Earlier this year, I covered the investment case for private equity firm KKR & Co. LP (KKR, Financial). My analysis was sparked by the announcement Jeff Ubben (Trades, Portfolio)’s hedge fund, ValueAct Capital, initiated a 5% stake in the company, calling it one of the last remaining 50-cent dollars.
As I wrote at the time, after revealing the position, ValueAct President and Chief Investment Officer Mason Morfit claimed the company is "one of the oldest, most storied private equity firms in the industry." 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," Morfit said.
KKR’s growth over the past several years has been nothing short of phenomenal, but the market has seemingly failed to grasp its potential. I recently stumbled across this 2010Â Barron’s article, which estimated KKR's shares could be worth as much as $17.22 on a sum-of-the-parts basis:
“KKR ran $55 billion in assets across a variety of strategies as of March 31. Simply valuing the management fee stream from these assets at a 15 price-to-earnings multiple, in line with other money managers, and placing a lower multiple on its capital-markets unit, yields $3.25 or so per share in value, fully taxed. Adding the straight book value of its private and public direct investments produces another $6.25 per share, for a total implied value of $9.50….
One hedge-fund manager who has been buying the stock pencils in as plausible an 8% annual gain in the private funds, calculates the present value of the resulting performance fees (or the 60% of performance fees that flow to shareholders after employees get their taste) and gives this line item a 10 multiple to arrive at $3.70 a share in value. That produces a total sum-of-the-parts target above $13, more than 35% above the current price.
Analysts at Keefe Bruyette & Woods go even further, figuring KKR’s operating business to be worth $9 to $11 per share and the private-equity portfolio worth another $6.22 atop that, for a total value between $15.22 and $17.22.”
If KKR had gone nowhere over the past seven years, this valuation this might still be justifiable, but that is not the case.
Assets under management have grown 2.3 times since 2010, and 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 risen from $15 billion to $56 billion as management fees increased from $57 million to more than $300 million.
The best investment theses are simple, and it does not take a complex spreadsheet to work out KKR should be worth significantly more today than it was on a sum-of-the-parts basis in 2010.
Taking the earnings stream from the above management fees alone and placing a 15 times multiple on them gives a potential market value of $11.5 billion, compared to the current market capitalization of $15.5 billion. This valuation excludes profits from private markets monetization. In total, management fees and private markets monetization generated $1.5 billion for unitholders in 2016 and 2015 (rounded up). A multiple of 15 times on these earnings yields a market capitalization target of $22.5 billion.
Growing earnings
Wall Street believes KKR’s earnings are set to surpass 2016’s numbers this year. According to Bloomberg, on an earnings basis, KKR is the cheapest of all the alternative asset managers. Compared to peers such as Blackstone Group (BX, Financial), Apollo Global (APO, Financial), Ares (ARES, Financial), Carlyle (CG, Financial) and Oaktree (OAK, Financial), the company trades at a forward earnings multiple of 7.4, which is below the industry average of 10.4. None of these companies are really that expensive, but KKR is by far the cheapest.
What will it take for value to be realized? Well, considering the market has ignored the opportunity here for nearly 10 years, it looks as if a significant catalyst is required. Some analysts have speculated corporate tax reform is just what is needed as it will enable private equity firms to restructure away from complex partnerships structures into traditional corporate shells, which are easier to value and invest in. What if corporate tax reform never comes to fruition? Then KKR might continue to trade at discounted valuations. But with ValueAct involved, I am betting the activist firm nudges the company to unlock value in some form or another relatively soon.
Disclosure: The author owns shares of KKR.
