Jul 09, 2018
Todd Builione, President of KKR Credit and Markets, shares how the credit and capital markets business at KKR has grown and evolved over the years and how he views the growth path ahead.
Credit And Markets
President of KKR Credit and Markets, KKR
Good morning. I am Todd Builione; I am President of our Credit & Markets business and over the next 20 minutes my plan is to cover four topics. I will start out by talking about how Credit & Markets has evolved over the last ten years. I will then spend some time on our business model and use a couple of case studies to highlight that business model. I will then talk through our partnership with Franklin Square, or FS Investments, which recently closed in April of this year. Then I am going to end by talking about the growth path ahead.
KKR Credit & Markets
Ten‑plus years in the works
Our Credit & Markets business has really been ten‑plus years in the works. Back in 2007 we had just $11 billion of assets under management across KKR Credit; today we have under $60 billion. Credit management fees were $53 million back in calendar year 2007; in the latest 12 months just under $250 million. Transaction fees were a mere $1 million back in 2007; it was the first year that we got our Capital Markets business up and running and we participated in one public equity deal. In calendar year 2007 we syndicated $4.7 billion of equity and we arranged $106 billion‑plus of debt. That placed us number 11 in the sponsor loan league tables, surprisingly to us one spot behind Citigroup and two spots behind JP Morgan. You can see we monetized that transaction volume in the form of transaction fees: $434 million over the latest 12 months.
Total revenue back in 2007 was $78 million. That was a mere 7% of the aggregate of KKR. The last 12 months just under $800 million or 25% of the aggregate of KKR. Back at the end of 2007 we had 62 employees. Today we have 293 employees, or roughly 23% of the total firm.
Adam Smith is going to follow me and drill down on our Capital Markets business. So I thought I might take you through the 14‑year journey that we have been on in our Credit business to get to the point where we are today. First, I will start with leveraged credit; when I say that you should think traded credit: the tradable markets.
The business started back in August 2004 as we raised $800 million for a credit‑oriented permanent backed capital vehicle called KFN. We did three things really well since then that has resulted in the scaling of the business. The first is top‑tier investment performance. As an example, if you look at our flagship opportunistic credit strategy, over the last ten years we have outperformed the benchmark by more than 460 basis points on an annualized basis and our performance ranks on a relative basis to our peers top percentile over a one, three, five and seven‑year basis. Not top quartile, not top decile but top one‑percentile.
Second, we have been able to rejuvenate our CLO business since the crisis. Over the last 12 months we raised $2.4 billion of new CLOs. And finally, we bought Avoca back in August 2014. With Avoca came $8.5 billion of assets but much more importantly, a top‑tier European leveraged credit team that took our leveraged credit business from being a US‑only business to now being a US and European developed markets business.
In alternative credit we did two things really well back in 2010 that sowed the seeds for the building of this business over the years. First, we raised our first dedicated comingled fund to private credit: Mezzanine Fund I. We put up good numbers and we learned some lessons over the years about how to manage private credit mandates. On the back of those lessons and that investment performance we have been able to raise three comingled funds since: Lending Partners I, Lending Partners II and then Private Opportunistic Credit II, which we closed at the end of last year at $2.3 billion of overall AUM.
Second, back in 2010, we were able to convince three clients of KKR to entrust us with their capital with a brand‑new investment strategy for the firm: special situations, distressed, the event‑oriented investing. We had really strong performance out of the gate. On the back of that performance we have been able to raise two comingled funds since: Special Sits I at $2 billion and Special Sits II at $3.2 billion.
You can see over the last five years we have had an awful lot of momentum across this business: 20% CAGRs on an AUM basis excluding FS Investments; 26% with FS Investments. On a management fee basis, also a 20% CAGR.
There is something that is missing from this slide, though. Of the $59 billion of AUM, $6 billion of it is in dry powder. Like Real Estate, our model in Credit is that we need to invest the capital in order to turn those management fees on. There is about $60 million of annual management fees embedded as we turn that $6 billion of dry powder into invested capital.
