KKR: Cashing In on Credit Woes

Private equity giant Kohlberg Kravis Roberts has a plan to use the credit market meltdown to make money for investors

Henry Kravis and his colleagues at private equity behemoth Kohlberg Kravis Roberts have cooked up a bold plan to profit from the credit market woes—a mess that's largely due to the excesses of leveraged buyout (LBO) shops, especially KKR itself. And it wants some of its wealthy clients to partake, too.

KKR executives are raising at least $1 billion from investors for an existing KKR-managed hedge fund. The goal is to snap up bargains from some of the $300 billion in junk bonds and high-yield loans weighing on Wall Street banks that have promised financing for a gaggle of mega-LBOs. With many of those bonds and loans expected to be available for a song amid the market distress, KKR figures it can generate a fat profit down the road once the "anxiety in the debt markets" ebbs and the debt rises in value.

So confident is KKR of a sharp rebound in the corporate credit market, it's telling prospective investors in the KKR Strategic Capital Fund they can expect to reap hefty returns. An August marketing brochure for the new fund-raising drive by the KKR fund states, "Unprecedented opportunity to invest in current corporate credit 'meltdown' and earn estimated gross returns in excess of 20%." The 24-page circular continues, "Opportunity exists due to credit market technical issues, not deterioration in credit fundamentals."

Moving Into Debt Investing

In all, the hedge fund seeks to raise $2.5 billion in new financing. About $1.5 billion will come from KKR and various affiliated entities. But the fund's real buying power could reach $12.5 billion with the use of borrowed money. Prospective investors have until Sept. 14 to sign up with the fund, which had $3.3 billion in assets under management as of June 30. KKR declined to comment on the new fund-raising initiative.

Though known primarily for its private equity investments, KKR created a credit investment affiliate, KKR Financial Advisors, in 2004, which will manage the Strategic Capital Fund. The unit took in $81 million in fees in 2006, twice as much as the year before, and more than one-fifth as much as the firm's private equity fees, according to a recent filing KKR made with the Securities & Exchange Commission. Shortly after the venture was formed, co-founder Kravis told potential investors that the firm was moving into debt investing as a way to make more money from the knowledge it was already acquiring in equity buyouts.

KKR is not the only private equity firm looking to cash in on the credit crunch that has brought the buyout boom to a screeching halt and wreaked havoc on the stock market over the past month. Blackstone Group (BX) President Tony James, in an Aug. 13 conference call with analysts, said, "We are also starting to look at some of these debts trading at distressed levels, which are not distressed credits, for companies we worked on."

KKR's Leg Up

Apollo Investments (AINV), the publicly traded investment management arm of buyout shop Apollo Management, has been buying up LBO debt that's selling at discount. So too is an affiliate of TPG, the former Texas Pacific Group. A number of hedge funds are also said to be eyeing the market for discounted LBO debt.

KKR's pitch is that it has a big leg up over the competition when it comes to shopping for LBO debt, namely that fact that much of the funding backlog is for buyouts which KKR engineered or bid on. The marketing material claims that 80% of the pending LBO financing involves deals where KKR is either the pending buyer, knows the company well, or knows its industry and competitors.

Roughly one-quarter of the $300 billion in outstanding buyout financing is for pending deals led by KKR, such as the planned acquisition of credit-card processor First Data (FDC), Texas-based utility company TXU (TXU), and higher education provider Laureate Education (LAUR). Since Mar. 31, KKR has announced 11 LBOs worth $140 billion, of which three deals worth $84 billion are still pending, according to KKR filings to the SEC.

Disenchantment "Temporary"

KKR asserts that its hedge fund, which had posted a 10% gain in the six months through the end of June, has a competitive advantage investing in junk bonds and high-yield loans because of the relationships Kravis and KKR co-founder George Roberts have forged with Wall Street bankers over the years. The marketing material notes that the fund's "KKR affiliation provides us unique and proprietary access."

The private equity firm maintains the "general disenchantment with today's deal flow" is a temporary phenomenon to be offset by the fact that "default rates are at historical lows and are not on the rise." KKR attributes the problems in the credit market primarily to an "overhang" of financing deals that has forced "real money investors…on the sideline." The marketing brochure makes a passing reference to "fear" in the market. But it's oddly silent in commenting on the meltdown in the market for subprime mortgages—an event that precipitated much of the broadening credit contraction and investor fears about sinking new money into credit assets.

In fact, KKR's ambition in going after so-called hung financing deals may exceed its ability to sell investors on pumping new money into its hedge fund. Another part of KKR is KKR Financial (KFN), a publicly traded investment arm of the buyout firm, which has seen its stock cut in half over the past month because of the ongoing turmoil in the credit market.

Sold Mortgages At a Loss

KKR Financial, which converted in May from a real estate investment trust to a limited liability corporation, is still grappling with the fallout from its days as a real estate investment trust, or REIT, when it invested heavily in mortgage-related products, in particular mortgage-backed bonds. On Aug. 14, Standard & Poor's, which like BusinessWeek is a division of McGraw Hill (MHP), put two of KKR's mortgage-related securitization vehicles on credit watch for possible downgrade.

On Aug. 15, KKR Financial shares fell another 32% to about $10.40, after the San Francisco company disclosed that it had sold $5.1 billion of residential mortgage loans at a loss of $40 million. It still holds another $5.8 billion of mortgages, primarily through mortgage-backed securities, and may have to take an additional $200 million charge.

KKR Financial also said in its press release that it has begun discussions with investors "to resolve potential funding disruptions resulting" from the unprecedented turmoil in the mortgage and commercial paper markets. The firm has been getting much of its financing for those mortgage investments from so-called asset-backed commercial paper deals it has sold to outside investors.

Subprime Problems Spreading

Commercial paper is a short-term note, often paid back by a borrower in less than a year, that is widely used by corporations to finance ongoing operations. In recent days, the problems in the subprime credit market have begun spilling over into the commercial paper market, especially for financing deals backed by subprime assets.

Another hurdle is that KKR's strategy is predicated on the ability of the public company and hedge fund to use their leverage at a time when it is hard to borrow money, which, of course, is the reason loan and bond prices have been discounted in the first place. The hedge fund intends to leverage its investment four times and is counting on borrowing some of that money through collateralized loan obligations, the issuance of which has nearly ground to a halt.

KKR executives may be correct in predicting that the current crunch in the credit markets for LBO debt will soon pass. But judging from the problems its own publicly traded investment arm faces, actually making money from the current turmoil will be easier said than done.