Description

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Investment thesis

KKR & Co. LP (KKR) is a publicly listed alternative asset manager with $114bn of Fee Paying AUM (FPAUM) incorporated as a partnership. The partnership invests on behalf of clients, or Limited Partners (LPs), in a range of investment strategies, including private equity, real assets, special situations, and different types of credit strategies. The alternative asset management business can be an incredibly profitable business; KKR has a strong economic model and one of the strongest brands in the business. The partnership has recently generated between $500mm and $1.5bn+ of Economic Net Income (ENI) (the variance is due largely to volatility in performance fees) in any given year with 1,178 employees and no capital expenses. The partnership’s founders Henry Kravis and George Roberts are now each worth an estimated $5bn having started the firm 40 years ago with a $400k working capital check. Despite the inherit attractiveness of the business, KKR trades at the value of the management fee earnings (Fee Related Earnings or FRE), plus its discounted book value, ascribing no value to the firm’s performance fee earnings.

We believe the reader understands the economic virtues of a money management business that charges 1% management fees and 20% performance fees (actually fees vary across KKR’s strategies) with scaled FPAUM, thus we will not expand further. In addition to making money for themselves, KKR management has rewarded public unitholders. Since 2011, the partnership has grown FPAUM by 150%, and book value per unit by 60%, while paying out dividends of $7.75 per unit. Our research suggests that the main drivers behind this performance are in place for continued accretion of value to unitholders (except for a strong market tailwind, which we adjust for in our valuation). The alternative asset management industry has seen exponential growth since inception given its outperformance and the institutionalization of it as its own asset class. In the year 2000 the industry managed under $1 trillion in AUM, today that number is $4.7 trillion, and we believe there is room for further growth (albeit at a lower rate), particularly for firms like KKR that focus on private assets. KKR is well positioned inside the industry and stands to take market share as it scales newer, well performing strategies, and receives bigger checks on its core strategies.

Our thesis is grounded on four points:

1. KKR is a strong investment management brand with 40 years of positive investment results. The brand creates sustainable competitive advantages for continued investment results and asset growth.

o   Translates to: Customer captivity of existing customers and, facilitates the scaling of new strategies at current economics.

2. KKR’s industry is facing secular tailwinds that will allow the industry to keep growing FPAUM. In addition, KKR should be able to gain market share within the industry.

o   Translates to: Further whitespace for FPAUM growth.

3. An alignment of interest with the founders, who have a strong reputation, protects us from potential conflicts of interest.

o   Translates to: Low probability of impairment as a result of questionable behavior from management, which is particularly important in this business.

4. Book Value and contractual lock-ups provide a margin of safety should business fundamentals deteriorate.

o   Translates to: A minimum estimate of cash flows and book value for unitholders.

Our sum of the parts valuation implies an intrinsic value of $34 per unit or 40% above current levels with intrinsic value growing with time at a low/mid teens rate. We tax the cash flows at a 20% rate across the board which is likely higher than most investors would pay.

1.   KKR’s brand

As one of the founders of the leverage buyout KKR has been instrumental in helping private equity become an asset class. In 1997, KKR made its first investment in a manufacturer called A.J. Industries and has been investing ever since. Beyond investing, it has been building an infrastructure, and raising capital. In its four decades in business, the firm has built a network of LPs that trust them, a wealth of intellectual capital, operational partners, sourcing contacts, a team of able employees, and a strong culture.

Today KKR is one of a handful of global investment brands that carry weight. Brands are particularly important in the investment business. A strong brand attracts the highest qualified employees, facilitates capital raising, and increases customer captivity. Moreover, the brand gives peace of mind to selling owners, and enables negotiating leverage when financing a deal. This leads to more opportunities to increase investment performance and, ultimately, more capital to invest. Our research suggests that firms with a strong brand in the investment management world enjoy a high level of customer captivity.

