KPE is currently trading at a DISCOUNT to its NAV. This irrational valuation implies that this KKR fund will generate the worst investment returns in the firm’s 30-year history.  This stable, liquid asset trades at a substantial discount (peers trade at an average of 1.27x book), offers significant downside protection, has near-term catalysts and holds upside potential of 26%-68% (valuation below).  Furthermore, KPE represents an overlooked opportunity to participate in the rapidly growing slate of LBO mega-deals at a price that assumes a worst-case scenario of single-digit IRRs and with the ability to hedge credit-market risks through CDSs.  While this investment opportunity is not a “double” or “triple”, we believe the high margin of safety and extremely upward-biased payoff structure allows investors to aggressively size an investment in KPE to generate outsized dollar returns.

 

There are four key misperceptions underlying the current valuation:

 

(1)    “Dead money”: Public investors are myopic and place a “dead money” discount on this type of vehicle until capital is fully deployed.  There is a fear that it will take longer for KKR to deploy the capital than the timeframe KKR management has indicated.  Most peers have followed a similar trading pattern subsequent to their initial offerings, and have subsequently traded up to an average of 1.27x book value once capital is fully deployed.  We believe KKR will deploy KPE’s capital well within the timeframe to which they have publicly committed; moreover, we are confident that KPE will assume 20% to 40% leverage on top of its equity base to allow investors to enjoy the benefits of having significantly more capital working for them at an attractive cost of capital.

 

(2)    Anemic returns: An investment in KPE affords public market investors (with a ~10% cost of capital) the opportunity to earn a private market return (~15%+) with the twin benefits of liquidity and hindsight.  We believe (and demonstrate below) that this arbitrage deserves a premium.  The single-digit IRR implied by the current price of KPE is irrationally pessimistic, even after accounting for concerns that KKR is a much bigger firm than it used to be in its “good old days” and operating in a more competitive environment.  With an implied single-digit IRR implied at the current price, you are buying KPE on worst-case expectations and, whether IRRs are 15% or 50%, your payoff is tilted heavily towards the upside (especially when you consider the KPE leverage that will provide further juice to that IRR). 

 

(3)    “Flat” NAV: Investors are helped along by KKR’s practice of marking their private investments to market on a quarterly basis—KPE’s book value will accrete steadily even in the early years of investment (and hence book value will grow faster in the early years than the “at cost” accounting anticipated by the market).  In the coming quarters, as KPE moves rapidly towards being fully invested this year, we expect that IPO exits will begin to occur and—if met with early success—to accelerate.  The pace of NAV accretion should consequently pick up considerably towards the back half of 2007.

 

(4)    KKR incentives: Investors are wary of KKR’s incentives and ability to exploit unit-holders because units have no voting rights (Merrill Lynch analyst applies a 10% discount to valuation because of this lack of control).  The market fails to realize that this public vehicle is KKR’s “holy grail”—a path to freedom from the traditional cycle of fund-raising—and KKR management is completely agnostic economically between their private funds and KPE.  KKR is therefore more motivated than the market realizes to put KPE’s capital to work and making it a success.  Moreover, note that typical limited partners.

 

At the current price, investors are buying into KKR’s investments at a lower price than the firm’s limited partners (in addition to receiving the benefits of liquidity, hindsight, and—in the not so distant future—leverage), while receiving a FREE OPTION on (a) deal activity over the next 3-6 months and (b) on KKR’s ability to generate private-market IRRs in excess of the public-market investor’s 10% cost of capital (a prospect that we think is highly likely).

 

 

 

The current valuation of KKR Private Equity Investors, L.P. (“KPE”; ticker: KPE NA) implies that at least one of three events occurs:

 

(1)    that KKR fails to generate a private-market return on investment in excess of public investors’ cost of capital (something that has not happened in the firm’s 30 year history—we believe this is highly unlikely, no matter how jaded one’s view of the LBO market or KKR might be);

 

OR

 

(2)    that it takes KKR significantly longer than expected to put KPE’s capital to work (an assumption in direct contrast to management’s recent comments, the rapid pace of recent capital deployment, and the fund’s virtually limitless access to today’s generous debt markets).

 

OR

 

(3)    that the current liquidity boom comes to a crashing halt, likely spurred by default events at particular, highly-leveraged buyout names (we believe this is possible and a real risk, but can be easily and effectively hedged through credit default swaps, as discussed below).

 

We believe the focus is on the second factor (“dead money”); the third factor is an important one, but doesn’t prevent peers’ securities from trading at a 8%-44% premium to NAV, so we must assume that KPE’s discount to NAV stems from firm-specific factors.  We see this “dead money” discount dissipating during 2007 as KKR puts the remainder of the fund’s capital to work, IPO exits begin to materialize, and NAV accretion accelerates.  This should allow KPE to trade at an appropriate 20-40% premium to NAV.

