After almost half a century at the helm of KKR, co-CEOs Henry Kravis and George Roberts are handing over the baton to their successors. Kravis and Roberts are first cousins and, together with Jerome Kohlberg, they founded Kohlberg, Kravis, Roberts & Co (KKR for short) in 1975.
They pioneered the leveraged buyout and gained notoriety primarily with the hostile takeover of tobacco and food giant RJR Nabisco in 1988, made even more famous by the book Barbarians at the Gate. Today, KKR is one of the largest private equity firms in the world with USD 429 billion under management, spread across 40 funds.
The founders of KKR’s larger competitors such as the Carlyle Group, Apollo Global Management and TPG have also left in recent years. Kravis is already 77 and Roberts 78, still young compared to Buffett (91) and Munger (97). Before KKR, Kravis and Roberts were employed by Bear Stearns, now part of JP Morgan.
Corporate raiders
KKR profited from the emergence of the junk bond market in the 1980s. Somewhat euphemistically, this is usually called high yield, although the average interest rate on high yield in the United States today is lower than inflation. That was not the case in the 1970s and 1980s. In 1971, one Michael Milken became head of bond trading at Drexel Burnham Lambert, then a large investment bank. He saw great potential in junk bonds and managed to persuade more and more clients to buy them.
In 1984, Drexel Burnham was big enough to finance so-called corporate raiders with junk bonds, after which many mergers and acquisitions followed in the United States. By the end of the 1980s, the junk-bond market was worth USD 150 billion. Milken’s salary rose from $25,000 a year in 1970 to $550 million in 1987. In 1988, Milken and Drexel Burnham were indicted for fraud and after a 650 million dollar settlement, Milken left in 1989. Drexel Burnham Lambert went into liquidation and the junk-bond market collapsed. In the following decades, when selecting high yield managers, it was recommended that one or more employees had worked at Drexel Burnham Lambert, at least people with sufficient knowledge and experience of the high yield market.
No buy-outs without high yield
Without high yield, there would be no buy-outs. The 1990s were more reserved for venture capitalists who mainly profited from the IT companies in something that culminated in the dotcom bubble. This century, buy-out private equity is back. Financing is now provided by a syndicate of banks and investors through leveraged loans, which after the Great Financial Crisis were euphemistically renamed senior secured loans. What’s in a name.
Yet private equity today is a completely different market than it was in the wild 1980s. Private equity has become a mature investment category with many advantages, including a better return than on listed shares. If you look at the stock market, you will see that only a few percent of companies create long-term value.
More than half of the companies destroy value and the returns from almost the other half of the companies are needed to compensate for that. If this is compared to buy-out private equity, two thirds of the companies create value and only 14% of the companies lose money. The chance that an investor on the stock market gets it wrong is therefore much greater than that of a private equity investor.
Private equity is remarkably sustainable
KKR has contributed to the locust image of private equity through the acquisition of RJR Nabisco, but rather the opposite is true. Private equity currently plays an important role in the economy, certainly when it comes to accelerating changes within existing companies. Private equity is also remarkably sustainable.
In practice, private equity makes an extensive analysis of a company and thereby implicitly also takes into account the influence of that company on society and the environment. In essence, sustainable investment is nothing more or less than thinking carefully in advance about possible consequences, both within and outside the company.
One of the reasons why SRI came into being was to include negative externalities in the cost price, in order to repair the failure of the capitalist system. Ultimately, companies are presented with the bill for these negative effects anyway, but in the form of damage claims, negative publicity or stricter legislation and regulations. For private equity, it is especially relevant that a strong and sustainable company can yield more than a company with an unsustainable business model and a bad reputation. In such cases, the importance of a good return runs parallel with having a positive impact on society and the environment.
Gentlemen who left through the Gate
Due to the property structure, the thorough analysis, the major influence on the company and the oversight of the entire life cycle, private equity investors are much more focused on the long term than the quarterly capitalists on the stock market. Private equity is also becoming an increasingly important part of many portfolios. The sharply rising stock market is helping to give investors the final push, because not having a stock market listing also provides financial peace of mind.
Kravis and Roberts each own about USD 11 billion, much of which is still in private equity. In terms of reputation, Kravis and Robert have been fully rehabilitated. They are no longer seen as Barbarians at the Gate, but as the Gentlemen who left through the Gate.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear on Tuesdays and Thursdays in Dutch on Fondsnieuws and from time to time in English on Investment Officer Luxembourg.