Jul 09, 2018
Craig Larson returns to the stage to answer the most frequently asked questions he receives from an investor relations standpoint.
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Frequently Asked Questions
Head of Investor Relations, KKR
Thanks, Bill. So before Henry has some closing remarks, I thought it would make sense for me to review four frequently asked questions that, from an investor relations standpoint, we hear from investors. I am going to spend a little more time on some of the things that we thought about in terms of our decision to convert to a C-Corp, how we think our shares should be valued, what the impacts of a rising rate environment is on us in a particular focus on our private equity business. And then finally what happens to KKR in a market downturn. We have some interesting case studies, again, how the business has performed when we have seen some volatility.
C-Corp Conversion – Shareholder Expansion
So first, a little more granularity on our decision in the conversion, and the decision itself is actually one that was pretty simple, and it is stated here in the first bullet point. In that we think over the long term the opportunity for us to create equity value through shareholder expansion and ultimately multiple expansion is greater than the taxes that we are going to pay as a corporation. And I think the alignment around this decision is something that should be pretty well understood by everybody in the room given the significant employee ownership that we have.
Now to be clear, this was not a decision that we made thinking that we would see a one-time pop in our stock price. And I actually think that it is going to take a period of several quarters before we are going to really see the transition in our shareholder base. This decision was one that was really made with a focus on the long term and what we think really positions the company for a success over a long time frame.
Historically, what did the investor relations team hear?
Now, how did we think about this decision? Because in many ways the only thing you know with certainty in a conversion is that you are going to pay more taxes. So the first thing we did, we actually spoke with a lot of people in this room. And so I am going to review a couple of the comments that we heard actually from three people, all of whom are actually in this room. This exercise is actually somewhat cathartic for Bill and me, as an aside, and Scott. But historically what did we hear as people talked about the valuation profile of the alternatives?
I would say that 40 – 50% of the investors will not engage on the alts. It is tough to say this is entirely due to structure and K-1s, but I will bring out my comp sheet and begin talking about how attractive valuations are and they will stop me outright and say they are not interested in the alts and we will move on. This happens all the time.
If you do not convert, what you are betting on is there are enough niche and momentum-oriented hedge funds out there that no one has ever heard of that will drive your equity value because it is not going to come from US mutual fund complexes. And we have a couple of statistics on this point in a second.
And finally, I just do not think it will realize fair value relative to your fundamentals without becoming a mainstream equity security. So these comments again are pretty representative of the feedback that we heard. And first, thank you everybody for your candor as we talked about this as it really did have an impact on us in a number of different ways.
Ownership profile as PTP
So, after hearing this anecdotal feedback we began to peel the onion back and again looked at some of the more fundamental statistics to look at our ownership profile and look at that relative to a broad group of financials. So here you see the ownership that you have in KKR over time and the level of mutual fund we have, ownership that we have, relative to a broad group of financials. And you see that pretty consistently that number has been at a big discount.
At the same point in time you actually have significant over-ownership from the hedge fund community. And while I love the enthusiasm of the hedge fund community, there is an aspect of this that does come with some risk. In my experience a number of folks in that category can have a shorter investment horizon, and when volatility enters the market they all can go risk off, all go risk off together and there is not a natural buyer on the other side of that trade.
So I think when you look at the volatility historically in our units, and I think it is also true as it relates to our peer group, this is something that has contributed to the volatility you see in our share price.
Again, I think as people broadly understand, as a publicly traded partnership we have been irrelevant essentially to the suite of passive strategies. And this, again, was another statistic that we looked at and found concerning. In that if you looked at the mutual fund ownership that we did have, how many fund complexes did you have to look at in order to get half of that ownership profile? Well, the answer is you could count them on one hand.
So we looked at this composition of our shareholder base, and it actually felt pretty fragile to us in all candor, and we feel very differently about where we are now and the opportunity we have to really expand our shareholder base. So how do we think about that opportunity? Well, we think of it in three buckets. The first really are our existing shareholders. Again, one of the things that we heard very consistently was that as a PTP we actually were relevant to only a fraction of the institutional AUM within those respective complexes. One of the comments that we heard that had a pretty big impact on us came from a top-20 shareholder and the feedback that we heard was that as a PTP we were only relevant to 10% of the AUM within that mutual fund complex. That changed as of a week ago.
