Why is KKR Going Public?

With investors avoiding anything with unclear risks attached and a general feeling that interest rates are going up, it seems like a bad time to try and sell part of a company whose sole business is borrowing money and investing it in risky ventures. Yet one of the world's leading private equity firms is doing just that.

Private equity and leveraged buyout firm Kohlberg Kravis Roberts & Co has announced its intention to file for an IPO. The firm, most remembered in the public mind for it's negotiation of the RJR Nabisco buyout in the 80s (and dramatized in the book Barbarians at the Gate) is picking an unusual time to conduct this offering, given that IPOs for private equity firms like Blackstone and Fortress have performed so poorly since their entrances in early 2007. And by poorly, I mean both are down more than 50% from their IPO prices. KKR's stated reason for choosing this time is to generate sufficient capital to keep its European affiliate afloat amid difficult market conditions. KKR's publicly traded subsidiary - KKR Private Equity Partners LP (traded on the Euronext) is trading down 44% from it's IPO in May 2006.

Understanding as well as anyone the challenges of the current environment, several covenants are being put in place which will make it difficult for the partners to liquidate their holdings for several years, seeking to reassure investors that they aren't looking for an exit opportunity. Buyers will be doing so because they believe that KKR can continue to deliver the average annual return of 26% that the partnership has enjoyed for the last 30 years. The offering is also being touted as a pretty reasonably priced deal because the company is only being valued at 10 to 12 times its expected 2009 earnings.

The fact is, the guys at KKR have an impressive track record. Given the kinds of returns they've earned for their investors - obviously they're a smart crew. You don't build a 30 year track record by luck alone. But just because they're smart and have done well in the past doesn't mean that this is a good deal for their public market investors. The hassle of being a public company - the scrutiny, the disclosure, the liability that comes from having poor little old ladies own your stock is proving increasingly onerous and a major distraction to management. Presumably, being public acts as an impediment to quick and decisive action - a characteristic assumed of high flying Wall Street financiers. The private nature of these companies was generally seen as one of their strengths. So, why choose to raise money in the public markets instead of going to institutional investors, whom they've earned such massive returns? Given the terms of the deal, the only possible reason is that they are the markets of last resort for desperate firms like KKR and Institutional investors apparently aren't interested. At all. This begs the question, why?

If you expect that KKR can continue to deliver 26% a year, then the IPO is a great deal. Historically mid cap value companies (which KKR expect to be) have returned about 13%annually. This means that KKR would be expected to be 2x as valueable as a mid cap value company. Assuming that the company is only selling for 10x next years' earnings, with the Russell Mid Cap Value index trading at about 20x last years earnings, you'd think that this was a fabulous deal. Institutional investors should be all over this deal - even with the lousyness of the markets and a general skitishness, buying a stock at 1/4 it's fair value should be a no-brainer. They shouldn't need to go public, because institutional investors (which don't include little old ladies to sue you in class action lawsuits) should be all over the deal at these terms and willing to accept the illiquidity of a private investment. Heck - how illiquid would such a great investment be if it performed anywhere near as well as it has historically? It would be a great buy even if the company only returned slightly above 8% a year given it's deep discount!

So this tells us that the "smart money" (not always an accurate way to describe institutional investors, but the most commonly used one) doesn't think that KKR will return even that low percentage return. Who knows? But given the above and the poor performance of Blackstone and Fortress, this deal shouldn't really be possible if the markets are acting rationally. What the KKR IPO will tell us is whether investors are still willing to put aside all of the reasonable data and roll the dice. If they're willing to pay up for this company, then it suggests that there is still a great deal of overvaluation in the markets. I tip my hat to Mssrs Kohlberg, Kravis and Roberts for their past accomplishments and wish them the best in the future, but this deal doesn't make sense on paper.

I hope the investment community rejects this deal, not because I want KKR to fail, but because such a rejection will tell us the markets are starting to act more rationally. By rejecting an offering so clearly fraught with problems, it suggests that they conversely look at the fundamentals and start to recognize the value of truly promising companies as well.

New housing legislation and the Fannie Mae / Freddie Mac bailout

Not surprisingly, Congress is likely to pass legislation this week which will make a limited financial commitment to the government - sponsored mortgage giants and attempt to restart the housing markets. This avoids the unpleasant alternative of guaranteeing the mortgage giants' debt, which would dramatically increase the federal government's overall debt.

The legislation will expand the government's authority over the government sponsored enterprises, particularly their minimim capital requirements (which you can expect them to use), which means pretty much that Fannie and Freddie are likely to be slow growers in the future, as they will be forced to build up their capital and stop buying as many loans. My guess is that, if this legislation proves effective at stabilizing demand for mortgage-backed securities, you'll see it applied to the rest of the financial sector. Generally, I think that banking is likely to be over-regulated over the next few years, meaning a slow growth environment for the financial sector. That having been said, it should survive. Historically, banks were slow-growing, unremarkable, but reliable investments. I think you'll likely see that trend be encourgaged by regulators for some time to come.

Congress will also likely pass legislation allowing the FHA to buy mortgages from distressed borrowers at a 15% discount. Essentially the effort seems to cover institutions that expect that the entire subprime slice is going to default on their mortgages. This will, at least, remove the most skittish debt owners from the market. Certainly pricing on the individual mortgages that I have seen has improved dramatically in the last few weeks and morgage backed securities as a class have started to improve.

As far as mortgage rates are concerned, I suspect that they will trend upward over time, but remain fairly low by historic standards. That having been said, its reasonable to expect that financing will require 25% of the purchase price and the borrowers will need to demonstrate that they will find the cost of the mortgage very easy to handle on their incomes.

NVCA Declares "Capital Crisis for Start Up Companies"

This second quarter has the dubious distinction of being first since 1978 where there were no venture capital backed IPOs. The National Venture Capital Association has recently launched a public relations campaign to get congress to reduce post Enron accounting regulations on startup companies. “Venture-backed companies that successfully enter the public markets represent a critical job creation engine for the United States economy, and that engine has completely shut down,” said Mark Heesen, president of the NVCA. “We need to put regulators, legislators, presidential candidates, and the private sector on notice that this situation represents a serious problem that will have long reaching economic implications if not addressed. We view this quarter as the ‘the canary in the coal mine’.”

Given comments by Brack Obama in his Wall Street Journal Interview and campaign's director of economic policy, Jason Furman, to Larry Kudlow, it seems likely to be an issue in coming debates and feature prominently in his economic agenda. Venture capital firms like Kleiner Perkins have been actively attempting to increase their influence on Capitol Hill over the last few years and cultivating relationships with leading Democratic politicians like Al Gore. Support for tax breaks for venture firms is also likely to be well-recieved by congressional leaders, particularly Speaker Nancy Pelosi (D-CA, San Francisco).

Interesting Chart

A recent report from the Internation Energy Agency arges that large flows of investor capital don't explain the increases in oil prices. "OPEC production is at record highs and non-OPEC producers are working at full throttle, but stocks show no unusual build. These factors demonstrate that it is mainly fundamentals pushing up the price.”
As this chart from the Department of Energy shows, oil consumption patterns have been pretty moderate over the last few years and US consumption has slowed considerably.
Certainly this type of data lends credence to the view that speculation is driving the price of oil, rather than rampant growth from China.