Our business model
Back in the summer of 2016 the leadership team spent the full day together in a room that we call the KKR incubator. It is a funny name; all it is is a room full of whiteboards. We spent that day in a whiteboarding session, a brainstorming session. We were not talking about all the momentum that we had in the business, not talking about all the success that we had had over the last ten years. In fact, I do not remember any mention of that. We spent all of our time in classic KKR form talking about what lessons we had learned, how we could get better, how we could take our business and punch through to the next level.
There were two good, maybe great, ideas that came out of that session. We looked, by the way, as background, at the private credit industry and realized that maybe was the best opportunity that we had right in front of us. Why? Because we saw that industry AUM for private credit had grown by $400 billion over the prior ten years. We felt like we had the capability to attack that market in a more aggressive way.
The two ideas that came out were, one, to develop a more compelling business model. First, we realized that although the 134 investment professionals that we have across Credit & Markets are focused on originating financing opportunities for their sponsor and corporate clients, we had not really done a great job at connecting the dots with the 262 investment professionals that sit across our Private Markets business. We felt, bluntly, that that was pretty silly. The last we checked, our senior private equity partners, people like Pete Stavros, get paid in part to have very strong relationships with corporate CEOs and CFOs. The stark reality is I think at least 90 out of 100 times when we ask the question, 'Do you want we, KKR, to buy control of your business,' the answer is no. However, the reality is within 90% of the no’s, there is a yes. The reality is many of those same CEOs and CFOs need our help, helping them finance acquisitions, growth opportunities and many other uses for debt financing. So we started by connecting the dots more specifically across the organization.
The second thing that we did was turn our originators from product peddlers to solution providers. Any of us that have tried to build relationships in any context over time know that if you are product peddling one product versus really being a solutions provider, you are going to have a much better time and you are going to build much stronger, stickier relationships by really putting yourself in a client's shoes. We realized that we needed to move our originators from that product‑peddling position to a solution‑providing business. We did that by merging our Credit and Capital Markets business, creating Credit & Markets, and making our originators understand and appreciate that they ought to be indifferent between providing financing solutions that were capitalized by our credit and investing pools of capital, which might be a highly‑structured private credit solution, or those that could be capitalized by our debt capital markets capabilities that might be a plain vanilla syndicated loan opportunity that we could underwrite and distribute with our capital markets capabilities.
Case Studies – Leveraging our Business Model
There are a couple of case studies which hopefully will highlight this business model. I will talk through Sycamore's acquisition of Staples, which leveraged our entire solution base, both our credit and investing pools of capital, as well our capital markets distribution capabilities. I am then going to talk through Marlin Equity's acquisition of Virgin Pulse and Redbrick Health, which started with our Americas PE team.
Delivering a Financing Solution to Sycamore Partners
First, Staples. Back in June 2017 we got a call from Sycamore. Sycamore has been a longstanding client of KKR. They asked us for our help in helping them finance their take private of Staples. It was a highly complex transaction as their intention was to split Staples up into three entities. We were, within 2.5 weeks of getting that call, able to commit to a $500 million first lien term loan which formed the foundation for their capital structure.
How did we deliver this solution? We leveraged our full model: $150 million investment from our credit pools of capital, a $350 million commitment from our balance sheet and ultimate distribution via our capital markets capabilities to bring the $500 million together. What did it mean for the KKR shareholder? We turned on that $150 million of dry powder. So $3.8 million of management fees, $5.8 million carry potential and a $7.5 million capital market fee. To Scott's point earlier, around monetizing our opportunities, we created a $17 million revenue opportunity for a KKR shareholder.
Delivering a Financing Solution to Marlin Equity Partners
Next, in the first quarter of this year our Americas PE team was considering an investment in Virgin Pulse and Redbrick Health. We did not ultimately get there on the PE side but we, as an organization, running the firm as one firm, one team were able to pivot and create a financing opportunity out of it. We worked with Marlin, who had Virgin Pulse and Redbrick under LOI. We ultimately committed to a several‑hundred million-dollar first lien term loan.
