Jul 09, 2018
Finishing their presentation, Scott Nuttall and Joe Bae explain where our focus is now and our path to value creation.
Joseph Bae: So in this last section, what we want to talk about a little bit is where is our focus now. We have all spent a tremendous amount of time and effort and capital building what is today KKR, the capabilities we have talked about, the strategies we have talked about but what is really going to drive value creation for all of us in this room?
Generate Investment Performance
The first and most obvious is to continue to generate superior investment performance in everything we do. That is how we get the top three, that is how we maintain our positioning with investors and we are very, very proud if the track record we have. In private equity alone, you will hear a lot from Johannes after our presentation, which will talk about our global private equity business, really our flagship franchise. Our long-term track records over 42 years are very strong. Nearly 26% gross returns and 19% net. On a comparable basis over this period of time, the S&P has compounded at 11.8% and the MSCI World at 9%. So on a net basis somewhere between 700 and 1,000 basis points long term outperformance of the public indices. Johannes will get into a lot more detail, we are not stock pickers, we are active managers of businesses. We are able to drive value creation in companies using multiple different levers, which allows us to generate this alpha to the public markets on a consistent basis.
Track Record of Outperformance – Private Equity
This again is our long-term private equity track record more by vintage. As you can see, meaningful outperformance over a long period of time to the public markets, we have been successful investors through different cycles, different macro environments and this has been consistent with our track record; again, these are gross returns in the top bar. 25.6% versus the long-term S&P returns. You see a similar track record; our credit business is obviously a lot younger and still scaling but the performance has been strong, consistently outperforming the public benchmarks.
In the last 12 months, while the markets have been strong globally, we are particularly pleased with the continued strength and momentum that we see in our flagship businesses and private equity in the US, Europe and Asia, our funds were up on average 24% in the last year. In real assets, again, strong performance across real estate, infrastructure and energy and in the credit space, again, particularly strong returns in the last 12 months.
Scale Our Businesses
Also I want to spend some time now talking about the implications of scaling our business and what that economic model looks like when you approach an inflection point. For us, what we have seen in our business is as we have organically scaled different strategies, you really get to a point of inflection around year ten where you have incurred a tremendous amount of the expense up front as you built the platforms, you have hired the people, you have opened the new offices, you have all the G&A costs loaded, that is in the first five years and then you start raising the funds, the AUM starts to scale. Your first fund, the successor fund and then the third fund. That takes ten years. What is exciting is the carry is lagged. You invest the capital, those investments season over three to five or seven years, then on the back end, you have a very meaningful economic opportunity in terms of the carry and the performance fees. So the margin, the economic contribution of these businesses really starts to kick in starting year ten and we will talk a little bit about that.
Our Global business, our US, European and Asian private equity businesses are really the three businesses that have been around for ten-plus years on the private side. US for 42 years, Europe for nearly 20 years and Asia just at that tipping point of north to ten years. Those businesses today, as Scott mentioned earlier, represent 91% of our total carry in the last 12 months, so the $1.3 billion of carry and incentive fees we generated this past year, over 90% have come out of those three flagship strategies. It is not because our other businesses are not performing well, they are. It is because the carry is lagged. You invest the capital, those investments season and then you generate the carry down the road. So that opportunity in the blue bar, the green bar, for real assets and public markets is meaningful.
You can see it on this chart in private markets. Our three flagship strategies are ten-plus years old but what we are building in real assets, infrastructure energy and real estate, what we are building in the growth equity space, what we are building in core, these are strategies that are one to five years old, so really just getting off the ground today. You see the same thing in our public markets. It is our leveraged credit strategy that has been around for 14 years today. Everything else we are building in direct lending and private credit, our expansion to Europe, special situations are still relatively young businesses for us that have meaningful contribution potential.
So this is a chart Scott put up earlier. This is a historical snapshot of our carry and incentive fee payments at the firm. Relatively stable and growing over time. When you factor in what I just mentioned about the latent potential of our carry-generating AUM that is already in the ground, we believe it is easily $2 billion or more on a run rate basis. So we expect a meaningful step up in that line item on our P&L.
So again, I am going to walk you through some examples of how the scaling, this inflection point, really work in our business as we think about scaling and diversifying our business model. We have seen it in credit, where we have gone from 0 to roughly $60 billion over 14 years; we have seen it in capital markets, which has been around for around 10 years now from a standing start to over a $400 million contributor to the fee line at the firm. We have seen it in Asia where we have gone from $4 billion of AUM back in 2007 to now $18 billion in private equity AUM in the region and we are seeing it again for the first time in real assets where our infrastructure business is finally starting to sale and get to that sweet spot at this inflection point where we have gone from 0 to $13 billion of AUM in the last decade.
These are the four businesses near that inflection point. As you saw on the prior slide, we probably have a dozen other strategies and businesses that are between one to five years old that have not even reached this level of scaling.
