Description

Anyone on VIC knows that asset management is, or at least can be, a very attractive business model. With very low fixed costs a small group of people can control a large amount of assets on which they charge (often very high) fees, resulting in massive returns on capital for the asset manager. These businesses are particularly attractive when clients have to lock up their money for a long time, and therefore the fee streams aren’t going away any time soon. As this rather extreme example from the FT a few years ago shows, this usually works out well for the asset manager:

Mr Buffett’s fortune has come not through growing an investment management business, but from his own share in the value of the funds he manages. Suppose he had adopted a more conventional investment management structure, charging the 2 per cent management fee and 20 per cent of performance common in private equity and hedge funds. How much of that $62bn wealth would have been the property of Buffett the manager – Buffett Investment Management – and Buffett the investor – the Buffett Foundation?

The answer is astonishing. At “2 and 20”, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation.

http://www.ft.com/intl/cms/s/0/1ee8f0fe-ef8b-11dc-8a17-0000779fd2ac.html?siteedition=intl#axzz3KhH9JjND

While most investors intuitively know that this business is a good one, what surprises me today is that you can become a shareholder of some of the most successful and profitable asset management firms of all time at very reasonable valuations.

Specifically I believe KKR is an attractive investment today, with the current price offering a low valuation for an attractive, growing, and well-managed business. Since 1976 KKR has been a pioneer in the private equity world and today manages $96 billion in assets across a variety of funds and strategies. By buying the stock you essentially get exposure to a portfolio of on balance sheet investments as well as the earnings generated by KKR managing third party assets. KKR stands out in that it has the largest balance sheet amongst its peers, which provides meaningful downside protection to the investment and also allows the company to invest significantly alongside its clients and seed or purchase new products to sell through its global fund raising machine. Despite strong growth, industry tail winds, and the likelihood of significant incentive fees in the coming years, most of the current stock price can be justified by the company’s balance sheet investments and KKR’s recurring fee streams, and there is significant potential upside from incentive fees and continued growth.

Alternative Asset Managers (“AAM’s") Generally

Skip ahead if you want to get to KKR, but I wanted to start on the sector as a whole as I believe the space offers several attractive opportunities today for the following reasons:

1. Alternative investments are steadily gaining market share of the total investment universe

2. Large managers are gaining share within the alternative space

3. Both 1 & 2 are likely to continue

4. The large AAM’s are run by some of the most successful capital allocators in the world

5. AAM’s have diversified product lines with capital that is generally locked up for several years

6. These companies trade at a valuation discount vs traditional asset managers and the market as a whole

Last year McKinsey put together an interesting report on the asset management business that is worth a read if you are interested in these businesses: http://dailyalts.com/wp-content/uploads/2014/08/McKinsey-Company_2014_Capturing-the-Next-Wave-of-Growth-in-Alternative....pdf

Some interesting data points from the report:

• From 2003 to 2013 alternative investments grew from 5% to 11% of the overall investment universe

• The three main alternative subcomponents - private equity, hedge funds, and real assets – each grew at between a 9% and 11% CAGR over that time, compared to 5% for traditional investments

• Three quarters of institutional investors expect to maintain or increase their alternative allocations over the next three years

• Market share of alternatives will increase to 15% by 2020, increasing total alternative AUM from $7.7 trillion today to $14.7 trillion

• Between 2008-2013, mega alternative firms increased their share of the alternative market from 10-15% at the expense of smaller boutiques and specialist firms

Obviously take all of the report’s specific predictions with a huge grain of salt, but regardless it’s clear from looking at the #’s that large alternative asset managers have a nice tailwind behind them.

Interestingly a number of these companies have been written up on VIC in recent months, as shown in the table below. In addition to the large AAM’s, I’ve included a few other non-traditional asset managers that share some similarities (particularly their long-term, locked up capital):

What’s Misunderstood with AAM’s

I think there are several reasons why some of these companies might not be fully appreciated by investors and therefore mispriced today. Despite in theory having simple business models, the actual stocks are structured as publicly traded partnerships which requires unit-holders to deal with K-1’s, which likely limits the universe of potential buyers (using swaps is a potential work around to this, at a price). The GAAP financials are also hard to discern and basic info like the share count often shows up incorrect on places like Bloomberg and Google Finance. The public floats are small as a large chunk of the economics remains in unlisted, insider share classes that will gradually move over to the public markets over time.

