My visit to KKR

I took this photograph on Saturday while at KKR's 42nd floor office in Manhattan's Solow building. Not a bad view of Central Park!



I spent an hour speaking with an acquaintance who is an associate at the firm. Our conversation ranged from his career, (he was a St. Thomas undergrad in finance) to the last 2 years working in the capital markets, and from KKR's business strategy to its upcoming Dutch IPO. It was an excellent learning opportunity.



I also got the chance to pick up KKR's 2008 Annual Review and have spent a number of hours reading its contents.



While KKR does not have an office in MPLS, I thought that there is valuable information for us MPLS dealmakers to glean from the most respected private equity firm in the world.



In that vein, here are a few of my thoughts from my visit:

Point #1: The Public/Private Irony. Private equity firms argue that companies 'win' when they go private because they are not subject to the public scrutiny required by 8Ks, 10Ks, and the incessant need for manage earnings. Instead, the argument goes, companies can focus on creating long-term value. They can make investments now (R&D, or PP&E) that have long-term payoffs later. So, "it's better to be private" the argument goes.

But KKR has been trying for years to go public. In summer 2007, KKR filed with the SEC to issue a $1.25 billion ownership stake in its management company (this occurred 2 weeks after Blackstone's IPO). They pulled the offering after the credit crunch, and are trying to perform a reverse merger of its Euronext affiliate, KKR Private Equity Investors.

So how can PE funds legitimately say that going private is best, but still go public themselves? Isn't this a double-standard? No, it is not. I believe there is a legitimate reasoning, and it can be summed up in one word: funding.

The funding of private equity firms is likely to be very difficult for the next couple years. PE funds' investors are "LPs" (limited partners -- usually accredited investors under "Reg D"). The actual identity of these investors is almost always institutions: university endowments, pension funds, and HNW (high net worth) families. The money managers that run these funds usually have a specific sector allocation: 40% US equities, 20% fixed income, 10% private equity, etc.

Now, think of how quickly the value of some of those sectors get reported: at the end of every trading day, a money manager knows exactly how much his US equities portfolio is worth. But he does not know what the PE portion of his portfolio is worth -- those assets are not publicly traded. The result of this difference in reported valuations in the context of the Fall '07- March '09 selloff is that the percentage of a money manager's portfolio allocated to private equity has significantly increased in the past 18 months.

What does this mean for the manager of a private equity fund? It means that he will have a much more difficult time convincing LPs to provide new money into the manager's fundraising efforts. Liquidity dries up. This is especially pernicious when you consider that corporate valuations have come down, and PE managers may be spotting good investment opportunities.

So -- getting back to KKR -- the primary reason I believe that KKR is going public is so that it can quickly raise capital in a poor fundraising environment. Unlike at Blackstone, KKR's senior partners (Roberts and Kravis) are not selling any of their ownership in the fund. (Pete Peterson, founder of Blackstone and former CEO of Lehman brothers, did sell his ownership and received a $1.5 billion dollar check in the mail. ("pre-tax!", he reminds people -- see his Charlie Rose interview for more from him))

Point #2: Diversification. A second interesting point regarding KKR is its effort to diversify its abilities so that it can a) find new ways to develop cashflow and b) distinguish its capabilities from other firms. Put simply, KKR is not your regular buyout firm. KKR is increasingly providing a full suite of financial capabilities, including:

1. KKR Asset Management (KAM). In December 2008, KKR launched KAM to make investments across the entire capital structure of companies. The bulk of its assets are in senior secured (80%), but there is also high yield (15%) and second lien/mezz (5%). The thinking here is that, with capital markets still tepid, corporations will have a 'financing gap' that may be increasingly filled by non-traditional lenders like KAM.
2. Global Infrastructure Group (GIG). The GIG is an "upgrade" of the firm's energy industry team, and represents KKR's realization that there is a large global need to invest in infrastructure. KKR estimates that infrastructure -- especially in Asia where it has recently opened offices -- is a $3.0 trillion/year industry.
3. KKR Capital Markets (KCP). KCP supports transactions in its private equity, KAM and GIG. It's essentially an in-house investment bank that ensures dedicated banking services are available to all portfolio companies and retains the transaction fees that would otherwise go an I-bank. Among its capabilities are 1) raise debt/equity financing in public/private markets, 2) provide strategic capital market advice, 3) provide hedging strategies, 4) provide insight into adjusting/deleveraging capital structure, and 5) underwrite security offerings.
4. An "in-house global public affairs capability." With public scrutiny of large corporations getting stronger every day, KKR has astutely formed a team to address various stakeholder interests. The purpose of this group is to further the due diligence on a potential acquisition (or assist a portfolio company) on environmental, social, and regulatory issues.

In summary, KKR is expanding the types of services it provides so that it can ensure money is coming in the door, even when that money is not coming from its LPs. Additionally, providing these services makes KKR a more attractive suitor since any offer by KKR is accompanied by a best-in-class public affairs and capital raising teams.

While most Minneapolis firms are not large enough to provide this array of financial services, it is useful to see the strategic changes KKR is making amidst the chaning economic climate. Smart firms should consider how they can be making necessary adjustments too.