In this example we were able to capitalize that term loan 100% via our credit investing pools of capital. By doing that we turned on $8 million of management fees, $12.3 million of carry potential for a total revenue opportunity of $20 million‑plus.
As I step back and think through these examples, it is clear to me that we are approaching this business in a way that only we, KKR, can. We have all 396 investment professionals focused. We have a scaled credit platform with $59 billion of credit capital. We have debt capital markets capabilities that we have honed over the last ten years. We have a $16 billion balance sheet which allows us to optimize those debt capital markets capabilities.
Before joining KKR, above five years ago, I spent 15 years at other firms. I can tell you first‑hand that those other firms do not have all the tools in their toolkit that we have. They definitely do not bring them together in the way that we do at KKR.
Partnership with FS Investments
Let us go back into that incubator room, back into the summer of 2016. I mentioned we had two ideas. We talked through having a more compelling business model. The second idea was a pretty simple one to come up with, but a harder one to execute against. It was scale.
This is where our partnership with Franklin Square, or FS Investments, comes into play. Just a little bit of background because many of you might not know FS Investments. They are a Philadelphia‑based firm; they manage $25 billion of AUM. They are expert at delivering alternative investment product to the true retail client. By true retail, I mean $25,000, $30,000, $35,000 average ticket size. FS served as investment advisor and Blackstone's GSO as sub‑advisor to the FSIC BDC franchise. Think middle‑market lending, private credit BDC franchise. On April 9th this year, FS ended that relationship with GSO and formally formed a partnership with KKR.
That franchise, as you can see, consists of $13.2 billion of gross assets. We combine that with the franchise that we, KKR, built over the years through that same retail channel but with a different partner: $4 billion of gross assets. For $17.4 billion of aggregate AUM, 250,000 underlying retail clients. We make loans through this franchise through 150 sponsor relationships to 325 underlying borrowers.
My team, our team, is just as enthusiastic as I am about this partnership with FS because they see that the strategic value that it brings to our platform is great.
First, it delivers that scale word that we were after. It is scale in a space where scale really matters. Scale allows us to narrow the competitive universe in private credit. It is no secret that private credit has gotten competitive. The last I checked there were 75 or 100 different firms that are competing somehow in that space. By having scale, we narrow that competitive universe. We now compete with three, or four, or five firms that, like us, can routinely write $300 million, $400 million, $500 million, maybe even $1 billion‑plus checks. Scale allows us to have ball control; Scott referenced it earlier. In every situation in which we lend we effort to be sole lender so that it is just us and the borrower at the table. That type of bilateral negotiation tends to result in, for example, a better covenant package and more downside protection.
Scale allows us to focus on a part of private credit where we want to be focused: the true upper end of the middle market. At the end of the day, this is a simple business. We are lending money, we are collecting a coupon and then we are getting paid back our principal. Common sense would therefore tell you that you would rather loan money to bigger companies because bigger companies tend to have better competitive dynamic, they tend to do better through downturns and they tend to attract better management teams.
Second, the FS partnership delivered $13 billion‑plus of incremental permanent capital to KKR. You have heard a few times from Joe, from Scott, from Henry, about the importance of permanent capital to our go‑forward strategy. It took KKR Credit's permanent capital to 31% of overall AUM. If you include strategic client capital, it took the aggregate KKR's capital, permanent and strategic client capital, to 22% of AUM.
You are going to hear later on today from Suzanne Donohoe, who is going to talk about the rise of the individual investor in alternatives. This partnership gives us optionality to do things with a partner that is particular expert at bringing product, which we produce, manufacture and manage at KKR, to the retail client. We fully expect that we will be doing more with FS Investments over time.