KKR’s biggest LPs are large capital allocators; including pension funds (53% of AUM), financial institutions (20%), and insurance companies (20%). Generally speaking, these institutions are looking for four attributes when allocating capital to an external manager: (1) a long term track record, (2) ethical culture, (3) a low risk of blowing up, and (4) middle of the road fee structure. There are only a handful of firms in the world that can check those four boxes to the extent that KKR can. Given the rarity of finding a manager with these four attributes and the way large capital allocators do business, when large allocators begin a relationship with a manager they see it as a long term relationship. It generally takes massive underperformance, a front page news scandal, or increase in fees for the manager to lose that relationship. The stickiness of capital in the industry is demonstrated by the fact that large marquee public-market hedge funds have, to a large extent, avoided massive outflows despite years of underperformance.

To further understand the level of customer captivity KKR and some of its competitors enjoy, it is worth spending some time understanding who are the LPs making the capital allocations decisions. We can start by looking at the firm’s largest group of investors, pension funds. Generally speaking, pension fund investment departments are under-resourced. Their employees’ compensation structure does not reward superb performance, while wide underperformance is heavily punished. This incentivizes employees to allocate capital to managers that are likely to deliver at least modest outperformance but where the blow up risk is de minimis. When someone’s upside is minimal and the downside is getting fired, job security becomes of utmost importance. Firms such as KKR have created a brand around this, where the general perception is ‘no one gets fired for giving money to KKR.’ Given this dynamic, there is little incentive for an LP employee to take a career risk with a lesser known manager even if the risk adjusted expected returns of that manager are higher than a KKR fund.

Other groups of LPs might have higher wages and better resources, or work with a consultant that claims to have both. What generally does not change are the compensation structures, the consequences for picking a bad manager, and human nature.

To be clear, our thesis is not predicated on KKR’s ability to achieve meaningful outperformance. We believe that the brand can maintain its strength over time with only modest investment outperformance. In our conversations with LPs, it is clear that outperformance expectations are generally in the few hundred basis point ballpark.

KKR has delivered on its investment goals, with their North America funds achieving second quartile for three vintages in a row (beating both the benchmark and S&P500), Asia achieving first quartile across the board, and Europe seeing mixed results. Given the nature of the investment cycles, even if performance suffers (as long as it does not blow up), we believe it would take in excess of two vintages in each particular strategy, or 6+ years, for LPs to start reacting to the bad performance.

Moreover, today’s more competitive field makes it more difficult for new entrants to emerge and for smaller firms to scale. The firms that have scaled over the last two decades got there by investing at a time when the markets were more inefficient, and unlike investing in the public markets (which can be scaled with a handful of people), to run a successful multibillion dollar private markets fund today, resources and infrastructure are paramount. As the large firms keep investing in resources, they will keep expanding their competitive edge against smaller firms that do similar sized deals.

Even if there is a manager that is able to outperform consistently at scale and convince LPs to take a risk on them, the time needed to get to scale is such that few will get there, and the market is big enough that it can accommodate a few extra players. To put the timeframe into context, a manager needs many vintages performing well in order to scale. If vintages are ~5 years apart and 5 vintages are needed to start really scaling, a manager needs at least 25 years of good performance to approach KKR’s scale. The competitive structure varies across KKR’s strategies (even though most of the same managers are largely in the same strategies) but in general, there are 5-10 marquee competitors in each strategy, and underneath them a large number of medium sized players that have either had a difficult time or chose not to scale.

KKR has been able to scale new strategies because they have the patience, brand, distribution, and relationships with LPs. When KKR is coming in with a new strategy, LPs will listen, which is a make or break advantage in the investment management industry.

We expect the scaling of new strategies to be a major driver of FPAUM and will in aggregate represent an attractive capital allocation alternative for unitholders (though not all strategies will be successful). Currently the firm is particularly focused in scaling their real estate and infrastructure platforms, both of these strategies have had 1st quartile results on their first vintages and the addressable market is large. For example, KKR currently manages less than $1.5bn of third party capital in their real estate strategies. Blackstone, who has been in the market for longer, manages over $100bn.

2.   Industry tailwinds

Global AUM invested across private market strategies is $4.7 trillion, with meaningful growth across the board in the last 17+ years (as per below). To put the number into context, the market cap of all global stocks is around $70 trillion, there is about $59 trillion of none-sovereign global public debt securities, and $76 trillion of loans. Given the industry’s strong underlying capital raising fundamentals, AUM were barely affected by the financial crisis and while the industry is much larger and more mature today, the main drivers behind that growth are still relevant.

