A Kinder, Gentler KKR Wants A Piece Of Your 401(k)
A Kinder, Gentler KKR Wants A Piece Of Your 401(k) Original story appears in the February 11, 2013 issue of Forbes
Scott C. Nuttall, one of KKR’s heirs apparent and the head of its Global Capitaland Asset Management division, leans back in his chair while dining on the42nd floor of the firm’s midtown Manhattan headquarters and shares adream. “Maybe someday you will have private equity as a choice on your401(k) retirement plan,” he says, eyeballing a turkey sandwich served on aplate of fine china (the firm caters lunch for the entire company every day).“Today, if you are a retired school-teacher in California you can invest withKKR by virtue of a pension plan, but if you are a corporate executive managingyour 401(k) you cannot. There’s no product available.”Nuttall, 40, is in a hurry to change that–and change KKR in the process. He’sleading the charge to open the storied private equity firm to everyone.Barbarians at the service of the masses. Already, for as little as $2,500, youcan invest in a KKR mutual fund managed by the same team that runs globalcredit funds for some of the biggest institutional investors in the country. For$25,000 you can invest in a KKR fund that buys distressed debt.That’s a far cry from the $10 million or more qualified investors once neededto get into one of the firm’s 19 buyout funds, where their money could belocked up for more than ten years and net annual returns fluctuated from a1% loss to a 39% gain.
They’ve evolved a long way already. Nine years after it tactically diversifiedaway from a single-minded focus on leveraged buyouts, $29 billion of KKR’s$74 billion in assets fall outside its legacy private equity business. Nuttall’sgroup, the firm’s fastest-growing division, with $25 billion undermanagement, includes a global corporate bond and credit business, a so-called fund of funds, which allows investors to put money into a diversifiedbasket of hedge funds and a proprietary trading desk picked up fromGoldman Sachs in 2011. Since its inception in 2004 one of KKR AssetManagement’s important high-yield strategies has logged an average annualreturn of 10.8% versus 8.5% for its relevant benchmark.The biggest challenge Nuttall faces is gaining acceptance among individualinvestors and their financial advisors. KKR has never courted the little guy.Traditionally, the firm raised most of its capital from multibillion-dollarpension funds, banks, insurance companies and endowments. Theseinstitutional investors could–and did–thrive despite delivering mediocrereturns. After all, they were playing with other people’s money, often at agreat remove. Retail-level financial advisors, however, live and die by the verypersonal trust they earn by generating decent returns on their clients’ nesteggs. It takes more than a new wrapper on an old business to win overbrokers.
Which is why, on a cloudy day last November, you could find Nuttalland one of KKR’s billionaire founders, George Roberts (net worth: $3.7billion), shoulder-to-shoulder with Chuck Schwab, the patron saint ofretail investors, at the brokerage giant’s annual conference held inChicago’s McCormick Place convention center. Before a crowd of morethan a thousand independent financial advisors, the trio took to thestage to spread the gospel of investing Main Street savings with WallStreet titans.Roberts, the “R” in KKR and the founder known for his intellect andaloofness, even spent time manning the firm’s booth on theconvention hall floor, mingling with frontline brokers. Why woo hoipolloi? Because that’s where the money is: “There are huge pools ofcapital there,” marvels Roberts, 69. “I talked to one fellow thatmanaged $800 million and another that managed $5 billion.”Numbers like that add up fast. In all, there is about $2 trillion managedby independent registered investment advisors, and that number isgrowing at a 13% annual clip, according to Cerulli Associates, a Boston-based financial research firm.
The numbers become even more enticing when you look beyondadvisors to mutual funds and ETFs, which can also be purchaseddirectly by individuals. According to McKinsey & Co., by 2015 there willbe $13 trillion invested in these types of funds, and 13% of this moneywill flow into so-called alternative assets, a category that includesmany areas where KKR has deep expertise: private equity, junk bondsand real estate. That 13% is more than double the amount that wasallocated to alternatives in 2010.The money is vital to keep KKR well capitalized, as the big pensionfunds it relied on for decades dry up and are replaced by tens ofmillions of Americans managing their own retirements through401(k)s. “The implications for alternative asset managers arestaggering because the bulk of all their money has historically comefrom pensions that are now going away,” says Josh Lerner, whoteaches investment banking at Harvard Business School. “Over thenext five to ten years individual investors are going to be a veryimportant source of capital for alternative asset managers, and you’llsee them rethinking their business models.”