 

 

Any discount to NAV is irrational considering the following:

 

(1)    The current implied expectation of a single-digit return on capital in the private market is unreasonable (this has never happened for a KKR fund).

 

(2)    Robust debt markets are facilitating high return investments.

 

(3)    KPE’s peers all trade at a 8%-44% premium to their NAVs – e.g., KKR Financial (KFN), Apollo Investment Corp (AINV), Candover Investments (CDI.LN), SVG Capital (SVI.LN).

 

(4)    The fund had already successfully deployed $2.5B as of January 2007 (meeting internal targets).  In March 2007, management noted that it expects to have funded a total of $3.3B (66% of KPE’s total capital) of investments by June 2007, based on deals that have been announced but not yet funded.  This figure does not include: $500MM KPE will be contributing towards the $45B TXU buyout; $350MM it will be contributing to the $7B Dollar General deal; approximately $500MM KPE will be contributing towards the recently-announced First Data deal.  Any additional deals announced between now and June would represent further capital deployment above this aggregate $4.65B figure.

 

(5)    KKR plants to implement an “overcommitment” strategy for KPE, adding leverage as necessary to exploit the lower cost of debt at the KPE level versus portfolio company level.  The total leverage will likely be in the $1B-$2B range.  At the current pace of capital deployment, we believe this is extremely likely and a positive factor, significantly increasing the amount of capital working for KPE investors and providing a boost to IRRs.

 

(6)    We have the benefit of hindsight to assess existing investments (not available to a private equity LP investing at par).

 

(7)    The value of daily liquidity – again, an advantage over a private equity LP.

 

 

The primary near-term catalysts will be the completion of the capital-deployment process and the initiation of exit activity.  At current levels, KPE offers the opportunity to own a free option on these events.  In January, KKR management stated that that they have already funded $2.5B of investments and expect to fund an additional $800MM by June 2007 in deals that have already been announced—that represents a total of $3.3B (66% of KPE’s capital) of investments funded by June 2007.  The inclusion of $500MM to be contributed to the TXU buyout, $350MM to be contributed to the Dollar General buyout, and what estimate as a likely $500MM contribution to the First Data buyout bring the total to $4.65B (93% of KPE’s equity capital).  We anticipate the announcement of more large LBO deals with KKR’s involvement over the next 6 months, funding of which would be incremental to the $4.65B figure, and would require KPE to take on leverage as management has indicated it plans to do.  As the capital becomes fully deployed, we expect investors to stop worrying about the “cash drag” on KPE and start giving it credit for some reasonable future return (as opposed to the single-digit IRR implied at current prices).  We believe that if KKR’s performance on KPE’s capital is a bust, investors at current levels get their money back; if KKR delivers mediocre returns (~15%) on KPE’s capital, investors see 30%-40% upside; and if KKR delivers outstanding returns (as it has done in the not so distant past), investors own an option on what could be a double.

 

 

 

Our 1.2x book initial price target requires no heroic return assumptions, but merely that KKR is able to deploy the fund’s capital over the reasonable timeframe that they have publicly declared (and recently reiterated).  Beyond this 23% re-rating, there is additional upside to the shares if one just assumes that KPE will not represent the worst investment performance in KKR’s 30 year history.

 

Given the firm’s long-term track record and particularly exceptional returns from mega-buyouts, one might reasonably assume that KPE’s returns will be at or above the lowest return generated by any of KKR’s recent funds (+18%).  We believe these returns will drive NAV at a favorable annual rate over the next 3 to 5 years, creating additional upside well above our near-term valuation target (to as much as $54 per share).

 

We have confirmed that KKR will, as described in KPE’s filings, be valuing each investment and marking the entire (public AND private equity) portfolio to market on a quarterly basis.  This quarterly mark-to-market allows investors to benefit from a gradual increase in NAV as returns accrue over the life of the investment rather than imposing a three to five year wait until each investment is exited.  Future exits and IPOs will serve as longer-term catalysts for additional appreciation as KKR demonstrates its proven ability to realize value from its investments. 

 

In the near term, we expect to see exit events by the third quarter of 2007, which should accelerate NAV accretion considerably and also bolster investor sentiment as KKR demonstrates its ability to create liquidity events.  Based on KKR’s past modus operandi, we are confident that if the first one or two exit events are successful, KKR will move quickly to capitalize on market receptiveness and accelerate the exit process for the portfolio.  We have not accounted for this factor in our projections and hence expect upside from exits in the back half of 2007.

