Description

KPE was written up two years ago, and like the various other publicly-traded private equity and hedge fund vehicles, as well as the BDC's, the stock has been a disaster.  However, there have been two recent developments - one done and the other pending - that would dramatically change the dynamics of KPE.  The second event is the announced, pending Oracle acquisition of Sun Microsystems, which if it happens, would make this what I believe is a compelling risk-reward investment. 

As the 2007 write-up describes, KPE is an Amsterdam-traded vehicle that raised $5 billion in 2006 (200 million shares at $25) to invest as a limited partner in KKR funds, co-invest directly in KKR deals, and make other investments.  KPE is fully-invested (or committed, as there are unfunded commitments to current funds), and has made investments as of 12/31/08 with a total cost of $5.6 billion.  KPE has debt of $1.3 billion maturing in June 2012, including its fully-drawn revolver, and has a cash balance of $640 million.  Last July, KKR announced a merger of its overall management company with KPE, but that deal has been on hold and is likely to not proceed at this point, given how poorly other management companies such as Blackstone, Och-Ziff and Fortress have traded.

In addition to the general meltdown of companies like these in the market, another issue that has been weighing on KPE is liquidity.  Specifically, it has three years left in its debt agreements, and also has more than $950 million in uncalled commitments to the KKR funds, although the rate of capital calls has slowed dramatically in the past six months.  KPE also has to fund interest expense and management fees to KKR.

The first development, announced last month, is that an institutional investor is buying approximately $200 million of KPE's co-investment interests in 5 specific investments, at the 3/31/09 carrying values.  These are 5 of the better performing co-investments, but the prices being paid are clearly much higher than the value the market is placing on the portfolio.  I understand from speaking with KKR that the buyer is an international institutional investor that is independent of KKR.

The second development, which is much more significant, is the announced deal for Oracle to acquire Sun Microsystems.  KPE's largest single investment is $700 million of Sun Microsystems convertible debt due half in 2012 and half in 2014, which has a low interest rate and is way out of the money even at the deal price.  However, in a change of control, the debt is redeemable at par.  KPE was carrying this investment at $500 million at 12/31/08.  $350 million of the proceeds will have to go to repay long term debt secured by the Sun investment, and the rest will go into KPE's cash reserves.

My analysis, which I lay out below, had arrived at a net asset value of KPE as of 12/31/08 of $6.66 per share, versus KPE's reported NAV of $12.79 at that date.  My own valuation valued the fund investments at 30-40% of cost, cutting KPE's recent estimates by more than 50%.  On the individual co-investments, I looked at recent financial reports and high yield prices to come up with estimates, and came up with overall estimates that are less than 40% of cost, and 70% of the company's yearend estimate.  Since the transactions mentioned above are significantly above my NAV, they are accretive to my valuation, bringing it up to $8.33 per share.  Even more importantly, the liquidity situation would be dramatically enhanced.  Adjusted for the closing of these transactions, as well as some post-yearend sales of securities and a pending hedge fund redemption, and assuming interest and management fees through June 30, KPE would now have cash of $1.25 billion and debt of $950 million, or $300 million of net cash.  At $3.60 per share, KPE is trading for a total market value of $730 million, or an enterprise value of $500 million.  The cost of the remaining investments is $4.4 billion, KPE's stated current value is $2.6 billion, and my estimate is $1.5 billion.  Thus, at my valuation, on an enterprise value basis it is trading at 34% of marked-to-market value.

It is hard to know what the future is as public companies for many of these entities.  Clearly, many should not be public and probably regret ever having gone public, even though many principals pocketed a lot of money in the IPO.  This one is somewhat different, as it is a clean, pass through entity, and does not include a management company.  My guess is that KPE funds its remaining commitments over time, realizes on its investments over the next 5-7 years, and either ends up continuing to make new investments or liquidates.  It could also end up merging with KKR in a better environment.  Regardless, I find the current valuation very compelling, and I believe that as KPE continues to enjoy some realizations over the next few years, the discount from NAV should return to a much more normal level, perhaps not more than 20-30%.  History would suggest that the next few years will be a good investment climate for private equity, and KKR should be in a position to make good investments with the remaining undrawn capital in its funds.

There are a few other facts worth mentioning.  The management fee paid to KKR is 1.25% up to $3 billion of equity value and 1% above $3 billion.  Given the yearend company valuation of the equity at $2.8 billion, which will rise to $3.0 billion with the closing of the Sun deal, management fees will be around $36 million annually for now.   On the other hand, given the secondary market in KKR's funds and KPE's co-investments, they may have to take additional write-downs in the quarters ahead, which would reduce the management fees.  For purposes of calculating incentive fees, investment gains are subject to offset by investment losses within each category of investment (funds, co-investments and other), so there are unlikely to be any incentive fees until we have made multiples on our investment from this stock price.

One potential near term realization is an IPO of Dollar General.  Dollar General is performing extremely well, with comps running in the 10% area and EBITDA far higher than when the deal was done in 2007.  There are rumors that Dollar General will try to do an IPO in the next 6 months.  KKR paid a high price, so an IPO would likely return not more than 1.5x cost, and possibly as low as cost.  At 1.5x cost, the investment in Dollar General would almost cover the entire enterprise value net of cash.  The important point is that it will not take more than a few realizations from a large portfolio to put the liquid NAV of KPE substantially above the current price.  My target price for this year is $6, a close to 30% discount from my pro forma 6/30/09 NAV estimate of $8.33.

Risks

Sun - Oracle deal fails to close

Remaining portfolio will continue to be equity investments at highly leveraged companies bought at the peak of the private equity boom, with the likelihood that many of these investments will turn out to be worthless

Future capital calls of existing fund commitments end up being invested unsuccessfully

KPE continues to trade at a significant discount to NAV, in part because the company's disclosed NAV is not credible.  Given the nature of the company, it is difficult to assign a likely stock market valuation to it

Catalyst

Catalysts

Closing of the Sun Microsystems acquisition by Oracle

Market realization of the implications of the deal to KPE’s liquidity and NAV

Future realizations within the KPE portfolio, including a possible Dollar General IPO