Jul 09, 2018
Bill Janetschek, Chief Financial Officer, walks the group through KKR’s business model, provides additional information around our C-Corp conversion and offers some visibility into our performance.
Chief Financial Officer, KKR
Good morning, everyone. I am Bill Janetschek. I have been with the firm indirectly and directly for 33 years. I started my career at Deloitte and I was at Deloitte in the Tax Department for 13 years and 12 of those 13 years my only client was KKR. So one could argue that I was actually interviewing for a job at KKR for 12 years.
It finally took me 12 years, but 12 years later I actually got offered a position as a Tax Director at KKR, so I left Deloitte as a Tax Partner and came on to KKR, and was there about a year and then Henry and George asked me to be the CFO and that was in 1998, and so that is 20 years ago.
What I want to do today is cover three topics. Number one, I want to walk through briefly our business model. What I want to try to do is wrap everything up over what you have heard all morning and to reference some numbers.
Number two, I want to give you a little color around our C-Corp conversion; and lastly, I want to give you a little visibility into some numbers around our second quarter performance.
Business Model Review
Simple financial model
So when you think about our model it really is quite simple. We have three forms of revenue and two forms of expenses. We receive management, monitoring and transaction fees, and receive realized performance income and so that could be either carry or incentive fees from the third-party capital that we manage. And secondarily, we have realized investment income, and that is income off our balance sheet. And so that is investing side-by-side with the third-party capital that we manage. So again, pretty simple, only three revenue streams.
Operating expenses, categorized into really two major buckets. Our compensation, which includes equity-based compensation and occupancy and other operating expenses. When you think about our reporting historically and where we think we are going to be reporting prospectively, that compensation number, again, including equity-based comp has been roughly in the low 40%.
When you take a look at occupancy and other operating expenses that has varied anywhere in between 8–10%. So adding those two numbers together, on a pre-tax basis our margins have been roughly 50%.
We are going to be reporting not on ENI prospectively but on after-tax distributable earnings and that will be our new P&L metric prospectively.
So let us briefly go through the revenue streams. Number one is our fee revenue. That is made up of really management fees and transaction fees. Management fees, fortunately a good majority of them come from long-dated locked up capital that we get to manage over a very long period of time. Approximately 80% of the capital that we manage is of that nature.
And you can see that to the extent that we are making investments both for the capital that we are investing for the third-party capital that we manage, as well as transaction activity for our capital markets business, that is going to drive the increased revenue.
The one thing that I want to point out is that we have got $59 billion of dry powder; so that is capital that is already contractual, but we have yet to actually invest. $25 billion of that capital is what we call shadow fee paying AUM; meaning we have that capital but we just have not invested that capital. That $25 billion is being invested at a run rate of roughly 100 basis points. So, assuming we do not raise any additional capital from here on forward, which is not going to be the case, we already have got $250 million of run rate revenue built into this system that actually has not come through our management fees.
One last point, and this is for our new investors, I just want to make sure that you understand that the majority of the management fees that we receive are based upon either committed or invested capital. So to the extent that there is mark to market in any particular quarter, that does not impact the management fees that we calculate. Quite honestly going into the beginning of the year I can probably project with 95% accuracy what the management fee is going to be at the end of the year.
I want to spend a little time around infrastructure. When we actually raised our first infrastructure fund we actually gave away below market terms only for the fact it was a first-time fund and it was hard to raise that capital. So you could see that the first fund was $1 billion and the blended management fee and carry rate was 1%/10%.
Successful fund number one allowed us to raise $3 billion for fund two, but we still did not really see the solid performance as we were raising Infra II and so those terms were quite similar. But now, as we were raising capital for Infra 3 we had top quartile performance for Infra I and Infra 2, it was a lot easier to raise the capital and you could see that the blended management fee went from 1–1.2%, so a 20% increase. And, more importantly, the carry went from 10–16%.
We will be closing on roughly a $7 billion fund in Infrastructure III and that will take place in the back half of 2018. Now when that does happen you can see that Infra II, of the $3 billion, $2.9 billion is from third party capital at 100 basis points, that is $29 million. It is an infancy fund and so we have not sold any of those assets, infrastructure, those assets we hold for, you know, quite a long period of time. And so, when we go from the investment period to the post investment period, the rate is still at 1% so no change in fee. So 29 still is 29.
However, now we are layering on an additional $7 billion of capital at 120 basis points and you will actually see the management fees, in just the management fees from infrastructure go up by $80 million. And so, based upon the targeted final close, we will certainly see at least $20 million come through our P&L in the fourth quarter of 2018.
