KKR: Why a record year for Private Equity spells opportunity for investors

In Australia alone, more than $40 billion worth of PE deals were completed by the end of May, research from Refinitiv shows. This squares with an S&P Global study completed in January, which projected the global PE market would surge beyond the US$1 trillion record set last year. Even in January, investors were increasingly wary of rising inflation risk, interest rates and high stock prices – and concerns have spiked further still in recent weeks.

Australia’s biggest M&A deal of the year is the $30 billion bid for ASX-listed Ramsay Health Care (ASX: RHC) by a consortium led by US PE heavyweight KKR, whose Head of Client & Partner Group, Australia & New Zealand we interview below. While Nicholas Hyde couldn’t discuss the terms of the deal, he took a deep dive into the asset class and the opportunities it presents.

• How do some of the high-powered M&A deals splashed across the financial press create value for everyday investors?
• Where does PE fit in an investment portfolio?
• What level of returns can you expect?

These questions are just a few of those answered. Hyde discussed how the industry has changed in recent years and his outlook for the asset class. Some of the biggest sources of concern, and the most appealing themes on the horizon, also got a look in.

Please explain KKR’s process of investing in – or lending to – private businesses, including how this changes during the company journeys?

Our process begins by building relationships and connections across a network of companies, advisers and investors to best enable us to tap distinct sourcing channels and position KKR – and our investors – for success, both during our investment process and throughout the holding period of a company.

Once we’ve identified a compelling opportunity, we enter a period of due diligence that usually takes between six and 12 weeks. During this time we use KKR’s extensive internal resources, senior adviser network and outside consultants and experts to assess a target company across several factors. These broad-ranging factors include:

• The individual company’s operations
• Dynamics within the industry, and
• Environmental, social and governance considerations.

From there, we develop our investment thesis. This will generally align with a broader set of identified investment themes that KKR pursues in a market or sector, as well as our value creation playbook.

What is this playbook? It maps out the key operational considerations and factors we’ll look to address, in collaboration with company management, during our investment period.

The overarching goal here is to help make great companies even better through investment, operational enhancements, and through organic and inorganic growth programs. Some examples of operational improvements and organic growth are detailed later in our discussion of C.H.I. Overhead Doors, a company we recently exited. 

Inorganic growth refers to deals that might be described as "bolt-on acquisitions. There are many examples of these in the broader industry, but The Arnott’s Group’s (ASX:ARN1) acquisitions of Diver Foods and ASX-listed Freedom Foods’ (ASX:FNP) snacking and cereals division to form Good Food Partners is a good local example.

After seeking our investment committee’s approval, we can execute and implement our proposed plans over our multi-year holding period.

What does private equity deliver to investors and what are the return characteristics?

Private equity aims to deliver returns above public market choices for investors by investing primarily in leveraged buyouts and build-ups in which private equity sponsors own a majority stake and have control of a company.

Many private equity investors, including KKR, also have capabilities to invest growth equity, which is classified as an investment into emerging, high-growth companies in sectors such as technology, health care, fintech, consumer and newly emerging growth categories.

We then seek to drive returns through enhanced growth and innovation, operational improvements, creative structuring and accretive M&A. Usually we aim for gross returns of more than 20%, and mid-to-high-teen net returns. KKR Private Equity’s returns, across most of our funds, have beaten this target over a 45-year period.

We usually hold each investment for between five and seven years, and most of KKR’s private equity funds have a 10-to-12-year life.

Investors’ capital is drawn down over the first three to five years (usually only 75-80% of a limited partner’s commitment is drawn) and investors receive distributions starting from around year three until the final payout. While the overall commitment is long, most capital is returned to investors well within the 10-to-12-year timeline.

Where does private equity fit within investor portfolios?

There has always been a strong case for the inclusion of private equity in individuals’ portfolios in additional to public markets exposure. One key consideration is that private equity may offer investors exposure to sectors and themes that public markets sometimes have difficulty accessing.

Some of the most attractive, emerging investing themes of today include:

1. The rise of the millennial in Asia,
   
2. Digital and technology transformation,
3. Healthcare and wellbeing, and
4. Consumers’ prioritisation of experiences above physical products.

These are all difficult to invest in via broad public equity exposure. Private equity often enables earlier entry into emerging themes such as these, which, we believe, may enhance investment returns.

Private equity has outperformed public equities with lower annualised volatility in many periods during the past 30 years. This outperformance is even more pronounced for the top-performing managers.

We believe returns in the future will be lower than the past (across all asset classes), and that risk (volatility) will remain elevated. But we are also confident the illiquidity premium – which is the additional compensation for investing in less-liquid assets - will persist. In this context, the ability to outperform much lower-market returns will be critical to investors’ success.

What are some of the characteristics of the private companies in which KKR is looking to invest?