We think we have a lot of white space as we think about new prospective investors. If you look at the largest twenty mutual fund complexes in the US, only three of those own one million shares of Blackstone together with KKR. Again, we just think there is a lot of white space.
And then finally as it relates to passive strategies, ETFs, indices, smart beta, of course these strategies represent a pretty significant part of the equity markets already, and again that is a growing percentage.
Distributable earnings versus ENI
And one other point as it relates to the decision to focus on distributable earnings versus ENI, again as you have heard a couple of times, perhaps most importantly DE really is more reflective of how we run the firm. But at the same point in time I think there is another subtle advantage that will be very helpful for us in the long term, because I think it is going to allow there to be a greater focus on our business and where we could be in three to five years on a DE framework as opposed to an ENI framework.
If somebody is trying to think through an earnings path for us and where we could be in that three- to five-year period, if someone is focused on ENI in many ways they are going to be making a market call and however with a distributable earnings focus I think it is much easier to understand and embrace an earnings growth path for us, focused on DE, reflecting a lot of what you have heard today from a management fee standpoint as well as a realized carry standpoint.
So on to the second topic and how we think our shares should be valued, again a very frequently asked question.
Well, we are advocates of the sum of the parts-based approach and I think one of the key reasons for that actually relates to our balance sheet. Not only the size and the significance of our balance sheet, but perhaps as importantly it really relates to the nature of the underlying investments.
So our private equity investments we are likely going to hold for four to five years and our core equity investments we are likely going to hold for even a longer period of time. So we think that mark to book value on a quarterly basis, as Bill said, is a much more relevant statistic in thinking of the value of our balance sheet in that book value, instead of looking at the balance sheet on a multiple of earnings. So let us talk about each of these three pieces individually.
Fee related earnings
First, on fee related earnings, we do agree that FRE should be valued on an after-tax basis but at a multiple that reflects the growth and margin profile as it relates to the nature of the underlying earnings.
You have heard a lot already about we have long term committed AUM that leads to recurring and predictable management fees. You have, in the course of our firm, increasing diversification of investors, of funds, of strategies, of geographies with a lot of identifiable growth avenues. And again, importantly we think that we are going to eliminate the PTP discount that you have seen in us recognizing the change in our structure.
So you see in the lower left-hand part of our page our FRE trajectory 2016/17/18, these are the last 12 months ended March 31st. From ’16 to ’17, you see a low double-digit growth in our FRE that was with an 8% growth in management fees. And from ’17 to ’18 you see a 21% growth in our FRE with a 17% increase in our management fees.
So we do believe that FRE deserves a valuation that is at a premium to the S&P 500 and if you look broadly across financials, and certainly there are a number of examples of financials given the nature of their earnings, with a high recurring piece, again with upside and growth opportunities, where you have those P/E multiples that are premium to the S&P.
And in addition to that you have two C-Corps with companies that are focused on the alternative opportunity if you will in terms of Partners Group and Hamilton Lane, and both of those companies actually trade at a pretty tight band as it relates to a multiple of 2019 earnings.
So we think, again, that multiple-based approach is something that makes sense, but it should be at a multiple that is reflective of the quality of those underlying earnings.
So the second piece gets back to the balance sheet, again at a very high level. We think that that marked book value is going to be a critical piece of this framework. Now, again, as a lot of people who have looked at us know, you will see that sum of the parts framework, and I would say traditionally you will see a discount placed on our balance sheet for conservatism.
I do think that we are in a very different position today relative to when we first became a public company and I think that argument for conservatism made a lot more intuitive sense to me again when we first became public in 2010. At that point in time private equity was really a pretty new asset class through the broad public markets and we had a pretty chunky holding when you look at the balance sheet position. We had almost 50% of our investments in top five names.
Again, we feel very differently about how the balance sheet is positioned today. You have seen a significant change and diversification of the balance sheet, both in terms of the asset allocation as well as the significance of those top five holdings. And a lot of those underlying attributes of the balance sheet itself again are very attractive. So there is no management fee burden as it relates to the balance sheet investment portfolio.
And when you look at those underlying investments and think about it, it is actually interesting because a lot of our partners are paying us a fee, or a fee and a carry, in order to have the opportunity to invest alongside us across the vast majority of those underlying strategies.