There are two main reasons for the rise of private markets, particularly private equity: (1) excess performance, and (2) the increased need for large capital allocators to go outside of ‘traditional’ asset classes to achieve excess performance.

Even though it has increasingly become more competitive, private markets have been a fertile ground for investment returns. The capability to take on high amounts of leverage, execute an investment thesis over a multi-year time horizon, and control and positively impact a portfolio company have been major contributors to the asset class’ outperformance. The below graph, which compares different private market strategies’ performance vs the S&P, shows that private markets have outperformed by a wide margin over a meaningful timeframe. We use the S&P500 as it is a tough public market comparison. The only laggard in the private market ecosystem has been venture capital, which as we know is a difficult business to be successful in.

The long period of outperformance relative to the general markets has ingrained in large capital allocators the belief that private markets are likely to outperform public equities in the future. Exhibit 1 in the appendix looks at the return expectations of the largest 20 pension funds that provide long term expected returns. Across the board, the large public pension funds have a higher return expectation for private equities vs public equities.

Increasing pension asset-liability shortfalls is another tailwind fueling FPAUM growth at alternative asset managers and in particular private equity managers. The Federal Reserve estimates that the gap in pension liabilities across federal, state, local, and private pensions is about $4.3 trillion. Given return expectations, the way to close that gap is by increasing allocations to higher expected return assets.

A natural question would be what happens if the funding gap disappears when/if interest rates rise. It is difficult to determine the impact that higher interest rates would have on the current pension funding gap. One of the cleaner estimates comes from Willis Towers Watson who believes that a 100bp increase in interest rates can have a 15% impact on net pension liabilities. According to this estimate, it would take a 6.7% increase in long term rates for the deficit to disappear.

Furthermore, everything we see suggests that it would take significantly more than higher rates to balance what some have called the “hidden crisis facing America.” If we look at the past, see graph below, using state and local pensions as a proxy for all US pension funds, we can see that in 37 of the last 45 years pension funds have run at a net deficit. This deficit has historically been meaningful as a percent of GDP and today increasingly so. The time period in the graph includes various interest rate environments. Interestingly changes in interest rates have had little to no correlation with long term funding levels.  Another important driver of pension fund cash flows is the average age of the population. The Pew Research Center estimates that the US median age is going to go from 38 to 42, putting further pressure on the funds. While we are not experts in pension funds and there are a number of inputs driving the deficit, everything we see suggests that it will take more than higher interest rates to eliminate the pension fund deficit issue.

Both of these forces, higher returns and an increased need for the higher returns, have increased LPs’ target allocations to private markets. The below data shows the evolution in target allocations to private markets and private equities experienced by the 20 largest pension funds in the last nine years. In addition, as Exhibit 2 shows, all groups of large allocators are themselves under allocated to the private markets vs their target.

This led to a dramatic effect on the average pension fund balance sheet, with overall allocations to private markets increasing from 4% of total assets in 1997, to 24% today.

Moreover, within private equity, KKR and the other big firms are particularly well positioned to take market share from smaller funds. Out of the financial crisis, asset allocators changed strategies in the way they allocate private equity commitments. Previously they preferred to write smaller checks to a larger number of managers, while today there is a trend to writing bigger checks to a smaller group of reputable firms. As per below, the largest ten and twenty funds have increasingly been able to raise a higher percentage of total commitments. During the financial crisis people realized the challenge in keeping track of a large number of managers, and also realized that insuring quality is more difficult with smaller managers.

As we think about KKR’s business, different dynamics play out when trying to arrive to an addressable market. For the private equity business, the biggest constraining factor is the maximum market share that the private equity bucket will take from other asset classes. If we use the twenty largest pension funds as a proxy (which are themselves overexposed to private equity relative to other investors) a 12% average exposure to private equity has room for growth. The limiting factor is total exposure to all alternative assets, which at the current 27% still has some room but not a whole lot. We do see a path for private equity as an asset class to take share away from hedge funds, whose AUM hover around $2.4 trillion and have become increasingly unpopular with the typical public pension for a variety of reasons.

In other KKR strategies, such as real assets and credit, KKR is so small compared to peers and the size of the market that its destiny is in its own hands. Performance and having a good story will be important for scaling those strategies. It is important to note that there is execution risk with these strategies. We are less sanguine about the hedge fund and special situation strategies, so our valuation assumes outflows for those into the future.