Impact of FS partnership
Todd briefly talked about Franklin Square. I just want to help everyone model some numbers. Even though the transaction did not close until April 9th, we signed the deal in the fourth quarter, we were actually a sub-advisor to Franklin Square in the first quarter of 2018 and received roughly $7 million of management fees. Transaction closed April 9th and when you run through the numbers for the second quarter we are adding an incremental $6 million of additional management fees from that JV.
Taking into account the management fees and the incentive fees that we could earn from having that JV with Franklin Square, Todd mentioned earlier we expect that to be at a run rate of roughly $100 million annually. And again, that is management fees and incentive fees.
Realized performance income
Realized performance income, there is going to be two things that are going to drive this number. Number one, and we talked about this all morning, as Fund I turns to Fund II turns to Fund III and we scale these businesses, we are certainly going to be managing a lot more third-party capital, and what drives performance income is clearly based upon investment performance. So to the extent that our investment performance is strong, we are entitled to a certain percentage of the profit that we manage for our third-party capital. And you can see that number go up.
Bottom left, this shows the performance fee eligible fee paying AUM from ’13 on an LTM basis growing to $98 billion. And, more importantly, you could see, this is realized performance income that we have received, grow from where it was in 2013 of roughly $750 million to right now at approximately $1.3 billion.
Now, keep in mind we are investing, we are growing those investments and we are harvesting and so the number to the left is what we are actually monetizing. While we are doing that we are also having the ability to invest new capital and on a mark-to-market basis grow the net accrued carry. And that number has grown pretty significantly over the last few years.
Realized gross performance income and dry powder growth
This is a very interesting slide and it brings back fond memories of having conversations with Henry once we went public, and he would call me and say, I do not understand the stock price. You take sum of the parts, you look at the balance sheet, you look at the fee related earnings, it looks like our carry is trading at zero, am I doing the Math right? And I would say yes, yes, we are doing the math right, Henry.
I do not know why, but what I have heard from our investors is that the carry that we have realized is episodic, meaning that it does not happen on a regular basis and so we are not getting the full credit that we should deserve. And Henry’s point to me was always, well go and tell them that the value proposition at KKR really is not about the management fee, it is about the carry.
And I would say, Henry, Craig and I and Scott will try. And try as we did over the last eight years, but this is an interesting slide because if you take a look at, and this is on an LTM basis, first quarter of ’18 it is $1.3 billion off of going back to when we first went public at $346 million. So the realized performance income has gone up by 4x. The dry powder that we are able to invest to create carry later on has gone up by 4x and along the way the monetization of the carry has gone up by 3x.
And if you take a look at this chart it looks like a pretty steady stream of revenue and up and to the right, and so, and Henry knows this number so I do not want to put him on the spot again but we have been public now for 35 quarters. We have reported carry in 34 of those 35 quarters and so you might say carry is episodic, but if it happens 35 out of 36 quarters I would actually challenge that.
Significant opportunity key for realized carried interest
As we are talking about carried interest, when you bifurcate where the carry is, this is a very interesting slide. This shows the $120 billion of AUM that we have in which we are entitled to realize carry. 25% of the AUM is driving and has driven 91% of the realized carry, and that is really from the three flagship funds that we have in private equity. It is the ’06 Fund in NAXI for North America, Europe III and Asia II.
Interestingly, if you go down one box below we have got roughly $30 billion of AUM in funds that are above cost and have the ability to pay carry, but they are immature investments, meaning we have only held those assets anywhere between three and four years. And so, when you look out over the next few years you can see that that number is equal to the size of where right now most of the realized carry is being generated. And as we roll the clock forward, we have significant upside on realized carry from that category of funds.
The third box is those mandates where we are in the seasoning or working through our preferred returns. So these are very early stage funds and so we just started funding capital work in Asia III, we just started putting to work capital in Americas XII, and so the funds do not actually have any real performance to speak of. And as those continue to grow roughly $60 billion so 60/120, so 50% of the AUM that we are managing that have realized carry are really immature assets, which have the potential to grow significantly over time.
Balance sheet, very quickly, to state the obvious, we capture 100% of the earnings off the balance sheet, there is no fee sharing. And what is going to drive the balance sheet results are performance. And so, to the extent that we continue to do a good job and grow our platforms and produce great returns, this will come through in our balance sheet.
And as you know, and Scott mentioned this earlier, from the capital allocation policy, in the fourth quarter of 2015 we changed our model where, instead of paying out the majority of our free cash flow, we established a fixed distribution and took the excess and used it in two ways.
One was to either use some of that capital to buy back shares, or number two was to take the excess, put it back on our balance sheet, invest side by side with our third-party investors and continue to compound that book value. And you can see the realized investment income over the last few years has been pretty solid.
