Description

There have been a number of VIC write ups on KKR, s0 I will do my best to restrict this post to ideas that are additive to the conversation.

Thesis Overview

The alternative asset management industry is a $10 trillion industry growing at high rates. If you speak with the CIO of any major pension plan or endowment today, he or she will tell you that the alternative space, in particular private equity, has been the best performing asset class over the last five and ten years. This has naturally fueled increasing allocations from existing investors and heightened interest from investors who are new to alternatives. Unlike traditional fund investments that can be redeemed on a quarterly or monthly basis, capital commitments to alternative investment strategies often have legal commitment periods of over eight years, creating very long streams of highly predictable revenue. Over the last fifteen years, KKR has grown AUM at nearly twenty percent per year, and in recent years, the growth has been even higher. It’s rare to find a company with contractually structured margins, ten plus year revenue visibility, and twenty percent growth trading at a reasonable valuation.

Difference to Peers #1: KKR Capital Markets

A feature unique to KKR is their in house capital markets business that provides capital solutions to both KKR portfolio companies and third party clients. These services which have traditionally been provided by an investment bank allow KKR to increase the economic capture in every investment across the firm, further amplifying the benefits to scale. From acquisition to IPO, a significant opportunity exists for KKR to generate fee revenue from transactions that are already occurring at the portfolio company level. In addition, there are several strategic benefits to having an in house capital markets business that extend beyond generating fees. Consider this example. In December 2016, KKR sought to acquire Calvin Capital, a UK gas and electricity meter asset provider, in a transaction that would require £600 million of equity and £400 million of debt. KKR would make the investment from their $3 billion Infrastructure II fund, which to remain appropriately diversified could only invest $250 million. Caught in this situation, many firms would be forced to either call a competitor to complete the deal, or participate in a broader bank-led syndication. Ultimately, having a sizable balance sheet and in house capital markets team allowed KKR to keep the asset from entering a competitive auction process by speaking for the entire deal, syndicate the remaining equity themselves and source attractive debt financing. In addition to earning $18 million in capital markets fees for this transaction, the equivalent of seven years of management fees, providing the equity syndication in house allowed KKR to maintain control of this investment while investing less than fifty percent of the equity.  KKR generated roughly $300m in after tax free cash flow from their capital markets business in 2018, and they business grew twenty-five percent year over year.

Difference to Peers #2: Balance Sheet Focus

Unlike their peers, KKR retains a significant balance sheet and is the single largest investor in all their funds. To provide some context, KKR has approximately $14.5 billion in balance sheet cash and investments (adjusted for recent market movements), which is more than Blackstone, Apollo, and Carlyle combined. This difference in business model is significant, increases the alignment of interests, and allows KKR to compound their own capital alongside limited partners. In addition, retaining a balance sheet with scale allows KKR to opportunistically size up compelling investments, support a world class capital markets business, and grow AUM at a faster pace by seeding new strategies or by doing strategic M&A. A prime example of how KKR has strategically used their balance sheet is their partnership with Marshall Wace. After meeting with over 250 hedge funds, KKR took a strategic stake in Marshall Wace in 2015, giving them access to the largest part of the alternative asset management space. When the deal closed, Marshall Wace had $20 billion in AUM which today has grown to $39 billion in AUM, tripling the growth rate of the broader hedge fund industry. Critically, KKR would not have been able to build a business like Marshall Wace in house over this period of time. Having a balance sheet with scale allowed KKR to identify a partner that was a top three player globally and participate alongside them.

Difference to Peers #2 Continued: Uniquely Similar -Berkshire Hathaway & KKR

Berkshire Hathaway’s history of shareholder value creation is well known to almost everyone in the investing community. Over the past fifty-four years under the leadership of Warren Buffett, BRK common stock has compounded at twenty-one percent per annum, returning shareholders 24,000x their invested capital. While much of this success is attributable to Mr. Buffett’s aptitude as an investor, a substantial structural tailwind exists for Berkshire Hathaway in the form of insurance float.  In short, because insurers receive premiums from their customers in advance of paying claims, an excess pool of capital is created. This excess pool of capital called “float” is a form of debt, i.e., money that is received today that will ultimately be needed to satisfy a future obligation. Berkshire Hathaway’s advantage comes in its ability to profitably write insurance over a very long period of time, effectively creating negative cost debt. As the world’s premier insurer, Berkshire Hathaway might sustainably write insurance at a ninety-five percent combined ratio, creating leverage at a cost of negative five percent. We can easily realize the power of this leverage by considering a hypothetical five-year $100 million investment made with fifty percent equity and fifty percent debt. If this investment were to double in value over the next five years, the unlevered return would be fifteen percent per year. However, by funding the investment with fifty percent debt at a cost of negative five percent, the equity investment would more than triple, leading to a levered return of twenty-six percent per year. At its peak, Berkshire Hathaway’s insurance operations wrote enough business to generate float that reached fifty percent of Berkshire’s book value, mirroring the economics of the example above. By managing third-party capital, KKR similarly leverages its balance sheet investments with negative cost debt. This form of negative cost debt is fueled by contractual management fees and incentive fees, and can never become a source of loss. This allows asset managers to safely leverage themselves as much as possible, something that would be imprudent for an insurer (and impossible from a regulatory standpoint). Today, KKR has $14.75 billion in balance sheet capital that is leveraged by $140 billion in fee paying AUM. At ten times levered, the economics of KKR’s leverage net of compensation expenses is strikingly similar to the Berkshire Hathaway example above. Furthermore, it is substantially more attractive than today’s Berkshire Hathaway which is only thirty percent levered with insurance float. Consider the illustration below.

