KKR & Co: Investment Thesis
An analysis of incentive alignment, durability of capital, historical fund performance, horizontal integration, and valuation
Charlie Martin
15 July 2022
Paradise Divide Capital
KKR & Co: Investment Thesis
Disclaimer:
Paradise Divide Capital, PDC, or “the Fund” is long KKR’s equity (NYSE: KKR). As of July 14th, 2022, KKR & Co represented 7.3% of the Fund. This is not investment advice, or a solicitation to buy KKR’s equity, rather it is purely informational and educational. Please leave a comment if you have any questions and I’ll try to answer it to the best of my ability.
Introduction:
KKR was founded in 1976 by Jerome Kohlberg Jr, Henry Kravis, and George Roberts as a private equity firm focused on leverage buyouts. The trio had previously worked together at Bear Stearns where they were doing some of the first leveraged buyouts, and they decided to break off from Bear because of the large opportunity that they saw in the space.
Over the nearly 50 year history of KKR, they have completed some of the largest leveraged buyouts, including the 1989 buyout of RJR Nabisco and the 2007 buyout of TXU energy, which is still the largest buyout completed.
Today, KKR not only does LBOs (leveraged buyouts), but it is diversified across management buyouts, acquisitions, credit, special situations, mezzanine debt, growth equity, distressed debt, real assets, and smaller market investments.
As of 1Q ‘22, KKR had $479 billion AUM (assets under management), with $268 billion being in private market strategies and $211 billion in public market strategies.
KKR is the second largest private equity firm, trailing Blackstone, which manages $881 billion.
Methods:
Over this article, I will discuss many, but not all, of the reasons I see upside in KKR. I will try to keep my thoughts decently concise, but based on my previous Substack’s, that seems like an unrealistic goal. I will cover management incentive alignment, durable and long-term capital, horizontal integration, historical performance of funds, and valuation.
Management Incentive Alignment:
KKR & Co is an affiliate of KKR that was created when KKR went public in October 2009 that holds 30% of the firm's equity to be traded in public markets. 70% of KKR is still owned by the partners of KKR, which creates an unparalleled incentive alignment.
Not only are the employees and partners of KKR the direct beneficiaries of good performance, and are able to stake claim to the majority of the benefits, the partners and higher-ups receive “carry” in the funds, which means that they are able to invest in KKR’s funds with their own capital, creating even more incentives for good fund performance.
At most public companies, the vast majority of the employees at the company don’t monetarily benefit from the company doing well, but at KKR, every person making an investment decision is monetarily incentivized through either bonuses, carry, or both to make a good investment decision. This creates a rare opportunity for shareholders of KKR & Co where their priorities are completely aligned with the priorities of the employees and the partners of KKR.
Durable and Long-term Capital:
The history of durable capital and long-term commitment of capital by investors in KKR’s various strategies and funds is important to this investment thesis. As mentioned earlier, the vast majority of assets that KKR manages are long-term, which means that they are able to grow and accrue fees on those assets over a long period of time.
Only 14% of KKR’s total assets under management are subject to periodic redemptions, which would include some of their public market and credit strategies. 44% of capital that KKR manages is perpetual capital or capital that is committed over many decades and 86% of their capital has a lock-up period of 8+ years at the inception of the capital deployment.
The creation of perpetual capital is something that is relatively new to KKR, and the predictability and stability of future capital serves heavily to the benefit of KKR. Since 2018, KKR has grown its perpetual capital by 2000%, from ~$6 billion to over $120 billion. This is made possible because of KKR’s history of long-term growth of the capital they manage.
KKR’s funds are also attractive to investors because they offer less volatility than public market strategies, which creates downside protection for investors. As an example of this, while the S&P 500 decreased by 50%+ in the global financial crisis in 2008, KKR’s AUM only took a 4% hit.
Historical Performance and Growth of Funds:
At the core of KKR’s success has been their multi-decade long track record of outperformance, and their strategic investments that have allowed them to grow their capital base. In their traditional private equity strategies, KKR has a 40-year CAGR (compound annual growth rate) of 26%, crushing the S&P 500 over that 40-year period, which had a CAGR of 12%. To put this into perspective, $1 growing at 12% for 40 years would turn out to be $93, whereas $1 growing at 26% for 40 years would turn out to be $10,347.
Over the past 5 years, KKR has grown their rate of capital deployment from an average rate of 8% YoY to an average rate of 31% YoY. As the scaling of their different funds and strategies grows, their amount of capital deployed has grown as well, from an average of $8 billion a year to an average of $23 billion a year. This has coincided with an increase in their gross unrealized carried interest which for the past 3 years has had a CAGR of 42%. All in all, KKR has grown their unrealized gains to $9.1 billion.
As an example of their consistent and reliable outperformance, their Infrastructure II fund has had a 19.7% IRR (internal rate of return), which represents 1000+ basis points of alpha over a diversified infrastructure strategy, such as the Dow Jones Brookfield Global Infrastructure Index. Because of this, they are able to raise the fees on the capital over the lifetime of the fund. In their Infrastructure fund they have raised their management/carry fee from 1%/10% to 1.3%/20%.
In KKR’s newer strategies, their returns are even more impressive. In their dislocated and opportunistic credit strategy, they have been able to post a 52% IRR. In their high yield credit, they have been able to do 13% IRR, which represents 500 bps of alpha over the BAML High Yield Credit Index.
