This story appears in the February 10, 2013 issue of Forbes. Subscribe
Scott C. Nuttall, one of KKR's heirs apparent and the head of its Global Capital and Asset Management division, leans back in his chair while dining on the 42nd floor of the firm's midtown Manhattan headquarters and shares a dream. "Maybe someday you will have private equity as a choice on your 401(k) retirement plan," he says, eyeballing a turkey sandwich served on a plate of fine china (the firm caters lunch for the entire company every day). "Today, if you are a retired school-teacher in California you can invest with KKR by virtue of a pension plan, but if you are a corporate executive managing your 401(k) you cannot. There's no product available."
Nuttall, 40, is in a hurry to change that--and change KKR in the process. He's leading the charge to open the storied private equity firm to everyone. Barbarians at the service of the masses. Already, for as little as $2,500, you can invest in a KKR mutual fund managed by the same team that runs global credit funds for some of the biggest institutional investors in the country. For $25,000 you can invest in a KKR fund that buys distressed debt.
That's a far cry from the $10 million or more qualified investors once needed to get into one of the firm's 19 buyout funds, where their money could be locked up for more than ten years and net annual returns fluctuated from a 1% loss to a 39% gain.
They've evolved a long way already. Nine years after it tactically diversified away from a single-minded focus on leveraged buyouts, $29 billion of KKR's $74 billion in assets fall outside its legacy private equity business. Nuttall's group, the firm's fastest-growing division, with $25 billion under management, includes a global corporate bond and credit business, a so-called fund of funds, which allows investors to put money into a diversified basket of hedge funds and a proprietary trading desk picked up from Goldman Sachs in 2011. Since its inception in 2004 one of KKR Asset Management's important high-yield strategies has logged an average annual return of 10.8% versus 8.5% for its relevant benchmark.
The biggest challenge Nuttall faces is gaining acceptance among individual investors and their financial advisors. KKR has never courted the little guy. Traditionally, the firm raised most of its capital from multibillion-dollar pension funds, banks, insurance companies and endowments. These institutional investors could--and did--thrive despite delivering mediocre returns. After all, they were playing with other people's money, often at a great remove. Retail-level financial advisors, however, live and die by the very personal trust they earn by generating decent returns on their clients' nest eggs. It takes more than a new wrapper on an old business to win over brokers.
Which is why, on a cloudy day last November, you could find Nuttall and one of KKR's billionaire founders, George Roberts (net worth: $3.7 billion), shoulder-to-shoulder with Chuck Schwab, the patron saint of retail investors, at the brokerage giant's annual conference held in Chicago's McCormick Place convention center. Before a crowd of more than a thousand independent financial advisors, the trio took to the stage to spread the gospel of investing Main Street savings with Wall Street titans.
Roberts, the "R" in KKR and the founder known for his intellect and aloofness, even spent time manning the firm's booth on the convention hall floor, mingling with frontline brokers. Why woo hoi polloi? Because that's where the money is: "There are huge pools of capital there," marvels Roberts, 69. "I talked to one fellow that managed $800 million and another that managed $5 billion."
Numbers like that add up fast. In all, there is about $2 trillion managed by independent registered investment advisors, and that number is growing at a 13% annual clip, according to Cerulli Associates, a Boston-based financial research firm.
The numbers become even more enticing when you look beyond advisors to mutual funds and ETFs, which can also be purchased directly by individuals. According to McKinsey & Co., by 2015 there will be $13 trillion invested in these types of funds, and 13% of this money will flow into so-called alternative assets, a category that includes many areas where KKR has deep expertise: private equity, junk bonds and real estate. That 13% is more than double the amount that was allocated to alternatives in 2010.
The money is vital to keep KKR well capitalized, as the big pension funds it relied on for decades dry up and are replaced by tens of millions of Americans managing their own retirements through 401(k)s. "The implications for alternative asset managers are staggering because the bulk of all their money has historically come from pensions that are now going away," says Josh Lerner, who teaches investment banking at Harvard Business School. "Over the next five to ten years individual investors are going to be a very important source of capital for alternative asset managers, and you'll see them rethinking their business models."
It's all a long, long way from KKR's roots. The firm was founded in 1976 by three Bear Stearns alumni: Jerome Kohlberg, who had headed the corporate finance department at Bear, and the brash Henry Kravisand his cousin Roberts, who were Kohlberg's protégé. (Kravis was not interviewed for this article; Kohlberg was pushed out of the firm in 1987.) While at Bear, the three men pioneered friendly leveraged buyouts of public companies. The formula: have management borrow money against the assets and cash flow of a company, and use that money to buy a controlling stake of it. The process left the companies weighted with crushing debt loads, which was thought to be a good thing as it prevented management from embarking on wild spending sprees and ensured strict financial discipline (conversely, it also limited innovation and growth). Through a combination of cutting costs, selling assets and paying down debt, the now private firm could be brought public again, at a higher valuation, making a small (or large) fortune for the management team--and, of course, for Kohlberg, Kravis and Roberts.
KKR's first fund was tiny--just $31 million, raised from Allstate Insurance, Citicorp Venture Capital and well-heeled individual investors--but the firm grew fast and made piles of money for its investors. In 1984, less than a decade after its founding, KKR raised its first $1 billion fund. By then the firm was increasingly moving from friendly buyouts, undertaken with the cooperation of management, to hostile ones, where new management would often strip the target company like a stolen car, sell off choice bits to the highest bidders and fire thousands of employees along the way. In 1988, a year after Kohlberg left the firm, Kravis and Roberts engineered the ne plus ultra of hostile deals, the $25 billion highly leveraged hostile takeover of RJR Nabisco, immortalized in Barbarians at the Gate (Harper & Row, 1990). That deal generated nearly $1 billion in fees for the likes of KKR and its partners, including Drexel Burnham Lambert, but it proved less sweet for KKR investors, who squeaked out an 8.9% annual return in the fund that took RJR private. The takeover also resulted in the loss of at least 45,000 RJR Nabisco jobs. In all, during the 34 years between KKR's founding and its IPO in 2010, the firm raised roughly $61 billion in capital, performed 185 buyouts, saw its portfolio companies shed tens of thousands of employees--and returned an average of 19% per year to its investors.