And the balance sheet itself is one that is quite liquid. As of March, we had over $2.5 billion in cash. Now I do think that we intuitively are likely to always think of the balance sheet as much more of a strategic asset, but at least as we think about that valuation it does not seem to be too much of a stretch to us to think that, from a book based value standpoint we should be at least one times book, at least one times book placed on the value of the balance sheet.
Realized performance income
And then finally let us talk about carry, one of the points that Bill talked about. First, I do think and agree that when you look at our realized performance income it has been more consistent than one might think. This earning stream for us, again it is tough to really understand and predict realized carry on any forward 90-day basis. But if you look at our realized carry on a rolling 12-month basis, you see again a chart that shows nice growth.
Of course you see that again if you look at it over a rolling 24-month basis. And I do think importantly the peak to trough statistics again might be lower than one might expect in terms of the nature of this underlying earnings stream for us.
So how do we think it should be valued, but actually before we even get to that point, and this underlines one of the points again you have heard pretty consistently from us. When you think of the carry that we have generated, what you are really seeing is the performance of the private equity business and we again, as Bill went through with some granularity a few minutes ago, we have a lot of our newer funds, newer strategies that are seasoning and over time are going to have an opportunity to contribute to that overall realized carry profile for us.
And as we look at that run rate figure, this is a slide actually from Joe’s, again that number is at a significant premium relative to what we have reported on a trailing 12-month basis.
Discounted cash flow analysis
So it does strike us that a discounted cash flow analysis makes sense as you think about valuing our realized performance fees. Again, there are going to be a series of assumptions as you walk through this in terms of investment returns and underlying growth but again that framework is one that we think makes sense.
And importantly in that, again when you look at valuation approaches today in this framework, you do see this DCF based approach across a number of analyses. I think many times when you see that, that analysis is focused only on invested capital and dry powder that we have as of March 31st. So implicit in that assumption is almost a fact that it is a question whether we are going to be able to continue to grow and continue to raise capital, and again that feels punitive to us.
So when you put the three pieces together as we look at this overall framework this framework suggests a value of at least $40 per share and importantly, if we do our job, this number should continue to go up because we are going to be continuing to be focused on growing our FRE. We are going to continue to be focused on compounding our book value.
And again, if we do our job and are successful raising capital the opportunities for us to earn carry across our strategies is also going to grow.
What Impact Would Rising Rates Have on KKR?
So let us talk about rising rates. And I think the question or the belief that many people have is that a rising rate environment is actually going to have a negative impact, and this is the concern, on private equity returns. And I think that one of the things that is interesting about this concern is it is again very much opposed relative to the internal points of view that we have where there is lots of belief in our ability to generate attractive returns irrespective of the interest rate environment.
So the first thing we did in trying to think through this question was we actually looked at our history. So the two charts on this page look at the, and I am glad I can see the small print from here, it looks at the 110 North American investments we have made in our private equity business since 1984. And what the graph on the left does, is it says, okay, let us look on the one hand at the returns that we have generated and let us bucket those relative to what the 10-year treasury was at the date of that investment.
And so two things I think are interesting in this, one, it is actually not the case that we have earned outsize returns in low rate treasury environments. In fact, the data would suggest we have earned the most attractive returns in our US private equity business when interest rates have been modestly higher relative to where they are today.
And I think the important point also in this is that again we have managed to earn attractive returns over a wide variety of interest rate environments.
And what the graph on the right shows is it kind of takes this data and looks at it a little differently and it buckets our investments, not in terms of where the treasury was at the time of the investment, but how treasury has moved over the life of the investment. And again I think you have a similar result here where it shows our ability that we have been successful in generating attractive returns across a wide array of interest rate environments.
And I think one of the things that actually is so that is the historical perspective as it relates to this question. We have also thought it would be helpful to try and frame this in the framework of an LBO analysis. So if you spend a minute with me and think through again a simplified LBO model. If we were to make an investment, 9x purchase price, put six turns of leverage on it, have an average cost of debt of 6.5% in that investment, have 7% annual EBITDA growth and in five years we exit that business for one multiple turn less than we paid for it, and if you hit calc on this LBO model, it would generate a 22% IRR.
Now, if we keep all of these assumptions the same but instead of that 6.5% interest rate we increase the interest rate to 8.5%, keep all of the other assumptions the same, you see that the IRR is 20.5%. So in this specific example is an increase in interest rates, is it helpful to your IRR? The answer is no, it is not helpful. You see the IRR goes down.