It’s all a long, long way from KKR’s roots. The firm was founded in 1976 bythree Bear Stearns alumni: Jerome Kohlberg, who had headed the corporatefinance department at Bear, and the brash Henry Kravisand his cousinRoberts, who were Kohlberg’s protégé. (Kravis was not interviewed for thisarticle; Kohlberg was pushed out of the firm in 1987.) While at Bear, the threemen pioneered friendly leveraged buyouts of public companies. The formula:have management borrow money against the assets and cash flow of acompany, and use that money to buy a controlling stake of it. The process leftthe companies weighted with crushing debt loads, which was thought to be agood thing as it prevented management from embarking on wild spendingsprees and ensured strict financial discipline (conversely, it also limitedinnovation and growth). Through a combination of cutting costs, selling assetsand paying down debt, the now private firm could be brought public again, ata higher valuation, making a small (or large) fortune for the managementteam–and, of course, for Kohlberg, Kravis and Roberts.KKR’s first fund was tiny–just $31 million, raised from AllstateInsurance, Citicorp Venture Capital and well-heeled individual investors–butthe firm grew fast and made piles of money for its investors. In 1984, lessthan a decade after its founding, KKR raised its first $1 billion fund. By thenthe firm was increasingly moving from friendly buyouts, undertaken with thecooperation of management, to hostile ones, where new management wouldoften strip the target company like a stolen car, sell off choice bits to thehighest bidders and fire thousands of employees along the way.
In 1988, a year after Kohlberg left the firm, Kravis and Roberts engineered thene plus ultra of hostile deals, the $25 billion highly leveraged hostile takeoverof RJR Nabisco, immortalized in Barbarians at the Gate (Harper & Row, 1990).That deal generated nearly $1 billion in fees for the likes of KKR and itspartners, including Drexel Burnham Lambert, but it proved less sweet for KKRinvestors, who squeaked out an 8.9% annual return in the fund that took RJRprivate. The takeover also resulted in the loss of at least 45,000 RJR Nabiscojobs. In all, during the 34 years between KKR’s founding and its IPO in2010, the firm raised roughly $61 billion in capital, performed 185buyouts, saw its portfolio companies shed tens of thousands of employees–and returned an average of 19% per year to its investors.Now the legendary raiders are donning the white hats. Besides the lure oftrillions of dollars in fresh capital, the retail investment business holdsanother attraction for KKR and its shareholders–steady and predictablerevenues from fees. In the case of KKR’s new junk bond mutual fund theexpense ratio is 1.31%. That’s puny compared to traditional private equityfees, but the firm can make up for it with massive volume: McKinsey & Co.estimates that fees from alternative investments by mutual funds will surgeto $25 billion in two years, up from $9 billion in 2010. “That’s $16 billion ofrevenues up for grabs,” says Nuttall.
And it’s the type of reliable revenue that Wall Street loves. Buyouts can beenormously profitable, but because the money is tied up for years whilemanagement restructures and pays down debt, the returns are extremely uneven.In 2011, for example, KKR’s net income was $1.9 million on $724 million inrevenues–a 0.3% profit margin. But just a year earlier the firm made $333 millionin profits on $435 million in revenues–a margin of 77%. Wall Street hates wildswings in earnings almost as much as it hates surprises, and as a result KKR’s stocktrades at an earnings multiple of around eight, far lower than the broader market.Compounding the sting: Steady-Freddy asset managers like T. Rowe Price andBlackRock are awarded above-market multiples of around 20 times earnings.“KKR and other private equity funds have a life cycle that’s lumpier thantraditional mutual fund companies, which can constantly raise assets, generatefees, exist and grow for decades,” explains Robert Lee, an analyst atKeefe, Bruyette & Woods.In order to jump-start its foray into the retail business KKR is tapping its $6.5billion balance sheet, which includes a $1.4 billion cash hoard, seeding its twomutual funds with a whopping $125 million, versus the typical $1 million seed atmost mutual fund companies. But this is not a market that KKR can simply buy.