Now the legendary raiders are donning the white hats. Besides the lure of trillions of dollars in fresh capital, the retail investment business holds another attraction for KKR and its shareholders--steady and predictable revenues from fees. In the case of KKR's new junk bond mutual fund the expense ratio is 1.31%. That's puny compared to traditional private equity fees, but the firm can make up for it with massive volume: McKinsey & Co. estimates that fees from alternative investments by mutual funds will surge to $25 billion in two years, up from $9 billion in 2010. "That's $16 billion of revenues up for grabs," says Nuttall.
And it's the type of reliable revenue that Wall Street loves. Buyouts can be enormously profitable, but because the money is tied up for years while management restructures and pays down debt, the returns are extremely uneven. In 2011, for example, KKR's net income was $1.9 million on $724 million in revenues--a 0.3% profit margin. But just a year earlier the firm made $333 million in profits on $435 million in revenues--a margin of 77%. Wall Street hates wild swings in earnings almost as much as it hates surprises, and as a result KKR's stock trades at an earnings multiple of around eight, far lower than the broader market. Compounding the sting: Steady-Freddy asset managers like T. Rowe Price and BlackRock are awarded above-market multiples of around 20 times earnings.
"KKR and other private equity funds have a life cycle that's lumpier than traditional mutual fund companies, which can constantly raise assets, generate fees, exist and grow for decades," explains Robert Lee, an analyst at Keefe, Bruyette & Woods.
In order to jump-start its foray into the retail business KKR is tapping its $6.5 billion balance sheet, which includes a $1.4 billion cash hoard, seeding its two mutual funds with a whopping $125 million, versus the typical $1 million seed at most mutual fund companies. But this is not a market that KKR can simply buy. Despite decades of experience and enormous Wall Street cred, it remains a Main Street newbie. "They don't have a manager with experience in a publicly traded mutual fund, but these guys are smart, so I'll keep an eye on them," says Brian Amidei, an investment advisor based in Palm Desert, Calif. with $600 million in assets. KKR has responded by recruiting Michael Gaviser from AllianceBernstein, who joined in November to build relationships with the likes of Fidelity and Pershing. "The things we're doing in these new funds are things we're already doing," says Gaviser. "But now it's structured in a wrapper for investors who want daily or quarterly liquidity."
Robert echoes the idea that KKR isn't altering what he calls its "internal DNA": "If you want to paint a picture of our firm, private equity will continue to be at the center of it." But he also admits that the makeover has been a long time coming. He distinctly remembers that in 2008, after the annual partners meeting, he gave attendees white T-shirts with two black circles on them, one tiny and one large. "The message was that the big black circle was our brain and the small black circle was what we were using of it," says Roberts. The problem was KKR's laserlike focus on leveraged buyouts was costing it huge opportunities. "If we went to see a company that didn't want to do a private equity transaction we'd say, 'Thank you very much,' and we couldn't do anything else with it," Roberts says. The problem was so bad, Nuttall says, that KKR began maintaining a spreadsheet listing opportunities it had to turn down.
One still burns today. Williams Companies, a Tulsa, Okla. energy firm, was ready to be taken private by KKR's private equity fund back in 2002. But shortly before the announcement Williams' stock began to sink as one of its subsidiaries came under fire over shoddy energy trades. Instead of going private as planned, Steve Malcolm, Williams' CEO, was calling KKR to help his company with at least $900 million in financing it required to avoid bankruptcy. In exchange he offered KKR $2 billion in natural gas reserves and an 18-month secured note at 25%, plus warrants.
"We had to turn it down. It was very painful, but at the time KKR only had private equity funds and this was a credit investment," Nuttall recalls. "Ultimately Warren Buffett made the investment along with a couple of hedge funds and generated something like a 30% or 40% return in 15 months."
That's not going to happen anymore. "We thought of ourselves as a private equity firm to that point," says Nuttall, "when it became very clear that we are an investment firm."
Barbarians Tamed
From masters of the universe to mingling with the masses.
1969: Henry Kravis joins his cousin George Roberts at Bear Stearns to work under Jerome Kohlberg Jr., who was developing a specialty in leveraged buyouts.
1976: Bear's boss, Cy Lewis, refuses to support the trio's buyout business, so they leave to launch Kohlberg Kravis Roberts & Co. with offices in New York and San Francisco.
1979: KKR completes the first major leveraged buyout of a public company for $380 million with Houdaille Industries.
1987: Kohlberg is forced out after clashing with Kravis and Roberts over hostile deals.
1988: KKR's audacious $25 billion hostile takeover of RJR Nabisco marks the high-water point of 1980s greed. Two years later KKR is vilified in the bestseller Barbarians at the Gate .
1994: KKR plays white knight for troubled dairy giant Borden, financing its $2 billion deal partly with RJR stock, which struggled after its 1991 IPO.
1998: Buyout funds boom during the bull market, and KKR opens its first international office in London.
2004: The firm expands outside private equity and launches KKR Asset Management.
2007: KKR takes over Texas-based power utility TXU for $45 billion, the largest LBO in history and one of KKR's biggest losers.
2010: Shares in KKR begin trading on the NYSE.
2012: KKR goes retail with the launch of its first-ever mutual funds.