Spend a couple of minutes on expenses, compensation expense; you can see that when you take into account all of the three forms of revenue, so that is fee income and carry and balance sheet earnings and you take into account the compensation that we pay. I mentioned that we are targeting in the low 40s and you can see that in 2017 on an LTM basis that number is roughly about 40%.
Occupancy and others
Occupancy and others, we mentioned this earlier. What we did was, as we were growing these platforms we spent money to build the infrastructure, knowing full well that the revenue would show up later. And so, you could see that when we started a lot of these platforms in 2010 through 2012, we spent a good amount building up the infrastructure. And so, when you see the occupancy and other expenses, it is growing at an annual compounded rate of roughly 3%.
However, from 2013 through 2018, and this is just management fees, so it is not any of the other earnings of the firm, that has actually grown at 11%, so far greater than the expense that we had just to establish all these platforms. And on an annual run rate I would imagine that this number is going to blend anywhere in between that 8 – 9% venue annually.
C-Corp Impact and Business Update
C-Corp conversion – financial implications
Let us spend a couple of minutes on C-Corp. From a capital allocation policy what we decided to do, we are going to pay more in taxes and so we have established a dividend of 50 cents annually that we are going to be paying to our unit holders. No more PTPs, everyone is going to be an owner in a C-Corp, and so the dividend that is received by our individual investors is going to be a qualified dividend and they are only going to have to pay tax on the dividend that they received. We also announced that we were going to increase our share buyback to an authorized number of $500 million.
Spend a minute or two on taxes. The transaction itself was tax-free. So our unit holders had a PTP unit, on July 1st that converted into a C-Corp unit and that was a tax-free transaction for our unit holders. However, because of the conversion from us being a partnership to a C-Corp, we actually received a $2 billion benefit, meaning we have the ability to step up the assets that we have in our enterprise by roughly $2 billion.
Roughly speaking, 50% is going to be allocated to goodwill and that is going to be amortized over a 15-year period. The other billion dollars is going to be allocated to the accrued carry that we have on our balance sheet as of June 30th, and to the balance sheet assets that we have. So we are stepping those assets up as we are monetizing those investments. The tax leakage is not going to be that severe, certainly over the next few years. So the way to think about it is we were a PTP on June 29th and when you look historically over the last seven or eight years, our effective tax rate was roughly 7%. It will be 7% starting on June 30th because again as we are monetizing some of that accrued carry, and we are selling those balance sheet assets, there is not going to be any tax leakage.
And the way to think about it is, our tax rate will go from 7% to roughly 20% over the next five years. We will receive some of the benefit from that goodwill, which will be amortized over a 15-year period. But over a longer period of time our run rate tax percentage is going to be that 22%.
One other housekeeping item around taxes: when we talked on the first quarter earnings call, we had several positions on our balance sheet that were marked down to next to nil. A lot of these were assets that we had in either energy or credit. On a mark-to-market basis those losses already ran through our P&L when we reported ENI. On a mark-to-market basis, which is how we value our book value, it was already embedded in our book value, and most importantly, to the extent that we monetize any of these assets is really going to be no impact on cash flow.
The subtlety here is that, as a PTP, our income flowed up to our unit holders. When you think about our unit holder base, if you are an individual in high estate tax, your tax rate would be 37%. Once we go C-Corp if we actually monetized those assets the corporation was going to receive only a 22% benefit. And so, we thought it was prudent to take a look at all those assets that had actually gone down and got a value, that we did not think had any real true opportunity for any recovery and decided to sell those assets to give that benefit to our unit holders pre C-Corp conversion and receive that 37% benefit.
From April to June and in April we actually had targeted that that number would be roughly $650 million, we went through asset by asset and took a look at every single asset and, happy to say that we did a little more work and monetized some of those assets that were written down and embedded in book value. And I want to make sure everyone understands that, and that number has actually grown from $650 to $725 million.
Simplified reporting. No more ENI. So when we reported in our first quarter we actually had two P&Ls. We had an ENI P&L and then we had a total distributable earnings, which is the real cash earnings, which is really how we run the business. So we are stepping away and not actually going to report ENI prospectively.
That being said, we are still going through our valuation process every single quarter and we will mark to market our carry as well as our balance sheet and embed those marks in our book value, so we will report true intrinsic book value every single quarter. But again, the metric that we are going to report on is after-tax distributable earnings. The one subtlety is that we are going to embed stock-based compensation in that calculation. Stock-based comp was in ENI. When we removed ENI, we thought it was prudent to actually burden our cash earnings by that stock-based comp.