3.  Alignment of interests with founders

Conflicts of interest are an important consideration when investing with the alternative asset managers. KKR has demonstrated transparency and fairness in dealing with LPs and public unitholders.

Out of the public alternative asset managers we studied, KKR has the most consistent and rules based compensation structure that we have seen. In addition to the base salary that employees receive (which is not material in the context of overall compensation), KKR pays employees exactly 43% of the performance income.

Furthermore, we are aligned with founders Kravis and Roberts, who are the partnership’s biggest unitholders. Kravis and Roberts do not get paid a discretionary bonus or stock awards, their compensation consists of a $300k salary plus a participation on the performance carry pool, that participation has been between $50mm-$65mm per year in the last few years. As unitholders, we know what our performance income margins will be, so we are not overly concerned about how the carry pool is allocated. More importantly, Kravis and Roberts own 88.7mm and 92.5mm units of KKR respectively, which at $24 per unit represents $2.1bn and $2.2bn. Since KKR’s 2010 filing, they have sold less than 4mm shares cumulatively. Given the value of their holdings, we believe they are most incentivized to increase unitholder value. To put this in perspective, every 10% increase in intrinsic value increases the founders’ net worth by $213mm and $221mm, so even a small increase in intrinsic value trumps the $50mm-$65mm they currently get paid.

Lastly, the general perception of KKR is one of integrity where weight is placed on reputation and relationships. The SEC has investigated and given fines to a couple of KKR’s competitors for the use of LP funds for personal reasons, and we have found no evidence of similar behavior at KKR.

4. Downside protection with Book Value and FRE

KKR’s contractually locked FRE and its balance sheet provide a margin of safety should fundamentals stagnate or even deteriorate. As of 3Q 2017, approximately 78% of FPAUM are not subject to redemptions for at least 8 years from inception. According to our estimates, KKRs private markets segment will distribute about $5bn per year (or 4.5% of total FPAUM) up to 2028, which means KKR’s private markets segment will lose about $5bn of FPAUM on average every year. This is a small number compared to the firm’s capital raising abilities. For context, KKR has been able to raise an average of $10bn per year in its private markets business in the last four years, and the least it has raised since 2009 was $2.2bn in 2011 when it had half the current assets and strategies.

The partnership’s balance sheet is our other source of safety. Current book value stands at $13.8 per unit. The balance sheet is conservatively capitalized with 23% of its value in cash and 53% on investments that are unlikely to be impaired over a multi-year period of time. Looking through the different balance sheet components, about half of the assets are invested in private equity, the partnership’s bread and butter, and another 35% of the assets are on real estate, infrastructure, and some form of credit, which we also believe has a low probability of impairment.

In aggregate, between retained performance fees and investment performance, KKR should be able to compound book value in excess of our 10% cost of capital.

Valuation

Below are the key assumptions for our SOTP valuation.

• FRE: 2018 to 2022 cash flow projections

o Assumptions: For Private Markets, we assume the company is able to raise $10bn of new capital per year plus 3% inflation. Fund distributions to roll off linearly over the funds’ lives. For the Public Markets segment, we went through each strategy and made assumptions on performance as well as inflows/outflows. For Capital Markets, which is a volatile business, we averaged the cash flows generated by the business from 2012-2016 and grew it by the projected FPAUM growth in the Private Markets business. On the expenses we assume little operating leverage. Given recent large capital raises, most capital raises would disproportionately add to FPAUM (rather than replace harvested FPAUM). 20% tax rate, 17x terminal multiple, 10% discount.

• Book Value: We value the firm’s book value at current NAV. We also went through each line item and made admittedly somewhat arbitrary, but also likely conservative, assumptions as to what each item could be worth to us in a less favorable scenario. In the second exercise we favored strategies that have a higher risk/reward profile and probability of getting us to a 10% cost of capital; all items are valued at or below the current mark. Our impairment scenario shaves ~$3 off the book value.