Even if you wipe number one to number three off the slide, the economics of our partnership with FS are highly compelling to the KKR shareholder.
KKR Credit Snapshot – 31st March 2018
Where does this leave us? $59 billion of aggregate AUM in Credit: $25 billion in leveraged credit, $34 billion in alternative credit. We have investments in 750 underlying portfolio companies: about 500 in leveraged credit, 190 in private credit and 60 in special situations. We, importantly, have $2.7 billion of our own money invested alongside our client capital. $2.4 billion is from KKR's balance sheet; $300 million of it from employees.
Where Does Credit Go From Here?
As we think about where we can take KKR Credit from here, the first point, and it is an important point, is that we have expanded our investment capabilities over the years. Look back in 2007; it is only roughly ten years ago. Back then we were managing CLOs, loans and bonds, mandates and that permanent capital vehicle called KFN which I referenced earlier. Back in August 2014 we, with KKR shares, bought in that permanent capital vehicle in a highly strategic transaction for KKR, to increase the size of our balance sheet.
Today, look at everything else we are doing. As we think about the path forward, because of all the different investment capabilities that we have built within KKR Credit, we have many different ways to double AUM and double fees. There are really four priorities that we have, as we think forward, to get to that point.
The first will always be on every single page of priorities across KKR. We have to deliver top‑tier investment performance. With top‑tier investment performance everything gets a lot easier and everything gets a lot more fun. But as we think about businesses that we can scale from here, there is a handful of them where we just need to continue to run hard and capitalize on the momentum that we currently have.
I mentioned $2.4 billion CLOs raised over the last 12 months. This year we should probably get to something like $3 billion and we think over time we can take that number to $4–5 billion per year.
Our opportunistic credit strategy, I mentioned the top‑percentile performance, but what I did not mention is maybe the most exciting piece of this, that it is only about $1.5 billion in size today. With that investment performance and with the competitors' sized funds, which are $10 billion‑plus in size, we ought to be able to grow that business to $10 billion‑plus over time.
BDCs, I mentioned our partnership with FS Investments. What I did not mention is that that partnership will add, over time, about $100 million of run rate annual management fee and performance fee income. That is just on the current‑size business, but as you can imagine, we and our partners in Philadelphia have plans to grow the business, to grow the equity capital, to tap in to that individual investor community in a bigger way and to grow our BDC franchise.
On private opportunistic credit I mentioned we closed on the second fund, $2.3 billion at the end of last year. We are doing really differentiated investing within that strategy: asset‑based investing, structured finance investing. That is a fund that over time should have fund sizes of $5 billion, or even $10 billion.
And then special situations, our distressed business, is about $8 billion. The last I checked, the leading competitors are $20 billion or even $25 billion. We have a lot of room to run there.
We, like other businesses, are going to look to build out geographically. In fact, we took ourselves back into that whiteboarding room the week before last to talk about Europe as a management team. We decided that we could take that Credit & Markets combined model that I described earlier, that has worked so well in the US and we could apply that equally to Europe. Over time we should be able to raise $5 billion‑plus for European private credit.
And then Asia credit; the beauty there is it is a new business. We are sending someone who is a star in New York and his family to Asia to help us build out that business. It is technically new, but we are able to leverage the franchise and the platform that we have built in Asia across KKR. Eight offices, 125 investment professionals all of whom have relationships with CEOs and CFOs that can help us originate investments.
We will do all of this while always being creative, always being agile, always thinking around the corner, thinking about how markets are going to evolve and then leveraging all of the tools that we have in the KKR toolkit in order to go after those opportunities.
With that, I am going to hand it off to my partner Adam Smith, who is going to dive a little bit deeper on our capital markets business.
DisclaimerInvestor Day podcasts and corresponding transcripts have been prepared for KKR & Co. Inc. (NYSE:KKR) for the benefit of its public stockholders and is not intended to be a solicitation or sale of any of the securities, funds or services that they may discuss. Please find a copy of the presentation here.