We are going to simplify our story around fee related earnings and we will go through that momentarily. The one good thing for our new investors is that prospectively they are only going to see one compensation line. For old investors we were good about giving out granularity and so, believe it or not, we actually reported fee income and cash comp against that fee income. We reported performance income and performance expense against that earnings and then we had our balance sheet and we had stock-based comp.
And so, we are probably one of the only industries, and I am talking about the alternative asset managers, that actually report three compensation loads in their P&L. And so, we are going to combine those all into one and, as I mentioned earlier, that number is going to be targeted to roughly 40%.
One small item as it relates to interest expense; prior to the conversion we were re-looking at how we report, we actually showed interest expense as a reduction of our balance sheet earnings, so above the line in a revenue column we had realized and unrealized income, as well as interest and dividends minus interest expense. We are actually going to take that interest expense and move it down and just report it where we have the other expenses of the firm, mainly compensation, occupancy and G&A.
And one last thing, and you can see this in the appendix in the deck in front of you, is that we are giving you actually greater transparency around carry and incentive fee eligible AUM. What we had done historically in order to guide you as to the carry opportunity, we had one page in our press release that laid out all of the funds, all of the dry powder, the remaining costs and the remaining value. That number totaled when you added it all up, roughly $120 billion. We, at the time, as of March 31st, had AUM of $176 and we never actually built a bridge between that $120 reported and the $176.
When you peel the onion back, embedded in that $176 is roughly about $35 billion of capital that we are managing, we are entitled to an incentive fee. And we thought that was important to show both our old investors and our new investors. So $120 of the AUM we have is carry eligible, roughly $35–36 is incentive and the remainder is capital that we manage where we are just receiving a management fee and no performance income.
But when you add the carry and the incentive fee, that number totals roughly about 90% of the AUM that we have, we were receiving some sort of promote on. So we thought that was important new information.
Simplified reporting – four key metrics
We are going to keep it simple, so simplified reporting, we talked about this last quarter and we are going to talk about this every single quarter. It is important as far as the assets that we manage and obviously the assets that we manage are going to drive those management fees and so those are the first two metrics that we are going to report on.
Book value per adjusted share, again, this book value is burdened with the mark to market, and so this will be every single quarter on a mark-to-market basis what the true book value is of our balance sheet.
And lastly, no more ENI; after-tax distributable earnings burdened with that stock-based comp that I mentioned earlier.
Segment focus – fee related earnings
Real quickly I am going to go through this, but there is a numeric example in the appendix and so it is probably best for you to actually take a look at that to work through the numbers. But quite simply what we are doing is trying to keep fee related earnings simple. We have three revenue streams, that is a total. There are certain expenses that we are going to burden those revenue amounts by, one of which would be excluding non-interest operating expenses, to come up with a total margin.
That margin is going to be applied to our fee income and that is going to produce our fee related earnings. Again, if you want to take a look at an example you can look at it in your leisure, we have included that in the Appendix and so you can use that as a reference when you are modeling out what the second quarter fee related earnings number is going to be.
Q2 ’18 Realized Carried Interest and Investment Income Update
As it relates to 2018 second quarter results, what we have historically done is certainly on the quarterly call we would give you a little indication as to what we knew as of that moment in time, and we said that in order to help you model your numbers on a quarterly basis, we were going to try to be more transparent and talk about the realizations that we have had in our fund, which would produce realized carry, or monetizations off our balance sheet, which would obviously produce realized investment income.
So right now as we have run through the numbers for the second quarter, the gross realized carry interest, so that is not burdened by any sort of compensation, this is the gross number, we are going to report roughly $350 million of gross realized carry. And when we look at our balance sheet, this is not burdened by any interest expense, again this is a gross number, the realized investment income off our balance sheet from a lot of secondaries and strategic sales as well as interest income and dividend income, interest income coming from our CLOs, is about $150 million, so $500 million in total.
Q1’18 after-tax distributable earnings
And before I go, just one housekeeping item. We reported after-tax distributable earnings, excluding equity-based comp, in our first quarter results. That number was 37 cents. We have gone back and we have actually put on our website and filed an 8-K on Friday and recast all our numbers to the new reporting and we have recast first quarter of ’18, all of ’17 and all of ’16.
So I just want to make sure that you are mindful of the fact that when we report the first quarter numbers again it is going to be burdened by equity based comp and so it is not 37, it is 29, and obviously you are going to have to do the same thing in order to reflect what the second quarter TDE number is going to be, again with that stock based comp.
And so with that I look forward over the next several weeks and several months to sitting down with Craig and meeting with a lot of you as we try to get everyone to understand the KKR story, and with that I will pass it over to Craig Larson.
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.