In the middle of 2010, private equity firm KKR (KKR) went public. The deal was muted, and the stock would continue to languish for years thereafter … that is, until this year. In fact, the stock is up an impressive 64% in 2013, more than doubling the returns of the S&P 500.
Actually, much of the private equity sector has had a nice run. Consider that the Blackstone Group (BX) is up 88% and Apollo Global Management (APO) has posted a gain of 76%. The only laggard is the Carlyle Group (CG), which is still beating the market at 28%.
So going into the new year, what are the prospects for KKR stock? Can it keep up its winning ways? Let’s take a look at the pros and cons:
Global Platform: The private equity business is fairly young, with origins going back to 1976, when cousins George Roberts and Henry Kravis formed KKR. Their strategy was to buy companies using huge amounts of debt and then to take steps to improve operations. All in all, it has resulted in above-market returns, and private equity has grown into a massive industry. But along the way, KKR has continued to expand its platform. For example, the company has moved into lucrative categories like energy/natural resources and real estate. But KKR has also built up a strong asset management operation with hedge funds and credit vehicles.
Secular Trends: It’s tough for institutional investors to consistently achieve strong returns, especially with interest rates at low levels. Often this requires a focus on alternative investments like private equity and hedge funds. Yet institutions not only look for funds that have standout performance but also ones with experience dealing with multiple market cycles. What’s more, they want organizations that have lots of scale. It often means they can attract top-notch talent and get access to the best deals. All in all, KKR is in a great position because of its long history and infrastructure. It is also a one-stop shop for institutions that want to get exposure to alternative assets.
Bull Market: This has been a key driver for KKR stock. The firm has a portfolio of 82 companies across 15 industries, many of which are household names. Eventually, these companies will go public again or be sold, generating substantial returns. The good news is that, with the continued bull market, the IPO market should continue to gain strength. More importantly, investors are willing to buy private-equity deals, as we saw with the two major ones just last week: Hilton (HLT) and Aramark (ARMK).
Market Volatility: Again, a key to KKR’s turnaround has been the strong bull market. But there’s no guarantee that the momentum will continue. After all, there are signs that the Federal Reserve will began to tighten monetary policy, which could take down equities. There are also concerns that it will get tougher for Corporate America to produce profits. In other words, if there is a move to the bear side, KKR’s shares are likely to take a big hit.
Deal Risk: Even though KKR has a top-notch team that does tremendous due diligence, the risks are still considerable. Because of the huge sizes of a typical deal, a few wipeouts can have an adverse impact on returns. Just look at the Energy Future Holdings, which was the largest buyout in history (at $48 billion). But the timing was terrible, as the transaction was struck in 2007. The company suffered from the drop in natural gas prices as well as a general fall-off in demand for its electricity generation. As of now, it looks like EFU will file for Chapter 11, which will mean that KKR will lose much of its investment. But KKR was not alone. Other top investors lost a bundle like TPG and Goldman Sachs (GS) — as well as Berkshire Hathaway’s (BRK.B) Warren Buffett.
Retail Investors: KKR has dealt primarily with institutions and governments. But over the past couple years, it has been building a platform — such as with exchange-traded funds — for individual investors. However, there are some issues. While the market is substantial, there remains tremendous competition from players like Charles Schwab (SCHW) and BlackRock (BLK). For the most part, KKR has seen little traction. Even worse, it could be a distraction from its more profitable core business.
KKR has not been without its problems. The firm hasn’t gotten traction with its efforts with individual investors, and it has pulled off a few terrible buyouts.
Despite this, KKR remains a highly disciplined organization and has posted a consistent track record. In aggregate, its private funds generated an average annual internal rate of return of 26% for the past 37 years. That kind of performance is why KKR keeps attracting substantial amounts of capital, which provides lucrative fees.
And as the public markets remain bullish, KKR should keep growing its overall earnings. This should lead to further gains in the stock price and the dividend payout, which already yields a solid 3.7%.
So should you buy KKR? Yes — if you want to benefit from the secular trends in private equity, the stock’s pros outweigh the cons.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.