Despite decades of experience and enormous Wall Street cred, it remains a MainStreet newbie.“They don’t have a manager with experience in a publicly tradedmutual fund, but these guys are smart, so I’ll keep an eye on them,” says BrianAmidei, an investment advisor based in Palm Desert, Calif. with $600 million in assets.KKR has responded by recruiting Michael Gaviser from AllianceBernstein, who joinedin November to build relationships with the likes of Fidelity and Pershing. “The thingswe’re doing in these new funds are things we’re already doing,” says Gaviser. “But nowit’s structured in a wrapper for investors who want daily or quarterly liquidity.”Robert echoes the idea that KKR isn’t altering what he calls its “internal DNA”: “If youwant to paint a picture of our firm, private equity will continue to be at the center ofit.” But he also admits that the makeover has been a long time coming. He distinctlyremembers that in 2008, after the annual partners meeting, he gave attendees whiteT-shirts with two black circles on them, one tiny and one large. “The message was thatthe big black circle was our brain and the small black circle was what we were using ofit,” says Roberts. The problem was KKR’s laserlike focus on leveraged buyouts wascosting it huge opportunities. “If we went to see a company that didn’t want to do aprivate equity transaction we’d say, ‘Thank you very much,’ and we couldn’t doanything else with it,” Roberts says. The problem was so bad, Nuttall says, that KKRbegan maintaining a spreadsheet listing opportunities it had to turn down.One still burns today. Williams Companies, a Tulsa, Okla. energy firm, was ready to betaken private by KKR’s private equity fund back in 2002. But shortly before theannouncement Williams’ stock began to sink as one of its subsidiaries came under fireover shoddy energy trades. Instead of going private as planned, SteveMalcolm, Williams’ CEO, was calling KKR to help his company with at least $900 millionin financing it required to avoid bankruptcy. In exchange he offered KKR $2 billion innatural gas reserves and an 18-month secured note at 25%, plus warrants.
“We had to turn it down. It was very painful, but at the time KKR only had private equity fundsand this was a credit investment,” Nuttall recalls. “Ultimately Warren Buffett made theinvestment along with a couple of hedge funds and generated something like a 30% or 40%return in 15 months.”That’s not going to happen anymore. “We thought of ourselves as a private equity firm to thatpoint,” says Nuttall, “when it became very clear that we are an investment firm.”Barbarians TamedFrom masters of the universe to mingling with the masses.1969: Henry Kravis joins his cousin George Roberts at Bear Stearns to work under JeromeKohlberg Jr., who was developing a specialty in leveraged buyouts.1976: Bear’s boss, Cy Lewis, refuses to support the trio’s buyout business, so they leave to launchKohlberg Kravis Roberts & Co. with offices in New York and San Francisco.1979: KKR completes the first major leveraged buyout of a public company for $380 million withHoudaille Industries.1987: Kohlberg is forced out after clashing with Kravis and Roberts over hostile deals.1988: KKR’s audacious $25 billion hostile takeover of RJR Nabisco marks the high-water point of1980s greed. Two years later KKR is vilified in the bestseller Barbarians at the Gate .1994: KKR plays white knight for troubled dairy giant Borden, financing its $2 billion deal partlywith RJR stock, which struggled after its 1991 IPO.1998: Buyout funds boom during the bull market, and KKR opens its first international office inLondon.2004: The firm expands outside private equity and launches KKR Asset Management.2007: KKR takes over Texas-based power utility TXU for $45 billion, the largest LBO in history andone of KKR’s biggest losers.2010: Shares in KKR begin trading on the NYSE.2012: KKR goes retail with the launch of its first-ever mutual funds.