Finally I believe the market underappreciates the incentive fees these companies are likely to earn in the future, and therefore places a very low multiple on that fee stream due to its unpredictability. To me it’s a classic case of the difference between risk and uncertainty – these companies, with some of the smartest investors in the world controlling dozens of funds across various strategies and asset classes are almost certain to generate a significant amount of incentive fees in the future. Most of these companies generate large incentive fees every year, and the amounts are growing, but since it’s impossible to model precisely most analysts put low multiples on that stream of earnings – Goldman uses an average of 5x for example. I’ve also seen analysts make the mistake of assuming that incentive fees are based off a single fund’s performance (“if all of Blackstone’s funds return 10%, then incentives will be $XYZ…), which misses the fact that they have a large number of funds that each have a chance to earn incentive fees, and therefore the likelihood of overall incentive fee creation is greatly increased. A portfolio of call options is more valuable than a single call option.

KKR’s Business Today

KKR has evolved in recent years, moving away from what was a very PE-centric model towards a truly global, multi-asset class platform:

This diversified platform allows KKR to be opportunistic in raising capital depending on where global markets are offering opportunities. For example last month Henry Kravis highlighted opportunities in energy, real estate, and international markets like Europe and Asia as areas of particular focus today. Even if certain markets get over heated, there are typically opportunities somewhere in the world for which capital can be raised to take advantage of. Over half of KKR’s teams today are outside of the US, and the company has also steadily grown its public markets business:

This public markets growth includes the recent merger with KKR Financial (KFN), a specialty lender that was previously listed on its own but is now included on KKR’s balance sheet. KFN was written up three times on VIC historically so I would suggest looking at those for more background. The short story is that the KFN purchase provides KKR with diversifying exposure to credit investments that it knows extremely well, given that KKR managed and underwrote all of the assets previously. The company expects the assets they bought to generate 10-11% returns, which can then be redeployed into higher return opportunities as the investments gradually roll off. The portfolio also came with $1 billion of perpetual preferred and long-dated debt securities, with no maturities until 2036. Given the relatively reliable stream of cash flow from KFN’s portfolio, KKR plans to pay out 100% of the gains from that portfolio as part of its quarterly distributions. KKR only pays out 40% of its gains from its non-KFN balance sheet investments, so this move meaningfully increased the dividends that unit holders can expect to receive.

KKR’s overall asset raising continues to be strong, with new raises keeping up with the large amount of capital the company has given back to clients in recent years. Overall AUM has grown significantly through the appreciation of KKR’s investments as well as through acquisitions:

KKR continues to have a strong brand with institutions and is also rapidly growing its high net worth distribution, with almost $5 billion of capital raised in 2013 coming from individuals, largely through third party distribution relationships.

Valuation

On a fully diluted basis and including the unlisted shares, the company has a market cap today of $20.6 billion. The balance sheet has $10.6 billion of net asset value, although $1.2 billion of that is in accrued incentive fees not paid out yet, which we’ll exclude for now to avoid double counting. I believe that’s rather conservative, as you would clearly pay more for a company that has those incentive fees accrued then one that does not (all else equal), but it’s relatively small anyways and leaves us with $9.4 billion worth of investments into KKR’s various funds and deals. Given KKR’s extremely strong historical performance (26% IRR on all of their mature PE investments since inception) counting this at NAV seems reasonable, and leaves us paying $11.2 billion ($20.6 - $9.4) for the remainder of the business.

For the remaining $11.2 billion that you are paying net of investment value, you get KKR’s stream of earnings, which includes management fees, advisory fees from a growing capital markets business, and incentive fees. In the past 12 months KKR generated $319 in after tax “Fee Related Earnings”, which excludes incentive fees earned. Large mutual fund companies – which as a whole feature very liquid products with mediocre investment results - are trading at an average of 18x, and if you apply that multiple to KKR’s FRE you get $5.7 billion in value.

So versus a market cap of $20.6 billion, you get $15.1 billion of value from the investments ($9.4 b) and relatively predictable, recurring FRE ($5.7 b), which represents three quarters of the stock price today. That $15.1 billion in value should grow nicely from here between KKR’s balance sheet investments appreciating and the fee streams from third party asset management continuing to grow. It’s impossible to be predict with precision, but for one guess Goldman estimates that FRE will increase 40% in 2015 over 2014. If that estimate is correct and KKR’s balance sheet investments grow by 10% by the end of 2015, the value of balance sheet investments plus FRE at year-end would represent 90% of the current stock price. That would mean you are paying around $2 billion for KKR’s incentive fee stream, and here is what the company has generated in incentive fees in recent years (pre-tax):

Barring a major market drop, incentive fees are likely to remain strong and possibly grow in the next couple of years given where in the cycle KKR’s funds are at the moment. It wasn’t until 2014 that all of KKR’s funds became eligible for incentive fees and they have several large funds currently in harvest mode:

Yes, I'd say just more broadly on the topic, we still think there's a lot of embedded value in the portfolio as you think about our ability to generate cash carry going forward. I mean, as a reminder, 12, 15 months ago, we had about 35% of our private equity funds paying cash carry. Now it's virtually 100%. And so if you look at the makeup of the unrealized value in that private equity portfolio that's now paying cash carry, we have, boy, over $20 billion of its marked at 1.5x or greater. And about 45% of it – of the unrealized value is from 2008 and prior vintages. And so obviously, these companies are getting more mature. It's part of the reason you've seen our cash carry increase so significantly. But the good news is that there's plenty left to go.