 

KKR management’s incentives are well aligned with those of KPE unitholders.  KKR management bought $75MM of KPE units alongside the initial offering with a 3 year lock-up.  In addition, 25% of KKR’s ongoing carry/incentive compensation from KPE is automatically reinvested into newly-issued units of KPE (at the prior 10 day average price), also with a rolling 3 year lock-up.  Our discussions with KKR team members and executives have also made it clear that the success of KPE is a high strategic priority for KKR’s top management, given the permanent capital source that it represents.  The management team’s compensation terms in KPE are exactly the same as the terms of their compensation from KKR’s other investment vehicles; however, management owns a significant number of units in KPE, making them more likely to make KPE’s success a high priority.  Lastly, KKR’s management is going to do everything within their abilities to ensure that their high profile investment vehicle does not experience a public failure.

Based on KPE’s peer universe (below), its shares should already be trading at a 20%+ premium to book, implying a fair value of $29.82 per unit or 23% appreciation from current levels.  Note that on the most recent earnings call in late March, Henry Kravis indicated that the NAV as of March 31, 2007 should be in excess of $25 (the offering price for KPE units), suggesting that our projections are somewhat conservative.

 

 

Our Expected scenario (see Assumptions section below) implies a 2008 target price of $34 (48% upside), while our Low scenario implies a 2008 target price of $31 (34% upside).  Our High scenario, in which KPE achieves rates of return in line with KKR’s more successful funds, implies a 2008 target price of $39 (70% upside).

 

 

Investors are afforded exceptional downside protection from the following factors:

(1)    Current discount to KPE’s net asset value;

(2)    KKR’s track record and high-quality team;

(3)    Likelihood that KKR would buy back units if they started trading at a deeper discount.

 

 

We believe that, based on quality of investment team and track record, the most comparable securities are AINV and SVI—KFN is a REIT with different market dynamics, while the other firms do not have the same quality or length of track record that KKR, Apollo, and Permira enjoy.  Given AINV’s focus on mezzanine debt, which has lower expected returns than equity, KPE should in fact be trading at a premium to this comp, while SVI is not fully valued yet because it has only ~88% of its capital currently invested (and hence suffers from the same “dead money” discount that afflicts KPE).

 

Below we lay out some basic math to demonstrate WHY a security like KPE should trade at a premium to book value.  The rationale is that, like any other security, KPE should be valued on the basis of future expected “earnings” – in KPE’s case, “earnings” consist effectively of the accretion to NAV in each period.  If one assumes a 10% cost of capital for public market investors, the key driver is expected future return on KPE’s capital – as long as one believes KKR will generate an IRR in excess of 10% on KPE’s capital, the delta between the expected rate of return and the cost of capital implies that the present value of the security lies at a premium to NAV.  We have laid out two methods for determining the forward-looking valuation of KPE – in both cases, we have used a 15% expected IRR (which we believe is highly conservative, given that KKR’s worst performance in its 30-year history was an 18% gross IRR on its 1996 fund).  With these assumptions, KPE units should be trading at a 25% to 36% premium to current NAV.  We would emphasize that our bullish view on KPE does not require you to make any bullish assumptions on the returns KKR will generate – as long as you don’t believe that KKR will lose money, you will at worst get your money back and, if KKR generates a return in excess of 10% (our estimated long-term cost of capital in the public markets), you will make a lot of money in a highly likely range of positive outcomes.

 

 

 

 

 

We have projected KPE’s performance under various scenarios, with three main variables:

(1)    Duration required for full deployment of capital.

(2)    Returns generated on capital deployed.

(3)    Asset allocation across KPE’s defined classes of investment.

 

 

Our return assumptions in the low scenario ($31) are below the performance of any KRR fund over the firm’s thirty-year history, while the expected scenario ($34) reflects modest assumptions well within the historical average range.  Even the High scenario ($41) return assumptions reflect an upside scenario that is still considerably lower than the historical returns achieved by KKR’s most successful funds.

 

 

Note also that the lowest gross IRR achieved on any of the seven funds sponsored by KKR prior to 1997 was 12.1% (2.1x invested capital) and the highest was 48.1% (17.1x invested capital).

 

In all scenarios, returns are weighted along a J-curve so that the bulk of returns are accrued toward the latter years of the average five-year life of each investment.  In addition, per Company guidance, realized cash returns are re-invested in subsequent years, net of carry and planned distributions to fund estimated tax obligations for U.S. unitholders.

 

 

We believe the investments KPE has made to-date reflect a good mix of risk and return potential:

 

 (Notes:

- An “A” rating under Return Potential denotes high expected returns, based on our subjective assessment of sector and company prospects and purchase price

- An “A” rating under Risk denotes low risk, also based on our subjective assessment of sector and company prospects.

- In addition to the direct co-investment, the amount of investment above includes, wherever the information is available, the amount of capital funded to a deal through other KKR funds.)

