Finance

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

KKR & Co. kicked off private equity earnings season on Tuesday, beating expectations and setting a positive tone as rivals prepare to report later in the week.

The New York-based firm benefited from investment gains, as well as profits from sales of stakes in companies such as Walgreens Boots Alliance. But KKR also has high-yield investors to thank for its outperformance.

Since July 1, three of its holdings -- helicopter ambulance operator Air Medical, Indian life insurer Max Financial and outdoor retailer Mills Fleet Farm -- either borrowed money or are in the process of taking on more debt to raise cash for a payout to KKR. The move, known as a dividend recapitalization, lets the firm leverage its investments by tapping financial markets to take advantage of demand for high-yield debt. 

Many Happy Returns
KKR and its private equity peers have enhanced their profits thanks to willing debt investors, a trend that is likely to continue until interest rates are materially lifted
Source: LCD, an offering of S&P Global Market Intelligence

More notable was the disclosure that because each company has been held by KKR for less than 18 months, the dividends will be recycled back into the firm's respective funds (a fairly routine industry practice). That essentially gives KKR two bites of the apple: It can reinvest dividend proceeds, while locking in a partial return that will cushion the blow if valuations retreat and the cycle turns by the time it's ready to flip those businesses. 

This year, KKR has recapped companies including US Foods (before its IPO), Sedgwick Claims Management, Internet Brands as well as the three companies I mentioned earlier. That's not to say any of these companies have been placed in perilous positions -- debt investors are discerning and firms' equity interests remain linked to a portfolio's performance over the medium term.

The prevalence of recaps, driven in part by limited IPO opportunities, has climbed across the board as demand for high-yield debt remains strong. Already this year, private equity-backed companies have issued U.S. loans for such purposes totaling $30.5 billion, eclipsing 2015's full-year sum, according to LCD, an offering of S&P Global Market Intelligence.

Combine recaps with seemingly quenchless M&A appetite from strategic buyers, continued sales of blocks of stock in companies they own, and you get the type of "robust realization activity" that KKR saw in its latest quarter. That's a recipe for one measure of success at the firm and across the industry. 

For KKR, the toughest sell remains its own shares. Even after gaining almost 3 percent on Tuesday's earnings news, the stock's valuation still trails rivals by a number of measures.

Discounted
KKR trails peers like Apollo, Blackstone and Carlyle which each trade on blended forward P/E multiples of 8.8 or higher
Source: Bloomberg

KKR could narrow that valuation gap by sweetening its fixed dividend policy or extended its $500 million share repurchase program (it's more than 90 percent of the way complete, according to data compiled by Bloomberg). But for now, the firm reckons its cash is better spent elsewhere, like seeding new strategies or allocating capital to its slather of funds. These types of efforts should help lure third-party investors, which in theory should lead to accelerated growth in assets under management and subsequently, higher management fees. 

Cash Only
KKR has signaled its reticence to use its growing cash pile to lift its fixed dividends or enhance its buyback program, preferring instead to invest it in funds as a way to attract third-party investors
Source: Bloomberg

"Cash is a strategic asset for us," said Scott Nuttall, head of KKR's global capital and asset management group, on the company's earnings call Tuesday. The focus, he added, is on building the firm for the long-term "as opposed to any short-term trading dynamics." KKR is betting that perhaps, over time, shareholders will reward that decision -- even if they haven't yet. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net