Monday, July 28, 2008

KKR: Has Private Equity's Death Knell Just Rung?


Private equity giant KKR, which gained fame by taking RJ Reynolds private two decades ago, will go public on the New York Stock Exchange through a takeover of its Amsterdam-listed investment fund KKR Private Equity Investors LP.

This morning David Faber talked about the deal on CNBC's Squawk Box (click here to see discussion). It is worth mentioning that KKR isn't looking to raise new capital, but the arrangement with KKR Private Equity gives it access to the fund's investments at a much cheaper price. And for investors in KKR Private Equity, who have watched shares fall from their initial listing price of $25 to the $10-range, the deal provides assurance that they will recoup some of their losses.

Unlike Blackstone's partners, KKR's partners will not cash out on the deal. At least not for the next six years. Instead, the two founding partners released the following statement:

"For KKR, this transaction provides us with additional capital for our business. Moving forward with a public listing will allow KKR to do what we do best -- grow companies around the world and produce solid returns for our investors from a larger platform and a deeper capital base."

Clearly times are not good for private equity. That closed end fund in Europe was trading at a 50% discount of its net asset value (NAV). KKR's partners were forced to do something to bolster the fund and I think it was a good move on their part (the market seems to agree as the Amsterdam-listed fund jumped 27 percent this morning).

In my opinion, private equity's woes will continue. Last August, Fortune published an article, Why the private equity bubble is bursting, which described the origins of the private equity mania:

The combination of low interest rates, depressed stock prices, and rising corporate profits created ideal conditions for private equity firms to flourish. Using dollops of cash and bushels of debt, they were able to snap up solid companies on the cheap - in 2002 buyout prices averaged just four times cash flow (defined as earnings before interest, taxes, depreciation, and amortization, or Ebitda). In a typical deal a private equity shop would borrow about 70% of the purchase price (those loans go on the acquired company's balance sheet, often doubling or tripling its debt load).

With that kind of leverage, even modest improvements in the company's profits generated huge returns for the private equity firms and their investors. In some cases, they paid themselves dividends that allowed them to recoup their entire investment within a year. And to top it off, they raked in huge fees from the companies for arranging the deals and the financing, as well as for managing the business. (The deals also got a boost from Uncle Sam. The interest on all that debt is tax-deductible, so the companies saw their tax bills drop drastically.) The math made the buyouts bulletproof. "The market was so good that dead people could have made money on LBO deals," says Chris Whalen, a managing director at Institutional Risk Analytics.

The article ends off by stating the following:

For the private equity shops, higher rates reduce the potential value of the companies they hold, since a new buyer will pay more in interest to carry the debt. "If spreads on high-yield debt stay this wide, it's extremely negative for the profitability of private equity firms," says legendary investor Carl Icahn.

The biggest losers, though, are likely to be the swashbuckling hedge funds that gorged on high-yield debt and did it in the most reckless way possible. To amp up their returns, they borrowed heavily to buy the bonds of already highly leveraged companies. That's piling risk on top of risk in a rickety structure that a slight bump can topple. Wall Street firms promoted the practice. Not only did they sell high-yield bonds to the hedge funds, they also lent them money through their prime brokerage arms to buy the bonds on margin. It wasn't uncommon for the funds to borrow 80% of the price of the loans. With that kind of leverage, for example, they could earn 18% or more owning bonds with a nominal interest rate of 10% or so.

The same leverage that magnified their returns will multiply their losses, with potentially dire effects. Here's what the worst-case scenario might look like: As the hedge funds get margin calls from Wall Street, they're forced to dump their holdings of loans and bonds to raise cash. The glut of distressed debt for sale crashes prices and pushes yields to towering levels. Then everyone holding high-yield debt, from Asian banks to small investors with money in junk-bond mutual funds, will take a horrendous pounding.

What we're seeing here is simply sanity returning to the market. And as always in the aftermath of a bubble, sanity returns the hard way.

Sanity has indeed returned the hard way. It's amazing to see how so many "smart" pension funds rushed to diversify their asset mix away from public equities into private markets like private equity, real estate, and infrastructure. It only proves that smart money does do dumb things when they act collectively.

An article from the Boston Globe puts it more succinctly:

Investors stretching for yield are making all kinds of markets do strange things. Look at the subprime mortgage market to see how that practice can end badly. Private equity's debt bubble could become another story with an very ugly ending.

The private equity and real estate party is over. Investors need to carefully monitor their private investments, making sure that they are investing into top quartile distressed debt funds and they need to pay careful attention to their fund's total exposure in private markets to properly manage downside risk.

As far as pension fund managers waiting for an improvement in credit conditions, they might want to remember Keynes' other famous quote that "markets can stay irrational longer than you can stay solvent" and take this opportunity to revisit their redemption policies.

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