• Performance Income: We laid out KKR’s carry-earning FPAUM, assumed a base case gross IRR for the different groups of funds and extrapolated the performance fee that each fund group will be able to charge on that performance and the current FPAUM. Our assumptions are usually lower than current and long term performance by a few hundred basis points. Then we assumed 43% would get paid out to employees, ~$400mm in unit based comp, and a 20% tax rate. We applied a 12x valuation multiple. While we do assume meaningful FPAUM growth in our base case, we have effectively neutralized the impact of the growth on performance fees due to lower fund returns going forward. The above assumptions result in the below SOTP valuation.

Why the opportunity exists?

Rather than having one large overarching misconception related to the value of the business, we believe that there are a few reasons why the opportunity exists:

• Partnership structure related: Small investible universe, complicated accounting, people do not like bothering their clients with K1s, a number of investors are not allowed to own partnership structures.

• Cycle: Analysts are worried about the cycle and current valuations.

• Often analysts do not assign any real value to the performance income given its unreliable nature.

• Newness of business model as the first IPO of an alternative asset manager was completed in 2007 with most of the competitors going public after 2010. The power of the business model is, therefore, still being proven to public market investors.

Risks and Mitigants

-          Market Cycle: There is a lot of capital in the current market environment, multiples are high and there is intense competition to get deals done. According to Mckinsey, the average deal multiple today is 9.3x EBITDA. The multiple does not imply exuberance, rather sale multiples will likely be at best equal to purchase multiples with some probability of them being lower. In a cyclical downturn capital raising will also likely suffer.

All the return will need to come from leverage/operational improvements in a market where everyone bidding is focused on those aspects. As a result it will be increasingly difficult to get excess returns to justify current fees. The below graph illustrates that current deals are generally getting done in the US on the bottom quartile companies (in terms of valuation). In other words, deals are being done on what are perceived to be the lowest quality companies. The last time we were at similar levels was before the financial crisis, which did not turn out well for the industry in terms of performance (though FPAUM was not affected).

o   Mitigant: KKR is a global firm, as of 2016 year-end 48% of assets were invested outside of the Americas where valuations are lower. In addition, we feel comfortable hanging our hats on the FRE income (which is contractually binding and is mostly charged on committed capital) and book value. Our assumptions look through the cycle and where appropriate we adjust for lower expected returns. We do expect KKR to be a volatile stock should financial markets and valuations turn.

-          Excessive strategy diversification diluting the brand: At the time of IPO in 2010, KKR had one major business, private equity. Today private equity represents 47% of total FPAUM and we expect that number to decrease as time goes by. KKR built its brand and reputation on investing in private equity, moving away from its core competency presents the risk of negative excess returns. This could impair the value of the brand. The firm has had funds, such as the Natural Resources Fund (2010) and Energy Income and Growth Fund (2013) that are returning negative IRRs. Given the importance of the brand, its dilution can significantly impair future cash flows.

o   Mitigant: Our conversations with LPs suggest that investors distinguish amongst strategies. Investors in KKR PE Asia do not see the KKR Mezzanine fund as being run by the same group of people, subpar results in the Mezzanine fund would not halt an investment from an Asia PE LP. Furthermore, bad performance associated with a firm will deter its image, so we are paying close attention to new strategies. We have visibility and believe will be able to tell if management is going too far. Lastly, as we look at the current seed strategies, cumulative LP capital in these is small at less than $1bn.

-          Owning a set of assets in the balance sheet that we do not control: At $13.8 per unit, a large portion of KKR’s intrinsic value is derived from the company’s book value. After the 2015 change in dividend policy, we expect more of the cash flow generated to be retained by the balance sheet. As none-controlling owners, we do not have a say or control on the balance sheet. We generally invest in companies with competitive advantages that generate cash flows and where we have a relatively good idea how the excess cash will be used. These aspects are less defined here, therefore we are putting a degree of trust in management that is higher than what we normally would.

o   Mitigant: Our interests are aligned with management. Management’s core competency is allocating capital and they have done so successfully over the last 40 years. We believe in an adverse scenario the balance sheet could see a ~$3 impairment.

Appendix

Exhibit 1: Expected long term returns on private and public equity from the largest 20 US pension funds

Exhibit 2: Difference in target allocations vs current allocations for LPs.

Catalyst

Earnings and book value growth. Increased familiarity with the industry by the analyst community.