KKR's leap of faith

It's no secret Kohlberg Kravis Roberts & Co. drives a hard bargain. Just ask the long-suffering investors in KKR's publicly traded affiliate, who are now expected to give their stamp of approval to the buyout firm's latest bid to take itself public.

KKR recently tweaked its stalled plan to reinvent itself as a public entity. Rather than face a hostile initial public offering market, KKR presents a complex share-swap alternative that's trumpeted as a reasonably elegant solution to two problems at once: what to do with its underperforming European affiliate and how to raise permanent capital in today's market.

But hold the applause. On the face of it, the plan looks attractive enough, though investors have yet to see specifics, to be laid out in an amendment to KKR's IPO filings later this month. KKR's Henry Kravis is asking investors to buy into return projections just as returns in the leveraged buyout world have diminished. At the very least, it comes at an extremely awkward time when LBO funds -- KKR among them -- that paid boom-era multiples for assets in the past two to three years are now awash in write-downs, with limited exit prospects for big profits, at least in the foreseeable future.

Limited partners in KKR's traditional funds, as well as investors in the listed KKR Private Equity Investors LP, would do well to be wary of what might just amount to a shrewdly crafted face-saving measure. One investor, asked for his thoughts, let loose a long, anxious sigh, saying, "The devil is in the details."

It's true enough that given the current environment, KKR's prospects of raising $1.3 billion in a conventional IPO are practically nil. By offering KKR PEI shareholders 21% of the combined company, the buyout house will extract the other thorn from its side: the disastrous 58% drop in KKR PEI's share price since it floated on Euronext Amsterdam in 2006. KKR partners and employees will hold the rest. To sweeten the offer, each KKR PEI unit holder will get up to an additional 6% of the equity in KKR in the form of a contingent value interest, three years following the closing, if its shares are trading below $22.25, the public fund's current net asset value.

For now KKR PEI shareholders are left to take the plan's economics at face value. Using KKR's analysis, the deal values the combined entity at $15.6 billion to $18.7 billion, based on a multiple of 8.5 to 10.2 times projected 2009 earnings of $1.8 billion. This gives the target an implied purchase price of $3.3 billion to $3.9 billion, about 52% above the fund's current market value but still well below the fund's $4.55 billion net asset value. KKR is coming in cheaply, or at valuations lower than what KKR paid originally, which accrues to KKR partners' benefit more than its traditional LPs. Still, judging from the 29% stock uplift on the first day of trading after the July 27 announcement, investors liked the deal, though the stock has since slipped.

KKR may be one of the most innovative LBO firms out there, but its record in the public markets has been dismal so far. The $5 billion listed fund was intended as an evergreen capital source that would complement KKR's main LBO funds -- a reasonable proxy, in other words, for KKR. Its fund debuted at $25 a share; it closed at $12.86 on Aug. 4. KKR's financing affiliate, KKR Financial Holdings LLC, fared even worse. Listing in 2005 on the New York Stock Exchange, the fund's mortgage-backed securities business was hurt by the subprime credit crisis, and the fund is now being restructured.

KKR's governance, providing a majority of independent directors with full audit and conflict committees, purports to improve on Blackstone Group LP's, where directors are primarily insiders. But, make no mistake, KKR executives will control the listed entity, and public LPs will have limited voting rights.

KKR's -- and Blackstone's -- changing business model is discombobulating enough to LPs who are uneasy about the shift in strategy from a pure-play LBO to a diversified, fee-generating asset management firm. Having a listed entity, with all its distractions, doesn't necessarily improve the prospects of KKR's returns. It will certainly entail a leap of faith by investors that KKR will hold up its end of the bargain.