We generally seek out businesses with strong management teams in attractive sectors where we can leverage KKR’s capabilities to build leading enterprises. Beyond this broad umbrella, there are a few common characteristics through which KKR has achieved success:

1. Partnerships – Joining with an existing entrepreneur or founder of a business to help it transform to achieve its next growth stage.
2. Platform – A business that can expand into a much larger territory through either organic growth or accretive acquisitions.
3. Corporate carve-out – Usually solid businesses that have been under-invested within a larger company because they are deemed ‘non-core.’ These are complex situations where KKR’s unique toolkit can help to execute a carve-out then build out the potential of the new, standalone entity.

Please provide an example of KKR identifying a private market opportunity early on and realising investor value over the long term.

We recently announced the US$3 billion sale of C.H.I. Overhead Doors, a leader in the garage door industry headquartered in Arthur, Illinois, to a strategic buyer. This transaction represents one of KKR’s largest returns in recent history, at 10 times the original equity invested, including distributions throughout the investment term.

During our involvement, which began in 2015, we’ve seen a dramatic operational transformation of the business. On an organic basis, EBITDA increased almost four-fold. C.H.I’s EBITDA margin steadily improved over a seven-year period, ultimately increasing by more than 1,400 basis points from 21% to well over 30%.

Revenue grew by nearly 120% organically, enabled by investments in the existing manufacturing facility in Illinois and the construction of a second plant in Indiana. Operating improvements covered nearly all aspects of the business ranging from procurement and scrap reduction to labour productivity and net working capital optimisation.

Employee ownership and engagement at C.H.I. has been a key area of focus for us throughout the investment period. This had been a key driver in building stronger companies and driving greater financial inclusion.

When we acquired the firm, all 800 employees – including the factory workers, truck drivers and corporate office staff – became co-owners of the business. This was a free, incremental benefit for anyone earning less than US$100,000 and was not in exchange for benefits, wages or wage increases (wages increased by 12.5% in 2021 and 7% in 2020). And the return on this was substantial, due to the exceptional performance of the business.

At exit, in addition to around US$9,000 in dividends received since 2015, hourly employees and truck drivers will receive, on average, approximately US$175,000 as a payout on their equity – with the most tenured employees earning substantially more. As part of the overall package, all 800 colleagues will receive 12 months of pre-paid personal financial coaching and tax preparation services through Goldman Sachs Ayco Personal Financial Management and Ernst & Young.

In addition to making everyone an owner, KKR and C.H.I. invested in the workforce by giving them a voice on ways to improve working conditions. These investments were directed by colleagues in the factory and included air conditioning the manufacturing plant, adding new break rooms, building a new cafeteria with healthier food options, and putting up an on-site health clinic.

Safety also improved substantially. Both the rate and severity of injuries declined by more than 50% since 2015. During the past seven years, employees were also provided with functional training and personal financial coaching programs.

Why have many investors traditionally avoided private equity? Has this changed, and what do you see ahead for the asset class?

Closed-end funds were traditionally the most common way of accessing private equity. In addition to being limited to “institutional” clients who can meet US$10 million minimum investment amounts, these usually required investors to:

• commit for more than 10 years,
• be subject to multiple capital calls, and
• live with uncertainty around distributions.

Over the past 10 years, there has been a recognition that the above points are a strong deterrent to high net worth or private banking clients. In response, several firms have looked at offering open-ended funds. These use a variety of tools to provide some liquidity to investors while also preserving access to illiquid investments.

Structural features of these funds also often include:

• a mix of both debt and private equity,
• use of substantial cash balances as a buffer,
• the extension of liquidity lines from external counterparties, and
• limits to the amount available in a certain period.

KKR expects these new funds to receive a very positive response from the “wealth” market. These are investors who see the benefits of private market investments but needed a better way to access them. We are actively developing strategies and products tailored for the wealth market.

Can you give a view on private versus public valuations in the current market?

It has been a very volatile start to 2022 and this is something we expect to persist. As discussed below, there remain a lot of risks to contend with globally, and it wouldn’t seem that any will be resolved in the near term.

This has created pressure to public market valuations to the point that we feel that public markets do provide good value in certain areas. We see the potential for public-to-private opportunities to take advantage of this move in price. Coming out of these periods, private equity has shown an ability to strongly outperform.

What are currently some of the biggest concerns on KKR’s radar?

In today’s unsettled environment, we think that stagflation and policy missteps present key risks this tightening cycle. As a hedge, we believe in diversified allocations with shorter durations that can lean into volatility.

Despite the weak economic outlook, we believe central banks will maintain a meaningful and sustained upward rate-hiking path. Opportunistic pools of capital should prepare for opportunities linked to the rate reset.

The need to stay thematic becomes also more important. We believe many structural themes remain intact and may even strengthen in the current environment. For example, we continue to see significant opportunity to invest behind themes such as security, decarbonisation, and innovation, and remain confident in the potential of infrastructure, including data, data storage, power generation, and select parts of transportation.

Find out more about KKR in Australia & New Zealand 

KKR is deeply committed to helping Australian and New Zealand businesses achieve their full potential. Since opening a local office in 2007, KKR has focused on building long-term partnerships grounded in trust and transparency. Click here to find out more. 

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