Alternative Investment Managers: Inherently Anti-Fragile

It is common perception that private equity firms like KKR will experience substantial value impairment during a market selloff given the levered nature of fund investments. At a very basic level this ignores the fact that KKR has $60 billion of its $195 billion AUM in credit funds and $30 billion of its $195 billion AUM in hedge funds, both of which are strategies that should protect capital on a relative basis in a drawdown. But most importantly, this narrative fails to understand three counter-cyclical features to KKR’s business. First, over $100 billion of KKR’s AUM is invested in private fund structures. These structures are generally eight to twelve years in length, consisting of a four to six year investment period and a four to six year harvesting phase. During the investment period, management fees are charged on the capital commitment. This means that if an investor commits $500 million to the KKR Asian Fund III, they will pay a one and a half percent management fee on that full $500 million commitment over the first six years of that fund, irrespective of how much capital is drawn and irrespective of what the most recent fair value marks are. Once the fund moves beyond the investment period into the harvesting phase, management fees are paid on the cost basis of invested capital. The quarterly marked fair value of the fund could swing drastically between a 0.5x multiple on capital and a 3.0x multiple on capital, and it would have zero impact on the management fees paid to KKR. In fact, the cost basis of invested capital is only lowered through realizing an investment via sale or by the underlying company going bankrupt. Barring the latter, which is rare, a market drawdown generally extends the timeframe for realizing an investment thereby increasing the aggregate management fees paid. Second, $60 billion of KKR’s $195 billion in AUM consists of uncalled capital commitments that are deployed faster in a drawdown at valuation levels which will produce substantial incentives fees down the road. Consider the unit economics of $10 billion in private equity capital. If these funds are invested at a valuation that will result in a 2.0x gross multiple on capital, then a twenty percent carry rate would yield $1.1 billion in incentive fees net of compensation expenses. However, in a substantial drawdown, if we accept that KKR is able to deploy these funds at a valuation that would result in a 3.0x multiple on capital investment, then a twenty percent carry rate would yield $2.3 billion in incentive fees net of compensation expenses. In other words, for every $10 billion in dry powder that KKR deploys in a drawdown, it would earn nearly seven percent of its current market cap in additional incentive fees. Finally, KKR’s $60 billion in dry powder has latent value in the form of capital markets fees. When KKR deploys capital, there are regularly investments that are too large for a specific fund. Recall the Calvin Capital transaction discussed earlier. While the exact amount is unknowable, periods of increased acquisition activity would have positive effects on both KKRs own syndication fees and the third-party segment of their capital markets business. It would not be unreasonable to assume that a drawdown could produce an additional $200 million in capital markets fees, capital which could then be reinvested into attractively valued opportunities.

Valuation

I will first focus on KKR and then do my best to explain why I think KKR is substantially cheaper than any of their Alts peers. To some extent, all of KKR’s revenue streams are supported by growth in AUM, which has scaled at seventeen percent per annum over the last five years and twenty-six percent per annum over the last three years. This growth has enabled KKR to compound management fees at thirteen percent per annum while earning incentive fees each year that have ranged from 1.1x to 2.0x the level of management fees. Furthermore, KKR has more than tripled the level of capital markets fees over the last five years. Consider that a typical $10 billion private equity fund will earn roughly $1 billion in management fees over the life of the fund, and that a twenty percent carry rate and a 2.0x gross multiple on capital would produce an additional $2 billion in incentive fees. Also note that eighty eight percent of KKR’s third-party AUM is performance fee eligible. Thus, if we expect an average KKR fund to achieve a 2.0x gross multiple on capital over a ten year investment horizon, an outcome that would be a discount to historical performance, then we should also expect KKR to earn incentive fees that are 175% of their management fees. Furthermore, the proper terminal value for KKR’s fee revenue should reflect the potential future growth, duration of expected growth, and predictability of cash flows. Below I have outlined a base case scenario for KKR.

