KKR & Co. Follows Berkshire Hathaway (NYSE:KKR)

KKR & Co. (NYSE:KKR) is a leading alternative asset manager (aka private equity). Many consider it the pioneer of the industry and the second most important player today. Despite posting plenty about alt managers, it is my first on KKR. There is a specific reason for it, as will become clear later. Since KKR is a very complicated company, I do not even hope to cover all the nuances in a single post.

In what follows, I will assume my readers know what alt managers do and understand terms like management and transaction fees, carried interest (“carry”), assets under management (“AUM”), fee-generating asset under management (“FGAUM”), fee-related earnings (“FRE”), and so on and will not explain them here. For those uncomfortable with this approach, I suggest reading my “How Brookfield and Peers Make Money…” which explains alt managers in plain terms from scratch.

The Industry

Until recently, I considered the industry consisting mostly of 6 companies and 7 stocks in North America: Blackstone (BX), KKR, Apollo (APO), Ares (ARES), Carlyle (CG) in the US, and Brookfield (BAM) (BN) in Canada. After the recent progress and announced acquisitions, Blue Owl (OWL) belongs to the same Big League. There are many smaller players in various geographies, both private and public, but we will ignore them here.

The industry is still underestimated. Only Blackstone was recently included in the S&P 500. Never mind that Apollo’s insurance subsidiary Athene would likely be included in the index if independent. Probably, this will be corrected before long, as both Apollo and KKR are strong candidates for the prestigious index.

Between the Big 7, Brookfield, perhaps, excites retail investors the most. I know this because my articles on Brookfield were way more popular than on, say, Apollo or Blackstone, even though the latter two have delivered better returns. Brookfield’s emphasis on PR and incessant hype may explain this phenomenon.

What is KKR’s place in the industry? In size, measured by AUM/FGAUM or market cap, it ranks right after Blackstone on par with Apollo. But this is a rather shallow criterion. More importantly, the industry consists of asset-light and asset-heavy managers, differing by the size of their balance sheets. KKR houses insurer Global Atlantic and is asset-heavy. KKR has replicated Apollo’s insurance strategy, which provides a convenient comp. Today, both companies have significant insurance earnings in addition to FRE, carry, and investment income (mostly for KKR) on the asset management side.

However, this comparison is far from perfect for two reasons. First, Apollo is more fee-centric, meaning that its management and transaction fees dwarf carry and investment income. For KKR, the latter two are more important.

Secondly, Apollo is sharply focused on investment-grade credit assets in the US and Europe. KKR is more evenly spread between various asset types (traditional private equity, credit, infrastructure, climate, real estate, and hedge funds) and geographies (differing from Apollo, it has a big Asian business).

Most of the Big 7 have beaten the index over the long term by a wide margin, though it depends on the starting and ending points. For KKR, this achievement was proudly displayed during the recent Investor Day:

However, other players have delivered similar and even higher returns once dividends are counted (KKR pays meager dividends). Investors remain optimistic about the industry’s further growth due to several uncorrelated megatrends (infrastructure buildout including AI data centers, energy transition, population aging, bank retrenchment, and individuals investing in alts). There is little doubt that the Big 7 will be the primary beneficiaries of these megatrends compared to smaller players due to their global presence, scale, reputation, resources, political connections, and the concentration of investment talent. The alluring prospect poses an important question – which players are the most promising? Should one pick 2-3 stocks (and which ones) or split bets more or less evenly among the Big 7?

This question becomes even more important as the future is not without risks. First, alt managers are expensive. Management fee-centric asset-light companies are easier to gauge by a simple P/E ratio (a poor metric for asset-heavy KKR and APO or non-management fee-centric Blackstone) with Ares being a good example. Last year, ARES earned $3.65 per share, with ~90% of it coming from recurring FRE. With the stock at $110, it produces a ~30 multiple, high even for its 17% FRE growth in 2023.

