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TheStreet Open House

Rising Expectations for KKR Amid Energy Future Bankruptcy Talk

Stocks in this article: KKRAPOSYYAVGONLSNHCA

NEW YORK (TheStreet) - Private equity manager KKR (KKR) may see its share of negative headlines as one of its investments, Energy Future Holdings, the biggest buyout in the history of the private equity industry, hurdles towards bankruptcy. Energy Future's troubles aside, one stock analyst believes KKR is undervalued and that returns from the firm's flagship 2006 fund may translate to gains for the firm's shareholders.

Oppenheimer analyst Chris Kotowski wrote in a recent report that he believes, despite KKR's "black eye" of a buyout in Energy Future, the firm's other investments in its 2006 flagship fund have performed strongly, raising opportunity for public shareholders.

"There are a good many investments in this portfolio that have the ability to appreciate further. We don‟t want to put too fine a point on it, but it's pretty easy to see where you could get another 5% or 10% more appreciation from here," Kotowski wrote in a note dated March 6.

Kotowski calculates that if KKR's 2006 fund were liquidated at current prices, it would generate 89 cents in earnings for public shareholders, and notes that KKR's history for conservative investment raises the prospect of additional earnings.

"Some like First Data and Samson seem to be works in progress where markdowns have been taken, but KKR seems to be working the situation. Others, like Capsugel, Biomet and Go Daddy, seem like companies that are well positioned to grow," Kotowski said of yet-to-be-realized KKR buyout investments that may eventually provide earnings for public shareholders.

Publicly traded alternative asset managers such as KKR, Blackstone Group (BX), Apollo Global Management (APO), and Carlyle Group (CG) derive their earnings from annual management fees on the assets they manage. The PE firms also generate earnings from the value of residual interests they hold in their funds, which now span private equity, distressed debt and other host of other alternative assets.

Rising assets under management provides shareholders in PE firms with some reliable earnings streams, however, it is the prospect of realized and unrealized gains from fund investments, or so-called 'carry,' that often drives the shares of PE firms.

Over the last 12 months Blackstone Group and Apollo Management have seen their shares rise over 80% and 40% respectively as both PE firms realize many of their largest investments like Hilton Worldwide (HLT) and LyondellBasell (LYB).

In 2013, Apollo Group accounted for over 10% for the private equity industry's fundraising and investment realization activity, capping a banner year for the Leon Black run firm. 

Kotowski, the Oppenheimer analyst, now foresees the prospect that 2014 is KKR's year, given many of its yet-to-be realized investments. That comes even as KKR's biggest-ever investment faces a rising prospect of bankruptcy, according to media reports of restructuring talks. Warren Buffett, an Energy Future bondholder, recently expressed little hope that the company would be able to avoid a default.

Overall, KKR's flagship 2006 fund is marked at an 8.3% internal rate of return, according to Kotowski's calculations, valuing its aggregate investments at $15.1 billion. He suggests those marks could rise 5%-to-10%, generating significant carry for investors.

In particular, Kotowski highlights that recent partial sales of Alliance Boots and U.S. Foods could position KKR for further gains as the firm moves to realize the full value of those investments in coming years.

KKR still retains a controlling stake in Alliance Boots after it sold a 45% piece of the investment to Walgreens (WAG) and will sell down the remaining portion of the investment in coming years. Meanwhile, pending an antitrust review, KKR is poised to sell U.S. Foods to Sysco (SYY), in a mostly-stock deal that will give the PE firm over 43 million Sysco shares in a merger TheStreet believes could be one of the top deals of 2014.

KKR was also one of the more aggressive PE investors in the wake of the financial crisis, cutting acquisitions of Capsugel, Del Monte Foods, GoDaddy, and Samson Investment. Those deals, Oppenheimer's Kotowski believes, could generate new earnings for KKR as it eventually looks to cash out. That's especially the case because his review of data indicates that KKR-backed IPOs have outperformed the S&P 500 by an average of 8.1% in the first year following the IPO.

U.S.-based IPO's such as Dollar General (DG), Avago Technologies (AVGO) and Nielsen Holdings (NLSN) outperformed the market in their first year as a public company, while HCA (HCA) has recovered from a weak initial performance on stock markets. KKR has also been conservative in its marks of losing investments, holding Energy Future at just 5 cents on the dollar.

"The news is not always good, but KKR seems to take the bitter medicine early when it needs to," Kotowski said. He also noted that KKR faces no investment hurdle rates that would constrain carry from its 2006 fund, further improving the prospect that future investment gains flow to shareholders.

"[We] think KKR is the best organic growth story in the group because it has used its balance sheet investments to fund numerous first generation funds in Energy, Infrastructure, Real Estate, Credit and long/short equities. If these funds are successful, the next generation of funds should be larger, and thus we believe that KKR has the potential to grow nicely off a small base in these areas," Kotowski concluded.

-- Written by Antoine Gara in New York

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