– KKR Exec Scott Nuttall on Q2 2014 conference call

While sum of the parts is my preferred valuation method, the stock looks cheap on other metrics as well. KKR pays out the majority of its cash earnings and on an LTM basis has a dividend yield of 8.2%. Using Goldman’s 2015 estimates it would be 9.7% this year. In terms of P/E the company trades at 8.5x LTM “Economic Net Income”, the standard earnings metric used by the AAM’s.

Business Model

KKR’s business model is a bit unique amongst the AAM’s given the size of its balance sheet – it has the largest absolute $ amount of investments on its own balance sheet, and by far the largest as a % of market cap. This provides downside protection for the investment and also helps KKR invest permanent capital alongside its clients and seed or purchase stakes in other asset managers. This is a strategic advantage for the company as it gives it flexibility and firepower to start new products and attract outside capital to them. KKR’s growing capital markets business is another nice complement to the core business, letting the company earn additional fees for large deals it syndicates out to other investors. A good example is the $3.5 billion capital raise for First Data that occured last year. KKR put $700 mm from its own balance sheet into the deal, $500 mm of its clients’ capital, and placed another $1.8 billion using the capital markets team, which earned KKR a $40 mm fee. Management has publicly stated that they view all three parts of the business – third party capital, balance sheet investments, and capital markets – as important pieces over time. They think they can add an incremental 5-15% of ROE on top of their underlying investment returns by managing third party capital and utilizing the capital markets team. Finally the alignment of interest is strong with employees owning 46% of the shares today.

Risks

• Market sensitivity - All asset managers have inherent operating leverage and are quite sensitive in the short-term to market movements. If another 2008 type market occurred both KKR’s earnings and multiple would take a meaningful hit, and it would likely be a much better time to buy the stock then versus today. If you’re particularly worried about the market there are various ways to consider hedging that seem like attractive relative bets, including high yield CDS and/or poorly positioned active mutual fund companies (in my opinion, as a whole the AAM’s are trading at lower valuations, are growing faster, have superior business models, and have better management teams than the “traditional” mutual fund managers.)

• Active management generally – I have mixed feelings about many providers of active management, and tend to agree with Charles Ellis who once said “Seen correctly, active management may be the only service ever offered that costs more than the value delivered.” (I like that quote so much I chose to overlook the irony of including it in this active investment write-up…). While it makes them very profitable businesses, too many asset managers get paid too much relative to what they ultimately give back to their investors. Fortunately the large AAM’s like KKR do seem to truly add value for their clients and generally operate in less efficient markets like private equity. I wouldn’t be surprised if the investment universe becomes increasingly barbelled with low cost passive options (Vanguard, iShares, Wealthfront, etc.) and truly active managers like the AAM’s continuing to grow at the expense of traditional active strategies like mutual funds, which have been well documented to not add any value to anybody but themselves, in aggregate (and obviously with individual exceptions).

• Buybacks – with lots of cash, a cheap stock, and smart capital allocators at the helm, I wish KKR would buy back shares but they and their peers generally have not. I suspect they want to see their floats increase. Shareholders, including Leon Cooperman on the last conference call, have pushed them on this and it’s possible this could change in the future.

• Taxes – cap gains increases and/or changes in how carried interest gets taxed would have an impact

• Succession - Kravis and Roberts are 70

• Monitoring fees/Capstone – KKR does keep some of the fees it generates from monitoring and working with its portfolio companies, including to a related third party called Capstone that provides consulting services to its companies. These practices seem to be increasingly under fire by investors.

• Concentration – While KKR is actively diversifying its business, it still is heavily exposed to PE and to a few specific deals like First Data in particular

Conclusion

I believe KKR offers one of the best risk/returns in an attractive, growing space with long-term tailwinds. The company’s significant balance sheet provides downside protection and provides the business with competitive advantages relative to its peers, while the potential upside is attractive given KKR’s likely incentive fee generation and continued AUM growth in the coming years.

Catalyst

• Incentive fee generation
• Continued growth and large dividend payouts