last three sample K-1s (numbers assume ownership of 10,000 units):

Caveat: the chart contains the primary line items for KKR’s domestic earnings.  The chart/data ignores the foreign transactions contained within the right-hand column of KKR’s K-1.  My assumption is the domestic data are sufficient for analysis as it relates to domestic tax policy.

The three-year averages suggest 56% of earnings are taxed at preferential rates under current tax policy, which moves to 30% of earnings taxed at preferential rates should carried interest shift to being taxed at ordinary rates.

Below is my effort to assess potential revised personal and corporate tax rates affect on the net earnings to KKR owners under (a) #1 - carried interest continues to be taxed at preferential rates and KKR remains a pass-through entity, (b) #2 - carried interest shifts to being taxed at ordinary rates and KKR remains a pass-through entity, and (c) KKR converts to a C-corp and pays the reduced corporate tax rate.

Assuming this analysis is generally accurate, the lower corporate tax rate supports a change to KKR’s corporate structure irrespective of whether carried interest continues to be taxed at preferential rates.  This is especially true given KKR retains the bulk of its earnings (versus the other alt managers who distribute the bulk of earnings) as the incremental net earnings can be reinvested in the business to compound over time.  For a long-term owner, the compounded tax savings would be substantial.  Ultimately, a second tax bill would come due assuming shares are sold by a taxable investor but I’d assume the above calculus is how KKR assesses the issue given the value of compounded reinvested tax savings, the various methods to effectively shelter ultimate taxes owed on KKR shares, and the upward revaluation benefits of being a C-corp (expanded shareholder base and potential index inclusion).  Any move to C-corp status could benefit KKR’s valuation.

Catalyst

• Continued monetization of current investments and balance sheet repositioning
• AUM growth - Asia III fundraising ($7bn target), direct lending strategies, etc.
• North Americas XII fund fees turning on, driving higher FRE
• Tax policy reform establishing clarity of tax status and/or driving C-corp conversion
• More positive domestic environment leading to better outlook toward alt managers