Friday afternoon, what better time to delve back into KKR's Amsterdam offering memorandum and revel in its complexity, interwoven incentive structure and propensity to fleece the investing public in favor of its general and limited partners.
We left off with "opportunistic investments" and cash management, which readers will recall is a larger issue because of all the cash sitting around because this was a public offering. On opportunistic investments the memorandum says:
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.
I expect it will have occurred to most readers that this particular
segment of KKR is looking a lot like a hedge fund. If not, this
passage should be a strong hint: "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."
It is no secret that buyout funds have been jealously looking at hedge funds and their aggressive moves into the private equity space. This move, a little side fund, permits private equity funds to return the favor. A careful reading of the areas they cite as investment potential for this portion of the assets sounds a lot like hedge fund strategy. The only part missing is the short positions. I'm not sure if this means they don't intend to take short positions, or it was just too obvious to make explicit. The description is elaborated on later in the document:
These investments are expected to consist of
investment opportunities that KKR historically has not pursued due to the fact that they tend to be
inconsistent with the investment mandates of its private equity funds as a result of such factors as the
relatively small size of the investment, the fact that the investment involves a public company or a debt
investment or the unwillingness of the potential target to sell control of its business or pursue a
possible private equity transaction.
This looks a lot like Blackstone's recent German dealings. I wonder if "...the unwillingness of the potential target to sell control of its business or pursue a
possible private equity transaction," means hostile takeovers or shareholder activism opportunities. Your guess is as good as mine, probably.
Of course, one of the greatest features of a public offering involving a private equity fund is the ability of non-limited partners to get a peek at returns and internal financials. The memorandum does not disappoint:
...the annual compounded gross and net rates of return for the seven private equity funds that KKR sponsored prior to January 1, 1997 have ranged from a low of 12.11% and 8.83%, respectively, to a high of 48.14% and 39.18%, respectively, and the multiples of invested capital achieved by those funds have ranged from a low of 2.1x to a high of 17.1x.
A chart with pretty solid details is present in the offering memorandum, interested readers will enjoy examining it. It can be downloaded via DealBreaker.
Of course, when you're scooping in all these unrealized gains, you need some way to pay your taxes. Luckily, KKR PEI has thought of that problem. Not surprising since all funds with illiquid assets and lock-in periods have wrestled with this issue. The solution is to provide significant distributions on a quarterly basis. In this case:
...we intend to make cash distributions (which we intend to pay to all of our unitholders on a quarterly basis) in an amount in U.S. dollars that is generally expected to be sufficient to permit our U.S. unitholders to fund their estimated U.S. tax obligations (including any federal, state and local income taxes) with respect to their distributive shares of net income or gain, after taking into account any withholding tax imposed on our partnership.
KKR PEI does take pains to note, however, that they aren't required to make this distribution, and may decide not to. This highlights, once again, that owning limited interests in private equity vehicles can be damn expensive.
And speaking of damn expensive, how much does KKR Proper get from this new vehicle for management fees?
Under our services agreement, we and the other service recipients have jointly and severally
agreed to pay KKR a quarterly management fee in an aggregate amount equal to one-fourth of (i) our
equity up to and including $3 billion multiplied by 1.25% plus (ii) our equity in excess of $3 billion
multiplied by 1%.
Sounds like a Lehman formula in a way. How much will they claim if they have a $5 billion fund? Let us just see. Assuming their net asset value (which should initially closely approximate the "equity" calculation that drives the fee structure) is $5 billion they should command 25% of (1.25% of $3 billion and 1.00% on $2 billion). Or around $14.375 million per quarter.
Apparently, someone thought that sounded greedy, so KKR Proper graciously agreed to waive, just for the first year after the offering, the payment of any management fee on the assets raised by the offering that are still sitting in temporary investments. KRR PEI also gets to deduct from any management fees to KKR Proper any management fees they pay to KKR Proper or any third party as a result of investments (such as in KKR funds). KKR gets the typical 20% carry, but not before the offering and placement fees for the offering are caught up by PEI. Back when the offering wasn't yet $5 billion those fees were estimated at $85 million. (I love how these offering documents always call such fees "manager commissions"). It is interesting to point out at this point that KKR PEI probably won't itself get management and monitoring fees, since it is really a fund of KKR funds with a little hedge fund hooked onto the side.
We then run into their first summary of risk factors, which are mostly to be expected. Some, however, stand out.
• We expect returns on cash invested pursuant to our cash management policy to be lower than
returns on our private equity and opportunistic investments and, as a result, we expect that the
longer it takes to deploy our capital, the lower our overall returns will be.
In other words, we are sitting on a pile of cash making around 5%. Until we can spend it on LBOs and other stuff, your returns are sitting ducks. They elaborate later in the document:
The limited partners of KKR’s private equity funds generally are
only required to make capital commitments to a fund, which are funded only when a capital call
is made by the fund’s general partner, while our unitholders will be required to contribute their
capital to our partnership when acquiring our securities. Because our unitholders must fully fund
their investment in our partnership at the time they purchase our securities, and because our
cash management strategy is likely to result in lower returns than our private equity and
opportunistic investments, our unitholders may realize rates of returns on their investments that
are lower than the rates of returns realized by limited partners of KKR’s private equity funds.