However, is that move enough to turn a good deal into a bad deal? The answer to that again is no. And the other point is that if you think of when a transaction is being put together, there is obviously a positive relationship between your cost of financing and your purchase price. So if your purchase price goes from 9x to 8.8x, again you have offset the increase, or the impact from that rising rate. That change from that 6.5% to 8.5%.
So the underlying model itself again is not as sensitive to your going-in interest rate as I think people fear. Now what this model actually is pretty sensitive to is that EBITDA growth rate assumption. So a lot of what you heard today in Johannes’s piece and Pete’s piece, again about our focus on operational change and increasing EBITDA, that again is the piece of the puzzle that this math actually is quite sensitive to.
And if we are in a rising rate environment, and that is because there is economic growth, again I think that could actually end up being a very positive thing for us as it relates to private equity returns.
What Happens to KKR in a Market Downturn?
And then finally what happens to KKR in a market down turn? I think again for those people who think of us only as a leveraged play on equities and do not really think of the underlying fundamentals of the business, there are some charts in here that I think will be interesting to people.
In our experience
So first and foremost, in our experience we believe volatility can be good for our business. So having long term locked up capital, not subject to redemption, being able to time your entry, being able to time your exit, is a huge strategic advantage for us. We have the ability to be patient.
And at the same point in time our model has withstood periods of historical stress. So before we get to those case studies, just a reminder in terms of the capital base we have. Over 80% of that capital locked up for eight plus years at inception. Again, growing diversification by strategy, by geography.
And the bottom part of this chart is also important. We have $59 billion of dry powder at the end of March, that is up over 40% from the year prior period, up over 70% relative to two years ago.
And again to be clear, when volatility enters the market, having $59 billion of capital to invest that cannot be taken away from you, and valuations that are cheaper, that is a good thing.
KKR during the financial crisis
So how have we performed during period of stress? Let us go back to the financial crisis. You see here two charts, the assets under management on the left-hand side and management fees. You did see volatility of course in terms of the AUM line. I think the interesting thing is actually on the right-hand side when you look at management fees.
So you look at management fees at KKR, you saw them increase sequentially over each of those four years. And I do not think there are many asset management businesses globally that saw their management fees increase at a 24% compounded annual growth rate during the financial crisis.
And the dynamic you saw here was we turned on a handful of our benchmark private equity funds. We turned on our 2006 Fund, we turned on our Europe III Fund, we turned on our first Asia fund and those were all funds where we received management fees based on committed capital, where again the management fees we receive are not impacted by mark-to-market movements. So pretty powerful in terms of the underlying performance from a management fee standpoint.
KKR during periods of volatility
Now, let us look at us during a period of volatility. We picked the third quarter of 2011, as a lot of people in this room I am sure will remember, lots of volatility, concerns around the US debt ceiling and European financial companies. And the underlying performance of what we experienced is on the right-hand side. Our AUM was down modestly, recognizing the mark-to -market impact. Our fee paying AUM was actually flat and our management fees actually increased by $8 million.
But the other important point in here again gets back to the point of how we are not forced sellers and we have the ability to time our exits and how this is an important real strategic advantage for us.
So to try and highlight this point we have this slide, I know it is somewhat busy. But this slide says okay, let us look at our ten largest private equity investments in the third quarter of 2011 and let us see what happened and how they performed?
So the first bar you see under each of the ten logos is where those investments were marked as of the second quarter, the middle bar as of the third quarter and then that last bar is the final monetization we had in those investments, or for those that we haven’t sold it is the current mark.
So if you look at HCA, again a company that is probably well known to many people in this room, it is the fourth bar from the left. You see at the end of the second quarter it was marked at 3.7x our cost, a very successful investment. Like many stocks in that volatile period it was marked down, it went from 3.7x our cost to 2.7x, but we were not forced to sell that investment. We were not, we have capital not subject to redemption and instead we were able to wait until we feel it is an appropriate time to exit that investment. And you see ultimately that final investment was sold north of 7x costs.
So there is wonderful flexibility across our business model. When you look across these ten investments, eight of the ten you see that final bar being higher than the second or third quarter marks. And in many cases it is significantly higher, so again we thought that would give a little bit of a sense of the stability that we have and some of the advantages we have.
And so, with that I am actually very pleased to bring up to the stage Henry Kravis, who is going to offer some final remarks.
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.