The assumptions in the scenario above, in my opinion, are very conservative and are worth calling to attention. First, I assume that over the next three years management fees grow at ten percent per annum. This is considerably slower than recent growth rates and does not factor in the $25 billion of AUM that KKR already has that is not yet earning economics. This uncalled capital alone could generate two years’ worth of ten percent growth in management fees. I then value the management fee stream at a 16x multiple, less than a market multiple. Second, I assume that incentive fees are normalized at eighty percent the level of management fees. This implies that half of KKR’s funds come out at the expected 2.0x gross multiple on capital, while the other half generate no incentive fees at all. I then value the incentive fee stream at an 8x multiple, half of a market multiple. Third, I assume that the capital markets business grows at twelve percent a year over the next three years and deserves at 12x multiple. This business is currently growing at twenty-five percent plus per year, has latent value built up in the form of uncalled commitments, and arguably deserves a sizable premium to a market multiple. Finally, I assume that KKR’s balance sheet is worth 1.0x book value. Altogether, these assumptions would yield a $39.4 share price, or a 77% premium to today’s price. We can also assess a more optimistic outcome for KKR by adjusting some of our assumptions. Perhaps the element that warrants some further explanation is how to properly value KKR’s balance sheet. KKR has $14.75 billion in book value that primarily consists of investments in their own funds, the same funds that hundreds of allocators around the world pay high fees to access. In addition, as part of their investments allocators accept liquidity terms that are eight to ten years in length. They are willing to accept these terms because net of fees they still expect their investments to outperform the market. The simple reasoning works like this. If an allocator expects the broader equity market to return eight percent per year with daily liquidity, then an alternative investment with ten year liquidity must provide returns of twelve percent per year net of all fees. In order for an investment fund to produce these net returns the gross returns must be in excess of sixteen percent per year, something KKR has bested over the last four decades. While this might sound difficult to repeat, there are many reasons why private equity and alternatives can be expected to sustain higher returns than a comparable public equity investment. Private equity investors add value by improving the operations of a business, have the ability to apply non-recourse leverage, and are able to arbitrage the private to public discount. If we assume that allocators are sensible to expect twelve percent net returns from their investments as a limited partner, then KKR’s balance sheet should be worth in excess of 2.0x book value. Below I have outlined a more optimistic scenario for KKR.

The scenario above values KRR’s balance sheet at 1.5x book value, projects three year growth rates that reflect current growth rates, assumes an incentive fee level that implies an average fund performance of 2.0x gross, and gives proper credit to the quality of KKR’s revenues. This would result in a share price of $63.31, or a 184% premium from today’s price. There is one final way I think about valuing KKR. An interesting question to consider is, “What is a fair price to pay for an investment that can be counted on to beat the market by several hundred basis points per year?” With the benefit of hindsight, many investors correctly point out that such sustainably great businesses are perennially undervalued by the market. Throughout their public histories, there was practically no valuation too high to pay for companies like Berkshire Hathaway, Amazon, and Walmart. It seems that no matter the circumstances, Mr. Market’s DCF will assume regression to the mean some years into the future for any business earning abnormally high returns on capital. Would it really have been reasonable to pay 100x earnings for Walmart in 1975?  Knowing what we do today, the answer is undoubtedly yes. I would argue that KKR’s business model is one that lends itself to unusually predictable long-term outperformance. Over the last twelve months, KKR earned $1.2 billion in after tax free cash flow from fee revenue. They also have $14.75 billion in adjusted book value. This means that at present, KKR’s book value starts off with a 800 basis point head start over the market. In looking at the history of KKR, we also see evidence of this advantage coming to light. When adjusted for dividends, KKR’s book value has compounded at twenty-three percent per annum since their inception as a public company. This compares to eleven percent per annum for MSCI ACWI or a 1200 basis point differential. This outperformance was not only a result of reinvesting the fee income, but also from making underlying investments that outperformed the market. Below I have shown a table of what KKR’s share price should be worth based on the level of outperformance and the duration of outperformance.

You can see that as outperformance and duration increases, the value of KKR’s shares rises dramatically. In this respect, the feature unique to KKR is the tremendous duration of fee revenue, which ultimately drives their ability to sustainably outperform the market.  KKR is forty-two years into building a global investment franchise, and the business today is as strong as it has ever been. Given this backdrop and the advantageous structure described above, I believe KKR’s book value could easily be expected to outperform the broader equity market by 700-950 basis points over the next twenty to twenty-five years. Weighted evenly, these scenarios would yield a value of $87.37, or a ~4.0x from today’s share price.

Valuation Relative to Peers

When discussing alternative asset managers, I can’t tell you how times the conversation ends with “why don’t you just buy Blackstone”?  At this point in the conversation, I just have to scratch my head.

The table above shows important metrics for Blackstone, Apollo, Carlyle, and Brookfield. A crude way of accessing the value of an Alt is looking at the ratio of fee paying AUM to market cap. In this instance, the higher the multiple the better. You can see that even without adjusting for the owned book value, KKR trades at nearly the same multiple as Blackstone. Another simple metric would be the ratio of all non-performance based fess to market cap. On this measure, without adjusting for book value, KKR trades at a better valuation than every alt except for Apollo. When you do adjust for book value, KKR trades at a yield that is roughly 5.0x the peer group. It’s also worth noting that more than eighty percent of KKR’s fee paying AUM is performance fee eligible. This compares to fifty-seven percent for Blackstone and a low-sixty’s percentage for many of the other alts.  The last column on the table above shows the five year CAGR of fee paying AUM. KKR leads the group at nearly thirteen percent. Even though management sells a good story, the odds are against you when you are nearly $500 billion in AUM. KKR and many of the other alts will have a tremendous fundraising advantage by simply being able to sell the story to LPs that they are still much smaller than Blackstone.

Catalyst

(1) Book Value Compounding. (2) Increased understanding in investment community