I’m not positive that the KKR team ever left behind their private equity mindset when they decided to raise capital and become a publicly traded limited partnership in 2010. My basis for that opinion is the equity awards.
We have all heard Warren Buffett speak ad nauseam about the fact that he views his shareholders of Berkshire Hathaway as equal partners. He is able to do this because he owns 18% of Berkshire stock (he used to own about a third of the company before he started giving billions to charity) and he only collects $100,000 in salary. In other words, Buffett’s wealth comes from growing the value of Berkshire which makes the rest of the shareholders rich.
When business executive get rich from excessive equity grants, they don’t really need the business to prosper tremendously well in order to reap a significant return.
Among people who have historically followed the stock, Kohlberg, Kravis, and Roberts seem to get a wide amount of latitude because of their historical ability to reap 20-25% annual returns throughout the 1980s and 1990s. While a lot of that was the result of leveraging debt and then selling off piecemeal, the strategy worked long enough to personally make them hundreds of millions of dollars.
But something has changed. Their partnership is no longer based on growing returns from their business investments but rather by maintaining the status quo and diluting the absolute heck out of their existing ownership base with special compensation.
In 2017, KKR stock is going to get diluted by 5.2 million units to pay off executives. With the stock at $17, this means that there is going to be a value transfer of $88 million away from unitholders each year. Not to mention that most acquisitions are also funded via KKR’s equity and has resulted in unit count dilution from 212 million in 2010 to 430 million entering this year.
I also don’t understand how anyone can value the KKR investments in the portfolio. Take a look at last year’s annual report. Look at the consolidated statements on pages 221 through 226. Can you read through that summary of the business and fully understand it? If you can make sense of all that, you should set up shop on Wall Street and charge $1,000 an hour.
The cost of its debt is higher than you might think, as it has 14 million preferred stock units paying out just under 7% and carries $18 billion in debt against somewhere around a billion dollars in net profit (because it relies on finessing the tax code so much, the true earnings power of KKR’s asset management is nearly impossible to divine).
When private equity firms are at their worst, they are nearly impossible to understand, loaded with debt, paying themselves handsomely, and shuffling tax obligations onto their partner investors.
Well, that is what is happening to the current investors. Can you understand their oil and natural gas investments? Are you put off when you see a $13 billion company carry $18 billion in debt while issuing hundreds of millions of shares and paying 6.75% as its cost of capital? Do the millions in unitholder grants to the KKR management team bother you? Or how about the fact that the distribution recently got slashed from the $2 range to $0.64 while saddling investors with a forty-page K-1 form each year?
Now, a much more difficult question to answer is whether all of this has been appropriately priced into the stock at the current valuation. I’m largely agnostic on whether the price will move up from here. But as a threshold matter, I don’t think KKR stock is suitable for investment because the earnings power is too difficult to gauge and the debt burden is insanely large at over 18x cash flows. Barron’s recently argued that there is 55% upside, but I can’t imagine that the typical Barron’s investor knows what they are getting themselves into here. If its borrowing costs are high, what happens when interest rates rise? And if the stock is as undervalued as some people say, then what do you make of the fact that the KKR management team has issued over 200 million shares in the past eight years?
Originally posted 2017-01-08 21:35:04.