Friday, November 04, 2011

KKR and Blackstone Only Good for Insiders

Private-equity firms collect funds from limited partners and couple them with debt to buy companies and sell them -- either to other compaines or to public investors. That's one reason that it is ironic that two of the biggest private equity firms, KKR (NYSE: KKR) and Blackstone Group (NYSE: BX) are publicly traded companies.

As Jerome Kohlberg, the first K in KKR told me in a 2004 interview, private-equity investing was originally called bootstrapping. Kohlberg started this idea while a partner at the now-defunct Bear Stearns.

In bootstraps, he explained, investors purchase control of companies financed largely through bank loans, while giving managers a significant equity stake to link their personal wealth to the companies' financial results. The managers streamline operations and sell the company at a profit within 5 to 7 years.

"I insisted on [Bear Stearns] management having a piece of the equity," says Kohlberg. "I brought up the idea of long-term investments in these bootstraps to the Bear Stearns partners. My proposal was overruled."

Kohlberg who founded KKR in 1976, was also over-ruled by his other KKR partners, Henry Kravis and George Roberts who wanted to put too much debt on acquired companies' balance sheets. So in 1987 he left just as KKR was engaging in conduct that made it famous in Barbarians at the Gate.

Meanwhile, KKR, is now a publicly-traded company that in July 2010 sold so-called common units on the NYSE while removing the shares from Euronext Amsterdam. Those common units are not the same as shares of stock but they give investors some rights to the cash flows from the KKR partnerships.

KKR makes money in two ways. It receives management fees -- in the industry they average 2% -- as a share of the amount of money they raise from limited partners. And KKR gets 20% of the profits it can generate by investing the capital -- known as carry. So if a private equity firm raises $60 billion and generates $10 billion investing that money, it gets $1.2 billion in management fees and $2 billion in carry.

Friday morning, KKR reported results that were not good. Instead of reporting economic net income (ENI) -- a commonly used profit measure in the private equity industry -- it reported an economic net loss (ENL). And that was a step down from the year before. More specifically, KKR's ENL was $592 million in the third quarter compared to $317.3 million ENI in 2010.

But KKR's results were not as bad as expected -- its reported 91 cents a share loss was 11 cents better than the  average loss of $1.02 a share estimated by 12 analysts in a Bloomberg survey. According to KKR, the loss was due to an 8.5% accounting charge for a decline in the market value of investments that KKR is holding and has not yet sold.

Meanwhile, in its latest report, competitor Blackstone Group posted an unexpected loss after an 11% drop in the value of its buyout holdings. In its third quarter, Blackstone reported a loss of $274.6 million, about $230 million worse than the year before. And its loss per unit of 56 cents was 44 cents worse than in 2010.

Since their initial public offerings, Blackstone stock has lost 60% of its value since its 2007 IPO, while KKR's is up 40%. So why are these companies publicly traded? They give partners an easier way to turn their stakes into cash. But does that mean you should buy their common units? Avoid both -- despite their apparently low valuations.
  • Blackstone: rapid growth, unprofitable; very inexpensive stock. Blackstone's sales have increased 75.9% in the past 12 months to $3.42 billion while it lost $156.6 million . Its PEG of 0.19 (where a PEG of 1.0 is considered fairly priced) is cheap on a forward P/E of 8.4 and expected earnings growth of 43.5% to $1.69 in 2012.
  • KKR: fast growth, high margins; dirt cheap stock. KKR's sales have increased 31.4% in the past 12 months to $592 million while net income dropped 60.8% to $388 million – yielding a 66% net profit margin. Its PEG of 0.06 is extremely cheap on a P/E of 7.35 and expected earnings growth of 134% to $1.92 in 2012.
Both of these companies are hard for the average investor to understand. If they actually achieve the kind of earnings growth that analysts expect, however, their shares are extremely inexpensive. The reality is that these private equity firms will do well if investors' appetite for buying the companies they acquired revives.

Unfortunately, there is no evidence that such a fever is anywhere on the horizon.


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