And, they have no preference over limited partners (particularly over existing limited partners who want to make follow-on investments) in existing KKR Proper funds.
• Although we intend to selectively acquire limited partner interests in one or more of KKR’s
existing private equity funds over time, we cannot predict the extent to which limited partners of
those funds will be willing to sell their limited partner interests to us on acceptable terms or at
I'm somewhat surprised that KKR Proper didn't agree to give a preference to KKR PEI, but then on reflection I am not. KKR Proper, and its employees/partners, are the value driver. Pissing off their existing or future limited partner pool by, for example, giving the public a preference, is probably the wrong idea. Plus, the public is ravenous enough to really buy in regardless of how limited their interests are and how much they get screwed. More on this later.
• Your rights as a unit holder will differ substantially from the rights of limited partners of KKR’s
private equity funds and the potential return on your investment may not be commensurate with
the returns achieved by limited partners of KKR’s private equity funds.
This deserves much attention, we will get to it presently.
• Our organizational, ownership and investment structure may create significant conflicts of
interest that may be resolved in a manner which is not always in the best interests of our
partnership or the best interests of our unitholders.
Welcome to private equity.
Of course, these documents never miss an opportunity to pump up the "key men." (Interestingly, I've never seen a "Key Woman" insurance policy).
The departure of
any of the members of KKR’s general partner, including Henry R. Kravis or George R. Roberts, or a
significant number of its other investment professionals for any reason, or the failure to appoint
qualified or effective successors in the event of such departures, could have a material adverse effect on
our ability to achieve our investment objectives. The departure of some or all of those individuals could
also violate certain ‘‘key man’’ retention obligations specified in the documentation governing KKR’s
private equity funds.
More detail emerges on the control KKR exerts over KKR PEI:
...because our Managing General
Partner’s board of directors may take action (other than with respect to the enforcement of rights
under our services agreement or investment agreement with KKR) only with the approval of two-thirds
of its directors, and because we expect that more than one-third of our Managing General Partner’s
directors will be affiliated with KKR, our Managing General Partner generally will not be able to act
on our behalf without the approval of one or more directors who are affiliated with KKR.
Read: Kravis and Roberts (and perhaps their cronies).
While our Managing General Partner will be permitted to take action with respect to the enforcement of rights
under our services agreement or investment agreement with KKR with the approval of only a majority
of its directors, such approval would require the approval of all of its independent directors to the
extent none of the directors affiliated with KKR agree with such action. Such approval may be difficult
Sticking it to the public, vis-à-vis "normal" limited partners is a bit of an art here. Something that is really sneaky, after a fashion, is that the returns to KKR are segregated. This means that KKR Proper will command a carry from the one buyout that returns 6.00x cash on cash after a year, but that return will NOT be netted against $70 million in losses that KKR PEI put into "Ken Lay not-guilty" futures on the online betting exchange in Bermuda via their "Opportunistic investment" strategy. Moreover, because public investors rely on their ability to resell common units or RDU's, and those will likely be based on net asset value, public investors probably will be subject to those losses directly. True, KKR Proper will lose to the extent their own 2,880,000 units decline in value, but that's a paper loss offset by a cash gain. Public investors do not enjoy the same luxury. As a result:
Due to this limited netting, KKR’s affiliates
may be entitled to receive a portion of the returns generated by our investments (in addition to the management fee that will be payable to KKR under our services agreement) even though our
investments as a whole do not increase in value or, in fact, decrease in value.
Then there is this little quirk related to management fees to KKR Proper:
The management fees that limited partners of KKR’s
private equity funds must pay KKR, in its capacity as the investment manager of the funds,
generally are based on a percentage of capital committed to the fund during the fund’s
investment period and thereafter based on a reducing percentage of the cost basis of the funds’
investments, which causes the fees to decline over time. The management fee that is payable to
KKR under our services agreement, on the other hand, is based on our ‘‘equity’’ and does not,
by its terms, decline over time.
This means that overall unitholders pay much larger fees than limited partners.
Typically, private equity funds have provisions to "claw-back" fees paid to general partners of the fund in the event the fund closes with a net-loss. Not so here. To wit:
Distributions that are made to the general partners of
a KKR private equity fund pursuant to a carried interest in the returns generated by the fund’s
investment generally are subject to reimbursement in the event that the fund is in a net loss
position upon the termination of the fund. Distributions that are payable to KKR’s affiliates in
connection with our co-investments and opportunistic investments will not be subject to similar
reimbursement, although such distributions will take into account prior realized and unrealized
In other words, KKR PEI could be a total bust except for three big LBOs that KKR Proper was only able to complete because of the additional funds available from this public entity. Those LBOs would pay 20% carries to KKR Proper, but the rest of KKR PEI's investments could tank and drop the fund to below the initial offering price. Despite this, KKR Proper keeps the LBO gains, and keeps the management fees it has packed in over the last many years.
Speaking for myself, I was quite looking forward to getting a peek at the various investments KKR Proper was making via disclosures that would have to be made now that a public vehicle was attached. So much for that idea:
We expect that limited partners of KKR’s private equity funds will receive
comparatively more information concerning a fund’s portfolio company investments than will be
provided to our unitholders.
These will be subject to confidentiality requirements as well. Ugh. More in the days ahead.