Investment Theses

Investment Thesis KKR

13-01-2021

2021-01-13

At Laaken we invest part of our clients’ assets in listed Private Equity (PE) management companies. By discussing our position in KKR we would like to demonstrate why we think this particular kind of stock offers quite an interesting investment opportunity.

Kohlberg Kravis Roberts & Co (KKR) is an American investment firm founded in 1976 by three investors. The founders previously worked at Bear Stearns, structuring leveraged buyouts. Bear Stearns felt that the leveraged buyout program was too slow a way to add value to its business and declined to set up a dedicated buyout fund. This made the three decide to part ways with their employer and continue independently under the name KKR. KKR went on to be the founding father of the so called PE funds. Competitors such as Blackstone (1985), Carlyle (1987) and Apollo (1990) only followed many years later.

In a leveraged buyout, a company takeover is financed with debt. This practice became popular in the nineteen eighties, when the emergence of junk bonds (high risk bonds) provided ample access to debt. Initially, these takeovers were friendly, organized in cooperation with the management of the company, who often acquired a stake in the company as part of the deal. After the buyout, costs would be cut and funds would be made available for the necessary investments. Hostile takeovers soon followed, with the much publicized takeover of RJR Nabisco in the late eighties famously discussed in the book ‘Barbarians at the Gate’ by Wall Street Journal writers Burrough and Helyar.

Investors can take a direct stake in the investment funds of PE management companies. That way, the investor gains access to deals that we, as investors in listed equities, don’t have. Non listed family owned companies for example, that wish to sell. Or listed companies that trade at low pricing and poor liquidity, due to high leverage. At Laaken, we limit ourselves to  buying the listed stock. The PE fund can buy the stock, re-finance the debt and create instant value. But an important disadvantage of investing in PE funds is the lack of liquidity: investors typically have to wait 7 to 10 years for their pay-out. All the while, costs are running high. Recurring annual fees of up to 2% are no exception, nor are 20 % performance fees.

In 2006, KKR was the first buyout firm to raise capital at the Amsterdam stock exchange for a new investment fund. Contrary to traditional PE funds, where investors can expect their money back in 7 to 10 years, this fund is not limited in time and has a potentially much longer investment horizon. Another advantage for the fund manager is the perpetuity of the management fee. After the market crash of 2008, KKR decided the stock at the Amsterdam exchange was undervalued. They bought back the stock, delisted, combined them with a fund management business in their portfolio and relisted at the New York stock exchange. This company that we currently invest in, is both invested in PE funds and earns management fees on the investments of other investors. Of the current USD 40 KKR stock price, approximately half of the value is attributed to investments in KKR funds. The other half is the value of the management firm. A welcome side effect of investing this way, is that as an investor in the listed KKR stock, no management fee is due over the exposure to the assets that they manage. Historically, KKR has achieved a gross return of 16% per year for the investors in their funds. But after fees, only 12% was paid out. So the possibility to be invested in the KKR funds without the costs is a significant advantage. Going forward, KKR expects to make a gross return of 17.5% per annum on their PE equity funds, 5% on their leveraged credit funds and 13-15% on their real estate and infrastructure funds.

In the Netherlands, KKR holdings include Exact accounting software, Q-park parking garages, Roompot holiday resorts and Upfield, a producer of vegetal food products with brands such as Becel and Flora.

During the last decade, demand for PE funds has soared. Because of their reputation, combined with strong historic performances, KKR has managed to grow both the assets under management and their profits by some 17% per year. Going forward, KKR is expecting an 8% annual growth rate, which we consider to be a conservative estimate. The expansion also makes the management firm an attractive investment. The implied valuation, approximately 20x earnings, is significantly lower than the valuation of other listed companies with a similar growth rate.

An important difference between KKR and some of its competitors is how the fees are distributed. At KKR, 40% of the performance fees are reserved for distribution among KKR staff. The rest is distributed to the shareholders. While 40% is certainly a lot, some competing firms keep up to 65%. Founders and co-CEOs Kravis and Roberts made around USD 40 mln in performance fees in 2019. At the same time, both have USD 3 bln of their own money invested in the company. So for them, adding value to the stock price is more relevant than collecting the performance fee, resulting in a proper alignment of their interests with those of their fellow shareholders.

Co-founder Jerome Kohlberg (1925) left KKR in 1994 and passed away in 2015. The company still carries his name. Co-CEO Henry Kravis (1944) has made it clear that his goal is to make sure that KKR can continue to flourish, with or without its founders. He seems to be more focused on creating his legacy than he is on maximizing his personal wealth. As he often points out, if the founders had decided to invest their own money from the start, KKR would now be bigger than Berkshire Hathaway, the company of famed investor Warren Buffett.

With founders and co-CEOs Kravis and Roberts striving to add maximum value to KKR and preparing the company for the future, we as fellow investors are positioned to profit from this success.

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