So let me walk you through a couple of specific examples. So Asia is a business I am very familiar with, obviously, given my experience at the firm. When we started the business in 2005, there were just two of us on the ground in Asia and we spent the next five years really incurring a tremendous amount of the cost to build the infrastructure. We hired really talented people in the region. We opened multiple offices up – we have eight today. We built a tremendous infrastructure to support our business in Asia, all before the AUM was starting to flow, before the deals were starting to happen, this was the forward investment we made in the region in the first five years. So you see the headcount numbers at the bottom of this page. What follows next is AUM. We raised our first fund in Asia in 2007, a $4 billion fund. Our successor fund was closed in 2013. That was a $6 billion fund. Our third fund that was raised last year was a $9.3 billion fund. So we have been able, with performance, to scale our AUM from 0 to $18 billion in a little over a decade.
The economics follow. These are management fees. As we scale the AUM naturally, the management fee income follows. As the deal activity increases, we are able to leverage this unique model with KCM and again drive more economics to the firm through the participation of our capital markets team.
Then finally, as these early investments that we have made in 2005 to 2007, 2010 start to mature and we start entering the window of monetization, this green bar really talks about the carry, the realized carry that we have generated out of Asia.
We have a lot more AUM in the ground today than we did five years ago or ten years ago. That green bar you should expect to continue to grow as we monetize the investments we have in the ground.
Infrastructure – Management Fee and Carry Profile
Infrastructure is a very similar trajectory. Again, when you think about the people side and the cost side of the business, you start with a relatively low base as you are starting these strategies. You are building the teams, hiring the people. Then you start raising the AUM.
Here again, we are in our third fund in infrastructure. Our first fund was actually $1 billion. Our second fund was $3 billion. We have just closed our third fund which is $7 billion in size. The AUM is ramping. The management fees are growing in line with that AUM. You can see the step function change as we bring on Infrastructure III this past year. We are just at this tipping point where we are starting to exit some of our early infrastructure investments and carry is just starting to kick into the strategy.
Infrastructure – Total Revenue Profile with Capital Markets
Infrastructure is one of the poster childs in our firm, of our model working right. It is a relatively young strategy where we have relatively low AUM today, but we have an ability to punch way above our weight in this business because of our capital markets team.
We can target larger deals where we can speak for the equity check. We can syndicate to our partners, to our LPs and drive meaningful capital markets revenues for the firm.
Credit – Revenue Profile
Finally, in the credit side, a similar trajectory. You look at the headcount growth followed by the AUM growth driving meaningful management fees both in terms of leveraged credit and then alternative credit. Then finally, you start getting to a point where carry is kicking in. So a relatively consistent track record of building these businesses.
I think the other way you could think about scaling other than the ten-year inflection point approach is when you think about the size of some of our businesses today relative to both market size and the leading competitors in that space. Again, our desire and our goal is to be a top three player in everything that we are doing.
Large Addressable End Markets across Businesses
We are operating fundamentally in end markets that are large and scalable. These are the relative market sizes. When you look at KKR’s participation within this industry, we have a lot of room to grow. Even in our largest most mature segment in private equity, we are a sub 5% market share player globally in this space. In many of the newer strategies that we have been talking about, we are somewhere between 0% to 3% market share players in that industry.
Our Goal Is To Be a Top 3 Player in Every Business
If we look at this relative to our current size and the market leaders, again, meaningful opportunity in all of these businesses for us to grow through diversification of product, geographic diversification and successor funds. You see that in every single one of our businesses. There is a roadmap for our real asset strategy. There is a roadmap for our growth equity and our core investing businesses. There is a roadmap for our credit businesses in terms of product and diversification where we could meaningfully double the size of our businesses going forward.
Significant Scaling Opportunity
At a high level, whether it is real estate, infrastructure, credit, core equity investing or the hedge fund space, we are talking about growth opportunities that are two times to 40 times our growth over the next five to ten years if we are going to catch up and become a market leader in those areas.
For Example: Where Does Asia Go From Here?
Let me take Asia again as one example. When we started the business in 2005 and we raised our first fund in 2007, we were just a private equity firm in Asia at that point in time. What we have done is we have built around that platform to create more distribution, build investor relationships, establish a capital markets presence in the region and to a small scale enter the specialty finance space in India as a direct lender in that marketplace.
However, this first decade of work in Asia was in many ways the hardest thing to do. Trying to figure out how to operate across eight different markets in the region − how to do business in China versus India versus Japan − building those relationships with the entrepreneurs in each of these markets, with the CEOs and chairmen in all these markets. That all takes a tremendous amount of time. It does not happen overnight.
