KKR's Secret Syndicate

Like several similar outfits, the private equity firm has begun signing up investors to share profitsand risksin big leveraged buyouts

With each passing day, big private equity firms are looking more and more like Wall Street investment banks. Blackstone Group is advising on corporate deals and bankruptcy restructurings. Bain Capital is a major middle-market lender. Now Kohlberg Kravis Roberts is building a syndicated deal team, as the private equity giant looks to offer more opportunities for its own investors to sink money into the big leveraged buyouts it's pulling off.

KKR recently hired away a top Citigroup (C) salesman, whose main job was peddling shares in private placements and stock deals to hedge funds, sources confirm. Aren Leekong left Citi's equity capital markets group to join Craig Farr, a KKR managing director and Leekong's former boss at Citi, in heading up the private equity firm's co-investing opportunities team. Farr left Citi last summer. A KKR spokesman declined to comment, but people familiar with the buyout firm say much of Farr's and Leekong's responsibilities involve getting KKR investors to co-invest in leveraged buyouts the firm is arranging.

Here's how co-investing works—and how it's different from traditional private equity investing. The pension funds, universities, and other investors that put money into private equity have traditionally bought a limited partnership interest in a particular buyout fund that's run by the private equity firm's management team. It's just like buying shares in the fund.

Buyout Leader

Most private equity firms charge a fee equal to 2% of the assets an investor sinks into a fund. Buyout firms also typically take 20% of the profits generated by the fund. An investor who gets to co-invest in a specific buyout has a much more advantageous position. They're treated like any other equity investor and get to share in the profits generated from that investment. Co-investors usually don't have to pay an additional management fee to the buyout firm.

Right now there are a lot of opportunities for KKR investors to co-invest in buyouts. So far KKR has been involved this year in proposed buyouts totaling $105 billion, far outpacing any other private equity firm, according to market researcher Dealogic. The firm's most recent deal is the proposed $28 billion LBO of credit card processing company First Data (FDC) (see BusinessWeek.com, 4/2/07, A Big Transaction for First Data).

KKR also is teaming up with Texas Pacific Group on a $45 billion LBO of Dallas-based utility company TXU (TXU) (see BusinessWeek.com, 2/26/07, "How Green Green-Lighted the TXU Deal"). KKR is now moving aggressively to offer investors in its buyouts a chance to add to their returns by sinking money into specific transactions, say people familiar with the private equity firm.

Quitting the Club

Co-investing opportunities in private equity buyouts aren't necessarily new. Indeed, private equity firms long have permitted their biggest and most established investors to co-invest in deals as an added perk. But with corporate buyouts getting bigger and bigger, private equity firms are taking a much more democratic approach to co-investing. In fact it has become almost imperative for private equity firms to solicit money from their investors as a way of reducing the firm's own exposure to a deal. Every dollar a private equity investor sinks into a deal means one less dollar the buyout firm has to commit to the transaction, freeing up money for other deals.

Taking in money from investors also enables a private equity to go it alone in transactions, as KKR is doing in the First Data transaction. In recent years the only way private equity firms could pull off mammoth buyouts was by partnering with other firms in so-called club deals. But club deals have become controversial in light of an inquiry by federal prosecutors into possible collusion between buyout firms to squelch a bidding war. When a private equity firm flies solo in a deal, there's also no sharing of the profits with other buyout artists (see BusinessWeek.com, 2/12/07, "Private Equity Slugfest").

Erik Hirsch, chief investment officer for Hamilton Lane, an investment-adviser firm with more than $9 billion invested with private equity firms, says a surge in co-investing opportunities is a natural outgrowth of the feverish pace of LBO activity the past two years. "Bigger deals require a bigger equity requirement," says Hirsch. "And there's a growing sensitivity to not having as many club deals. From a buyout firm's perspective, Hirsch says "nothing is more complicated than having to share" with another private equity firm.

Long-Term Worries

Co-investing can benefit private equity firms in other ways. A few firms are beginning to charge deal fees to their investors who co-invest in a transaction. It's another way for the managers of private equity firms to rake in more cash. Taking money from investors also enables a buyout firm to reduce its own exposure in the event a deal goes bust in the future.

In a typical LBO, a private equity firm relies on bonds and bank loans to pay for two-thirds of the acquisition cost, with the firm's equity contribution making up the difference. Some on Wall Street are beginning to question whether buyout firms are adding too much debt-service to the companies they acquire.

One private equity investor, who declined to be identified, says some of the co-investing opportunities he's being presented with are for deals that appear "over levered." Right now, he says, many co-investing opportunities look good on paper, but he worries about how some of those deals will perform several years from now. Still, the investor says he has been intrigued enough to put money into some of the co-investing opportunities that have come his way.

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