In KKR’s overall credit strategy they have been able to grow AUM by 22% on average over the past 5 years, resulting in $164 billion AUM in credit. Since these strategies are relatively new, KKR has quite a large amount of growth potential. A large portion of KKR’s credit assets are in the early or developing stages of deployment, leaving a large amount of untapped potential.
Horizontal Integration:
As aforementioned, the majority of KKR’s AUM has been diversified over many different asset classes spanning geographically over Asia, America, Africa, and Europe. This allows them to limit their exposure to one certain asset class in case of a downturn, and it also gives them avenues for growth outside of their traditional private equity.
Their largest strategy is credit, which includes everything from leveraged credit to private credit to dislocated and opportunistic credit. KKR has $164 billion in credit strategies. KKR sees untapped potential in Asian credit, as it represents 60% of the global GDP growth, but only represents 8% of global private credit AUM. KKR has been supremely successful in their credit endeavors so far, and they aim to continue executing while also expanding into different markets and geographies.
KKR’s horizontal integration and diversification have allowed them to outpace other asset management companies in fundraising. KKR has grown assets at a 22% pace per year, whereas the rest of the alternative asset industry has grown assets at 11% per year. KKR’s real assets strategy, which includes real estate credit and equity, infrastructure, and energy, has grown at a 41% CAGR over the past 5 years.
In the near-term, KKR expects to raise $50 billion in private equity capital, $20 billion in infrastructure capital, $15 billion in real estate capital, and $25 billion in credit capital. KKR is also introducing new funds for investors such as Asia NextGen Tech Growth, Global Impact, and NextGen Tech Growth among others which will increase KKR’s scope and AUM.
Valuation and Projections:
There are a couple of methods that I will use to determine an accurate valuation for KKR, and why I think that KKR is currently trading at a significant margin of safety to its intrinsic value. While in this current economic climate, earnings remain very uncertain, I will try to provide a framework for what I see KKR’s future earnings being.
On a TTM (trailing-twelve month) basis, KKR did 2.940 billion of net income, and as of 14 July 2022, KKR had a valuation of 27.360 billion, which implies a trailing earnings multiple of 9.3x. The median earnings multiple of the S&P 500 is 19.15x. KKR has a free cash flow multiple of 8.67x, implying a levered cash flow yield of 11.5%. But I don’t think this provides us with a nuanced enough picture of KKR’s capital.
In order to get a better view of KKR’s valuation, I will look at their current assets under management, and using their fee structure, estimated growth, and operating margins, I will estimate what I think KKR’s future earnings will be.
KKR currently manages $479 billion, which is a 30% increase YoY (year-over-year), 77.4% of which is fee-earning capital. On a TTM basis, KKR made 3.477 billion in fee related revenues, 2.221 billion of which went directly to the bottom-line. Significant economic headwinds in 1Q lead to KKR taking a loss of (73.770) million. Revenues from both their asset management and insurance segments were down significantly in comparison to FY ‘21.
On a TTM basis, KKR averaged net fee related earnings of ~2.5 billion across both their private and public market strategies, which implies a post operating expense fee of ~0.5% on their working capital of $371 billion. Working capital, or capital that is currently accruing fees, is growing at 29% YoY.
Significant economic headwinds such as inflation, and the related interest rate increases, pose uncertainty to the near-term capital raising environment and performance of KKR’s private and public equity strategies, as well as their insurance segment. I see these as near-term threats to KKR’s revenue and earnings in FY ‘22, however I see these economic threats dissipating in the latter half of FY ‘23.
KKR is able to have operating margins between 50-60%, and I don’t see that changing in the next 5-10 years.
With that being said, I think that KKR will do a negligible amount, if any, net income in FY ‘22. I think that economic conditions will normalize in the next 12 months to pre-recession levels, meaning that KKR is able to have 0.5-1% fee related earnings attributable to shareholders on their working capital. Their working capital has increased at a steady rate of 20-30% over the past 5 years.
I think KKR will be able to grow working capital by 25% starting in FY’23 and extending through FY ‘28, which would mean that KKR would have somewhere around $1.132 trillion in working capital by FY’28. This estimate is possible because over 90% of KKR’s capital raised has a duration longer than 8 years. All in all, I think that KKR will do ~$8.5 billion in fee related earnings attributable to shareholders in FY’28.
KKR’s other business segment, insurance, should be valued at 1.3x book value, which would give it a valuation of $4.452 billion.
So, where does that put us in terms of the current valuation of KKR? In pre-covid times, KKR has traded at 14-17x earnings, which would put the current valuation of KKR at $41.16 billion to $49.98 billion. However, I think this should be discounted because of the current economic uncertainty and the fact that KKR’s earnings in FY ‘22 will not be significant. I believe that factoring this all in KKR’s fair value lies between $35-40 billion, representing a margin of safety to the fair value of KKR’s equity of 22-30%.
While KKR is currently mispriced, I believe that this is not hugely important to the bull-thesis overall. Incentive alignment, horizontal integration, and fund performance serve as core to the thesis.
Conclusion:
Thanks so much for reading this piece. I know I haven’t done one of these in a while, but I figured I should share this investment thesis on a company I have strong conviction in. Again, if you have any questions, you can leave a comment down below or send me an email at charlie.martin@yale.edu.
Impressive financial analysis. I would like to learn more about the businesses that KKR owns/manages and how they are managed (by KKR principals?). On fees, are those dividends/distributions from the operating companies? Thanks!