KPE’s recent investment in Sun Microsystems senior convertible notes provides a compelling case in point of the high priority KKR places on making KPE a success.  Rather than distributing the deal pro rata across its various funds, KKR chose to do the deal entirely through KPE, making it clear that the management team has made it a priority to deploy KPE’s capital according to the timeline that has been publicly declared.

 

While many market commentators speak of the growing competitiveness of the LBO market, we would highlight two key points:

 

(1) The market for private equity transactions has shown no signs of weakening.  Given KKR management’s stated intention of deploying the remainder of KPE’s capital before the end of 2007, we do not expect to be exposed to any potential long-term decline in the availability of deals.

 

(2) As mega-buyouts and club deals have increasingly become the norm (and will likely be the means through which the remainder of KPE’s capital is deployed), it is worth noting that KKR’s recent run of mega-buyouts has included some of the most successful deals in the firm’s 30-year history.

 

 

While there is the possibility that the IPO market softens over the next year or two, the majority of public market exits on KPE’s investments would likely not occur until 2009 or 2010 (typical 3-5 year investment horizon), by which time we would expect a cyclical rebound in market activity.  Moreover, our primary thesis on KPE is agnostic to the timing and success of exits, and rests primarily on KPE’s ability to deploy the remainder of its capital in a timely fashion and eliminate the current “dead money” discount on its unit price.  To the extent that some of the Millennium Fund investments are taken public in the back half of 2007, that would provide upside to our projections and target price. 

 

 

The recent significant debt issues related to large buyouts (e.g., HCA, FSL) has shown that the credit markets remain buoyant, maintaining a healthy appetite for high yield debt.  Any future softening of this demand will simply mean less leverage on deals, which would dilute returns.  However, we believe that the current valuation is actually pricing in the highly unlikely destruction of capital.  Any reasonable return assumptions are sufficiently conservative as to allow for such potential future dilution given the current valuation.  While we view this ias the most significant risk to an investment in KPE, investors can hedge against the risk of a credit market collapse by purchasing credit default swaps (CDSs) on some of the riskier, well-known buyout names (e.g., Freescale Semiconductor – FSL) or on some basket of KKR deals.

 

 

KKR Private Equity Investors, L.P. is a Guernsey-registered limited partnership (“KPE”) listed on Euronext Amsterdam (ticker: KPE NA).  The initial offering of 200 million units (more than three times the number presented in the offering memorandum) took place on April 21, 2006 at a per-unit price of $25.00.  There are currently 204.55 million units outstanding. 

 

KPE invests in KKR-sponsored and managed investment opportunities, divided across four defined classes:

 

(1)    Class A: Opportunistic and/or temporary investments, comprised of (a) public securities on which KKR develops an edge through its work on particular deals or sectors, and (b) “temporary” (i.e., cash management) investments.  As of December 31, 2006, KPE had $158MM in non-cash Class A investments at a cost of $154MM.  In Q4, KPE exited one major position ($194MM cost) for a gain of $33MM.

 

(2)    Class B: Direct co-investments in transactions undertaken by and portfolio companies of other KKR funds.  As of December 31, 2006, KPE had $958MM invested in five deals (NXP, VNU, Capmark Financial, HCA, KION Group), and in the first quarter of 2007 invested $784MM directly into Sun Microsystems ($350MM), PagesJaunes Groupe SA ($235MM), ProSiebenSat.I Media AG ($199MM) during the first quarter of 2007.  In addition, in the first quarter of 2007, KPE committed to $750MM of co-investments in TXU Corp., Dollar General Corp., Biomet, Inc., and Laureate Education, Inc..

 

(3)    Class C: LP interests in other KKR funds.  As of December 31, 2006, KPE had drawn down $271MM to KKR European Fund, $165MM to KKR Millenium Fund; $56MM to KKR European Fund II, and $140MM to KKR 2006 Fund.  KPE also had unfunded commitments of $1.675B to these funds ($475MM of which is related to TXU Corp., Dollar General Corp., Biomet, Inc., and Laureate Education, Inc.). 

 

(4)    Class D: Investments in non-private equity investment funds sponsored by KKR.  As of December 31, 2006, KPE had drawn down $77.5MM to KKR Strategic Capital Institutional Fund (credit fund), with an addition $58.3MM drawn down in the first quarter of 2007.

 

 

 

 

(1)    Deal announcements / further deployment of remaining capital/assumption of leverage

(2)    Reported increases in NAV will correlate highly with share price increases

(3)    IPOs and other exits

(4)    Analyst coverage as capital deployed increases

(5)    Positive returns on investments

(6)    Potential interest rate reductions by the Fed (lowering cost of capital)