Jeff Ubben’s hedge fund, ValueAct Capital, notified the market at the end of April that it had acquired a substantial interest (an estimated 5%) in buyout firm KKR & Co. (KKR, Financial) looking to unlock value from the business.
This may be one of the last remaining 50-cent dollars. KKR is misunderstood. The business’ operating structure is usually blamed for its lackluster valuation. The business was formed as a partnership, a tactic designed to help minimize taxes and keep founders and employees in control.
While the structure has its benefits, it comes at a cost. According to Stephen A. Schwarzman, the chief executive of the Blackstone Group, if his firm were structured as a typical company and valued the same way as typical Standard & Poor's 500 stock based on dividend yield, shares in the company would be worth $100 each instead of $30.
After revealing the position, Mason Morfit, the president of ValueAct, claimed:
“If there’s any business we ought to know about it’s the asset management business, which we are in ourselves. It has an extraordinarily high satisfaction level among its client base, and we think that the future in the near term is extraordinarily bright because of this factor.”
He went on to say, "KKR is one of the oldest, most storied private equity firms in the industry," and yet KKR stock trades at just 3.5 times 2018 expected earnings. "That’s a valuation you put on a business that’s going out of business in the next three or four years.”
KKR: A complex structure
It’s difficult to argue that shares in KKR aren’t undervalued. The shares trade around $18.50, 90% higher than the level of around $10 for 2010 excluding dividends. Over the same period assets under management have grown 2.3 times and management fees have exploded. Private market fund management fees have grown from $396 million in 2010 to $466 million for 2016. Assets under management for public market funds have exploded from $15 billion to $56 billion as management fees increased from $57 million to more than $300 million. As management fees have grown, though, the underlying value here has been camouflaged, as Kyle Mowery of GrizzlyRock Capital explained in an interview last year:
"Alternative asset managers have half or more of their market cap in underlying investments, therefore reducing the enterprise value of the operating business and increasing the disparity of security price versus operating business value.
"While alternative asset managers have various strategies across private equity, hedge funds, public funds, etc., these companies together have a distinct feature: questions around free cash flow timing given performance fee uncertainty. On a short-term basis cash flows are uncertain, yet the cash flows are not risky. Risk is the probability of permanent capital impairment. We judge the risk of investing in the alternative asset managers to be low as many (most in some cases) of their clients have long-term contractual commitments. Management fees keep the lights on and pay us as investors a base dividend. Yet when performance fees kick in, we believe firm profitability and free cash flow distributable to investors is likely to be substantial."
KKR’s opaque business structure hides the company’s real value, a value that is hard to understand mainly because it’s masked by the corporate structure. But there is a value-unlocking catalyst on the horizon in the form of President Donald Trump’s potential tax reforms. The proposed changes will lower corporate tax rates; this may, in turn, inspire KKR to change its operating structure, a move that would likely see the market re-evaluate the stock as both income and earnings play as the new structure brings clarity.
A new structure would also mean institutional investors that were previously banned from owning the stock due to its partnership nature would be able to buy in. Indexes and exchange traded funds would be able to buy.
Disclosure: The author owns stock in KKR.