What is the right multiple? I do not know precisely but am more comfortable with 20-25 multiple in line with a multi-year FRE growth rate of ~20%. Hiccups in execution or other issues may cause sharp drops in alt managers’ stocks. As Carlyle shows, this is not a purely theoretical possibility – CG stock trades where it was three years ago.

Secondly, alt managers are notoriously volatile. This holds even when it should not be so. For example, during the last several days, the market turned jittery due to the expectations of higher rates for longer. Because of its humongous retirement business, Apollo is a clear beneficiary of higher interest rates, which did not prevent the stock from succumbing to pressure.

How much is KKR worth?

The company consists of asset management and insurance (aka retirement) segments. On January 2, 2024, KKR acquired the remaining 37% of Global Atlantic it did not own for ~$2.7B in cash, equal to its book value ex-AOCI. Simple calculations produce a value of around $4.6B for 63% of Global Atlantic on the KKR balance sheet at the end of 2023.

It is more difficult to value KKR’s asset management segment.

The table above shows that:

1. FRE is quickly growing at ~22% CAGR over the last four years. It deserves a multiple of at least 20-25x or even 30x as for ARES.
2. Realized performance income after compensation (i.e., net carry) is fairly large. In 2021 and 2022, it was only two times smaller than FRE. In other years, it was significant as well. It follows that KKR’s asset management business is not management fee-centric, and we cannot value it using a single multiple as we did for Ares.
3. Realized investment income after compensation is again rather big and fluctuates in sync with carry, as both lines depend on exits. It deserves a separate valuation.
4. In 2022 and 2023, the effective tax rate on operating earnings was 17%.

Theoretically, one is supposed to value carry by discounting future cash flows. Practically, it is unrealistic, and a simpler method is required, for example using multiples.

Brookfield being Brookfield evaluates its net carry by using an overoptimistic 10x multiple. Analyzing Oaktree’s partial acquisition by Brookfield several years ago, I concluded that Brookfield paid around 3x multiple for net carry, which seems low. In their presentations, Apollo several times mentioned 5-6x multiples for carry. Let us use the latter figure for the average after-tax carry over the last 5 years. It produces the following at mid-point:

Carry value = $600M*(1-0.17)*5.5~$2.7B.

This figure is dwarfed by the FRE value of at least

FRE value = $3,030*(1-0.17)*20~$50B

At 20x multiple, or ~$75B at 30x multiple. At the same time, it is not very different from the ~$3.4B of unearned carry on KKR’s balance sheet, as presented on the following slide:

Using the book values for Global Atlantic (ex-AOCI) and investments on the balance sheet is also logical. With this method, we may introduce small errors but they are hardly material compared with the massive FRE value.

Combining all this produces a simple formula for the KKR value equal to the Book Value (including net unrealized carry) plus FRE value. At 20-30x multiples for FRE, KKR value equals $78-103B or $88-116 per share. Thus, KKR trades close to the fair value range mid-point.

KKR and Berkshire Hathaway

On its recent Investor Day, KKR presented a captivating slide:

Referring to Berkshire Hathaway (BRK.A) (BRK.B), KKR’s co-CEO mentioned that the company wants to reproduce BRK’s success by holding some outstanding private equity stakes longer (for 10-20 years) to harvest the miracles of compounding and wise capital allocation.

BRK’s model consists of using insurance as a core and employing insurance float to build equity stakes or acquire in full some outstanding businesses. It does not hurt that Warren Buffett is the one to pick stocks and acquisition targets. The preferred period for holdings is forever, though it varies in practice for smaller stakes.

For all their investment ingenuity and creativity, alt managers are not known for compounding returns on their investments for long. Asset-light managers cannot do it since they do not have a balance sheet. They hold companies only for a duration of their funds, which rarely last for more than 7 years, but often shorter. They strive to buy a company using mostly (as much as possible, in fact!) other people’s money in the form of equity and debt, fix it, and exit at a higher price as soon as the market permits, collecting fees and carry. The worst companies are typically being held for longer, as it takes time to turn them around and sell at a profit.