Japan is our busiest market in Asia today. While everyone reads the headlines and we are doing large deals in Japan, they forget about the fact that we did not make our first investment in Japan for the first seven years on the ground. Looked at thousands of opportunities but we did not get comfortable deploying capital until year seven when we found the right pitch and took a hard swing at that. In the last five years, Japan has been our most productive, most profitable market in the region. But, this just takes time.
What is really exciting is when you put in that investment of people, time, relationships, you have a massive ability to outcompete and scale even faster going forward.
As Scott mentioned early on, we are going to leverage those same relationships with entrepreneurs to provide financing in terms of direct lending, specialty credit. There is an enormous real estate opportunity in Asia for us today.
A lot of the large families are heavy in real estate. A lot of the big corporates in Asia are heavy in real estate. Again, that is our wheelhouse. That is where we have strength and those corporate relationships and founder relationships.
We are very excited. This is where we think we are going to take the business in the next five years is to leverage our existing capabilities, our existing franchise, to build four or five new businesses in the region.
KKR’s Balance Sheet – a Growth Enabler and Accelerator
Scott Nuttall: The third thing we need to do looking forward is use our balance sheet to drive growth. We talked a bit about how we use the balance sheet, but it is really essential at several stages of our business development. It helps us create and develop new businesses. You can see real estate, Marshall Wace, healthcare growth, etc., on the slide. This is not an exhaustive list. It has been a big part of allowing us to create a number of new businesses at the firm.
It also allows us to accelerate the growth of many businesses. You can see some of those listed. For example, the private credit BDC platform with the Franklin Square partnership − not possible without the balance sheet. That took us from number eight in private credit globally to number one or number two − a meaningful accelerator of that business amongst others. Then it supports our more mature businesses like private equity and our CLO franchise.
Example: Marshall Wace
A good example of how we have used the balance sheet to drive AUM and fee related earnings growth is Marshall Wace. Now, Marshall Wace does not show up in our investment table on our balance sheet. The returns from the Marshall Wace investment do not show up in the balance sheet returns. They show up in our AUM and our fee related earnings. We do not mark the Marshall Wace investment to market on the balance sheet because we are booking the fee related profits.
When we made this investment, we now own about 30% of Marshall Wace − one of the largest and fastest growing hedge fund players in the world. They had $22 billion of AUM. It was actually less than 20 billion when the deal was agreed. It has now grown to nearly $40 billion so a 76% increase. It has been a great contributor to our AUM growth and our fee related earnings growth. We believe they can double again from here.
Critically, we would not have been able to build a business like Marshall Wace inside KKR in this period of time. But, the balance sheet has allowed us to now get exposure to the largest part of the alternative asset management space and a significant growing player with a lot of upside.
When you find the right partner that is top three in what they do, and you participate with them − they are helping us; we are helping them − you see you can create real upside in terms of growth. This gives you a sense of how the hedge fund industry has been growing: about 11% per year back to 2010. Marshall Wace growing at three times that growth rate. The balance sheet allows us to make investments like this to really scale AUM and fee profits.
Use Our Model to Increase Participation
The fourth thing we need to do going forward is use our model to drive participation. When we say participation, what we mean is we want to participate in more of the outcomes that we are creating as a firm.
I want to do a little example here with you. Let us say that we are all in a private equity firm together that we are all partners in this private equity firm. We find an investment that we like. It requires $1 billion of equity to buy this company. We look at the size of our fund. We cannot responsibly put $1 billion investment into a given fund, given we want to keep the fund diversified.
Let us say that we can take $500 million of that $1 billion and put it into our fund. We need to do something else with the other $500 million − find a partner somewhere else to fund that part of the equity. Let us say that investment pays $100 million of capital markets fees over its life. Let us say we make a good investment, 2.5 gross multiple of invested capital.
In a traditional fund-only model, the math is very straightforward. You probably have to call a competitor to syndicate the other $500 million of equity to them. You put $500 million into our fund. That $500 million turns into $1.25 billion, make 2.5 times our money. We have a $750 million profit. Twenty percent carry rate, we get $150 million of carry revenue. That is the revenue from that investment. It is pretty good.
Our model is a bit different. What we will do is we will take that same $500 million in this example and we will put it into the fund. We will generate that same $150 million of carry revenue from the fund part of the investment. But instead of calling a competitor and giving them our content for free, what we will do is we will use our model of balance sheet and capital markets and monetize the opportunity to a much greater extent.
Let us say that in our model, we take $100 million and we invest off the balance sheet because we like this opportunity. We think it has a lot of upside. That 100 turns into 250 so we have $150 million of capital gain from that balance sheet investment. Let us say that we then take the remaining $400 million. Instead of giving it away, we syndicate it through our capital markets and Client and Partner group. Those groups go off and find $400 million and we syndicate it with a 10% carry. That gives us $60 million of incremental carry revenue.
