At 319 pages the April 18, 2006 version of the KKR "Preliminary Offering Memorandum" isn't the largest such document I have ever seen, but it rivals anything I have seen for pure linguistic density (and I've read the work product of Arnold & Porter). Note that the April 18, 2006 copy I am reviewing still anticipated only $1.5 billion in investment, that was later revised to $5 billion and may well have undergone significant structural revision in the process.
Because I had to research the structure anyhow, I worked up a summary of the transaction and I'm including some diagrams for Going Private readers here. As you will see, the structure is complex and the offering document's diagrams often omit key entities. A overview of the structure can be viewed by clicking the thumbnail to the left. I'll attempt to review the entire transaction and highlight the bits that I think are interesting in this, and as many as three more entries over the next many days.
The basic building blocks are KKR itself, the Delaware based U.S. general partner that we all know and love. KKR Guernsey GP Limited, the general (managing) partner of the new entity, KKR PEI Associates, LP the general partner of the investment vehicle that is named KKR PEI Investments, LP. I am calling KKR Delaware "KKR Proper," KKR PEI Investments, LP "KKR PEI," for now. There's also KKR PEI SICR S.à.r.l., (or société à responsabilité limitée) Luxembourg Limited Liability Company. We'll get to the others later.
The managing general partner that makes the investment decisions and effectively directs the investment policy of KKR PEI (here that is KKR Guernsey GP Limited, "KKR GGPL"), is co-chaired by Henry R. Kravis and George R. Roberts (no surprise there) and an unnamed CFO. In general, KKR GGPL is toothless. All the real decisions are made at KKR Proper. To wit:
KKR will be responsible for selecting, evaluating, structuring, diligencing, negotiating, executing, monitoring and exiting our investments and for managing our uninvested capital in accordance with our cash management policy. These investment activities will be carried out by KKR’s investment professionals and KKR’s investment committee pursuant to our services agreement or under investment management agreements between KKR and its private equity funds. KKR will have broad discretion when making investment-related decisions under our services agreement and its investment management agreements and our Managing General Partner’s board of directors will approve specific investment decisions in only limited circumstances. Pursuant to our services agreement, our private equity and opportunistic investments will be approved by KKR’s investment committee.
Early on I, and other commentators, wondered how KKR Proper would be incentivized to invest in a separate entity that shared distributions with public investors. As a partner in KKR you certainly would have no incentive to permit a public investment vehicle like KKR PEI to co-invest and dilute your return and your carry. KKR devised a rather simple scheme to realign these incentives. That structure is described in the diagram below.
By requiring a degree of reinvestment, KKR PEI manages to lock up some of the distributions to KKR Proper. In this case an investment agreement requires KKR Proper to re-invest 25% of all pre-tax distributions it recieves from KKR PEI. This effectively links the return fates of the two meta entites. Says the offering document on the topic:
Additionally, under an investment agreement that we will enter into with KKR, KKR will agree to cause its affiliates to acquire additional common units from us on a quarterly basis with an amount equal to 25% of the aggregate pre-tax cash distributions, if any, that are made to KKR’s affiliates pursuant to the carried interests and incentive distribution rights that are applicable to our investments. Common units that are issued to KKR’s affiliates in connection with the global offering and related transactions or pursuant to our investment agreement will be subject to a general prohibition on transfer for a period of three years from the date of issuance. We believe these arrangements will create an incentive for KKR to pursue investments that help us achieve our goal of creating long-term value for our unitholders.
KKR PEI intends to make initial investments in limited partner rights to two KKR funds, the KKR European Fund II and KKR's 2006 Fund. Following those initial investments, KKR PEI will follow an investment policy permitting it to co-invest no less than 75% of its net adjusted assets in KKR investments as a co-investor and no more than 25% of its net adjusted assets in "opportunistic investments." The diagram below gives a quick summary.
And what about these "opportunistic investments?"
We intend to gradually invest up to 25% of our adjusted assets in opportunistic investments, principally those that KKR identifies but is not able to pursue in the course of its traditional private equity activities. We expect that our opportunistic investments will include long-oriented positions in publicly traded equity securities and debt securities and securities with equity-like features that we believe underestimate the asset quality or credit strength of the issuer. We expect that our opportunistic investments also will include investments made alongside the KKR Strategic Capital Fund, which is currently being formed by the manager of KKR Financial Corp. for the purposes of making investments in fixed income securities with a focus on stressed and distressed debt and investment opportunities created by market dislocation events.
There is also a planned investment of $50.6 million for a 2.5% stake in Capmark, the former GMAC commercial mortgage subsidiary. I wonder why an LBO fund would want a commercial mortgage subsidiary. Hmmm.
Of course, cash management is often less of an issue for LBO funds that have committed but undrawn funds from their limited partners. This is a larger issue with KKR PEI given the fact the the public is dumping all its cash, not commitments, into the fund. That mandates a careful cash management policy disclosure. I think KKR PEI's falls short:
Upon completion of the global offering and related transactions, we anticipate that our temporary investments will consist of government securities, cash, cash equivalents, money market instruments, asset-backed securities and other investment grade securities. We expect that, initially, between 30% and 50% of our surplus cash will be invested in government securities, cash, cash equivalents and money market instruments, between 30% and 50% will be invested in highly rated asset-backed securities (primarily relating to credit card receivables and mortgages) and up to 25% will be invested in other investment grade securities.