Asset-heavy managers can hold good companies for a long, but were not interested until recently, except for Brookfield Corporation. The latter, however, has limited its long-term holdings primarily to real estate, with still unclear results. KKR is the first to explore the miracles of long-term compounding from a diversified portfolio in earnest. Importantly, KKR has an edge here over even great investors.

Due to their private equity business, KKR intimately knows hundreds of portfolio companies and can gradually select the best for long-term holding. Imagine one out of 5 portfolio companies is a pure gem and KKR knows it for sure. Formerly, it would sell it nonetheless and collect one-time carry. Under the new approach, KKR will keep it for many years, compounding its returns.

This approach is supposed to minimize mistakes and provide a good entry price. At this point, 18 companies have already been selected across the most promising industries, and from Q1, their results will be reported as a separate new segment “Strategic Holdings”.

Currently, they are called “Core PE Businesses” and their past results show 16% annualized like-for-like growth in both revenue and EBITDA since 2018. KKR forecasts that by 2030, the value of the new segment will be ~$30 per share. The following slide provides some explanations:

Throughout the presentation, KKR used the terms “operating earnings” and “dividends” intermittently when describing Strategic Holdings’ companies. It implies not only compounding but also cash inflows in the form of dividends.

In each such company, KKR will hold a controlling stake. I guess this stake will be financed, at least partially, by a tiny piece of Global Atlantic’s ever-expanding balance sheet that consists mostly of float.

Apollo can do it too using Athene’s balance sheet, but I doubt it. Apollo has already found other uses for it.

KKR and Apollo

KKR is trading close to its fair value but expects to grow fast. The company forecasts FRE to grow from $2.68 per share in 2023 to $4.50+ in 2026 at 19%+ CAGR. Global Atlantic is expected to double its assets within several years through its organic channels and block acquisitions. Finally, Strategic Holdings will start providing its input at a scale several years from now. The megatrends I indicated earlier put these projections on solid ground. Hence, KKR seems quite attractive. But how does it stand compared with its asset-heavy peers?

There are two main comps – BN and APO. On a risk-adjusted basis, BN seems inferior because its real estate business is non-transparent with possible unpleasant surprises and its insurance segment is still untested. Insurance is a long-duration business that requires at least several years across the cycles to draw any conclusions.

APO is a better comp and I prefer it to KKR. First, APO is slightly cheaper at similar growth rates. I will not go into valuation details here, but you can check my writings on it if interested.

Apollo’s Athene is better than Global Atlantic by almost any metric – the size of its balance sheet and sidecars, financial strengths and credit ratings, multi-year ROE, and valuable stakes in other retirement companies that can be leveraged down the road. I think it is worth more than its book value – something almost unheard of for a life insurer, but not uncommon for P&C insurers.

APO’s management structure is more stable with a single CEO. KKR has two co-CEOs who have cooperated well so far, but this structure can sometimes be shaky. We do not know how it will fare when the two founders, currently co-executive Chairmen, are not around.

I also like the APO’s strategy, focused and clean. Fundamentally, it hinges on only two conditions – growth in the number of retirees and the ability to originate a lot of investment-grade credit. The first condition will be met naturally without Apollo’s participation. The second is already mostly met by Apollo’s efforts, though further scaling up is required. Execution, of course, matters too, but it always matters. Most of APO’s capital is permanent and grows organically, while there are plenty of inorganic opportunities if needed. And by the way, investment-grade credit assets are supposed to be less risky than anything else.

KKR has certain advantages over APO as well. The company is more diversified in terms of the types of assets it manages and has a stronger position in Asia. On their Investor Day, they emphasized the importance of the latter point in the slide below.

This slide reminds me of one of Charlie Munger’s sayings: “You’ve got to fish where the fish are”. In its presentations, Apollo acknowledges the importance of Asia and the company has made several steps in this direction, but it cannot be compared with KKR’s progress.

While I prefer Apollo to KKR, I understand investors who have the opposite view. Their position is further supported by Strategic Holdings’ differentiator. It appears promising and at this point, nobody has replicated it.