Let us say also through our capital markets teams, we have a 30% capture rate on that $100 million of capital markets fees that this investment generates over its life. That is $30 million. If you add it all up in our model, we generate $390 million of revenue relative to the $150 million in the fee-only approach, fund-only approach. You can see significant increase in revenues from the same investment with the same team members.
It is not just the incremental profits that we are generating under our model. There is a lot of other benefits to it that are strategic. It increases our opportunity set meaningfully. We can punch above our weight and speak for larger transactions and lock them down. We maintain ball control.
What that means is that we have a CEO and a management team with one partner, one boss instead of multiple different firms in the board room, really important. Because we are in the market every week with capital markets opportunities, we can enhance our capital markets execution. We are a more valuable partner for our LPs because they want to get this direct co-invest call. So, we are calling them all the time. There are not league tables for this kind of thing, but if there were, we would be number one in syndicating alternative assets directly to third parties. Our model allows us to significantly increase our participation in the economics from the transactions that we like. It allows us to do deals that otherwise we would not be able to do.
Example: Infrastructure in 2017
This is not just theory. This is happening inside our firm every week. You are going to hear later today from our partner Tara Davies who is going to take you through two examples of this from just in infrastructure, just in 2017, just in Europe. We are very active utilizing this model day in, day out.
Increase Duration of Our Capital
The fifth thing we need to do looking forward is utilize the power of compounding. Our balance sheet compounds with performance. We have permanent capital outside the firm that stays with us forever. We have core and strategic investor partnership capital that we recycle and with performance it grows. Then we have our more traditional locked up capital and then our leveraged credit and hedge fund capital that is subject to periodic redemption but we find with performance is very sticky.
We got the $190 billion third-party capital plus the balance sheet. Our goal is to grow all types of capital, but we have a dedicated effort around growing permanent capital and this recycling strategic partnership capital. You should see that increase as a proportion of a growing total.
Three Elements of Compounding Power
We are big believers of compounding at KKR. There are three elements of the power of compounding: the balance sheet compounds, permanent capital as a nice baseline and then recycling capital compounds with performance. As we have got growth on top of this compounding model and with the increased participation from using our model contributing, it allows us to compound our AUM, fees, carry and book value much more rapidly.
Compounding Example: Impact of Core Investment
Core is a great example of this. Core is basically a strategy, long-term investments, think 10, 15-year hold, more mid-teens returns, lower risk. Historically, we passed on these types of opportunities. We have now decided to pursue them. We now have a $9.5 billion business focused on that opportunity set. Joe showed you a slide. We think there is lots of growth opportunity in this business. $3.5 billion of the $9.5 billion is from our firm’s balance sheet.
If you believe we invest that capital over the next four years, generate a 15% gross return, you can see the $3.5 billion with the book value gain that we will generate plus the retained fees and carry profit turns into $11.7 billion or about 3.3 times multiple of invested capital. That is the compounding part of just one thing we are doing with our balance sheet.
As we do these five things – we generate performance, we scale and we have lots of opportunities for scaling, we use our balance sheet to drive growth, we use our model to drive participation in everything we are doing, and we compound – we will unlock our potential as a firm.
We are excited to be with you today because we think we are just starting to reveal the potential of this enterprise 42 years in. But we are just at the very early stages of it.
We Want to Leave You with Four Takeaways
Joe and I want to finish where we started. There are four big takeaways we want to leave you with today. We are taking share in a growing industry. Our model is different. We can create and compound value in a highly differentiated way. We have massive opportunities for growth everywhere we look. We are still creating new businesses. We are the biggest owners of the stock. We are committed to value creation. We believe as we do all this work to unlock the potential of our firm, the conversion to C-Corp will allow us to find shareholders who want to be part of what we are doing which will allow us to unlock the value in our stock.
KKR Looking Forward
As a reminder, if we meaningfully underperform our historical performance and our own expectations, these are the numbers that result. We have really been looking forward to today to be able to share our story with you. There is a palpable energy inside our firm about all the opportunities we have for growth everywhere we look. We are particularly enthusiastic about where we can take this enterprise based on the foundation we have built and all these great efforts we have ongoing. We keep our culture and we do everything we just walked through in these slides, which to be clear is happening everyday inside our firm. The opportunity is immense.
We want you to now meet a number of other members of our team. We have an extraordinary group of 1,200 people around the world. You are going to meet several of them today. We would like to now go a level deeper and get into a number of different opportunities we see in all of our businesses. We are going to pass it off to our partner, Johannes Huth who is going to talk about global private equity. Thanks for the time.
DisclaimerInvestor Day podcasts and corresponding transcripts have been prepared for KKR & Co. Inc. (NYSE:KKR) for the benefit of its public stockholders and is not intended to be a solicitation or sale of any of the securities, funds or services that they may discuss. Please find a copy of the presentation here.