KKR and PIPEs? What Are They Smoking?

Overview

So I'm glancing at an old issue of Business Week and came upon an article talking about KKR's purchase of a private convertible note from Sun Microsystems (also see Sun's Press Release and Jonathan Schwartz's blog post on the subject). I had heard about this but filed it away in the back of my mind until it was jogged loose. Now that I am looking at this I am asking myself: Why?

I am all about buying cheap optionality and managing risk (which KKR has done by investment via a structured debt instrument versus straight common equity), but is this really what I want from my hot-rod private equity shop? Can't I get exposure to this same type of security by investing in a convertible bond mutual fund, and without all those fees? Something just doesn't add up. Ah, protecting their fees! Now I get it.

Where's the Beef?

Let's consider a few facts (with some opinions sprinkled in, namely mine):

• KKR is making this investment from its publicly-traded, Euronext-listed vehicle, ticker KPE;


• KKR has a "carve-out" in its KPE document: "Up to 25% of KPE's assets may be committed to opportunistic and other investments identified by KKR that are outside the scope of KKR's traditional private equity investments;"

• Competition for deals has heated up across the global private equity landscape, as hundreds of billions in purchasing power has been raised over the past twelve months;

• KPE's trading performance has pretty much stunk, down about 5% from its IPO price;

• KKR is likely stinging from the poor performance of its listed vehicle, and would like solid if unspectacular deals to point to in order to say "Hey, we should be trading better than this;"

• The deal carries coupons of between 1.25% and 1.50%, certainly not the key source of return (at least it chips away at the KPE management fee, however);

• KKR likely wants to get a bunch of KPE deals under its belt so it can show it is not simply a "blank check" SPAC but an active and vibrant investment vehicle worthy of its premium fees;

• As full publc-to-private deals get harder to source and the pressure on private equity returns builds, KKR is going to want to be seen as a friendly, value-added investor to people like the Jonathan Schwartzes of the world so more of these PIPEs can be booked;

• KKR is banking on its relationships and reputation as a smart investor to help propel the stock; it is clearly not trading volatility around the embedded call option so is a classic buy-and-hold investor through the convertible; and

• KKR, by taking a Board seat, will be deemed an "affiliate" for regulatory purposes. Those who have said that this gives them an "insider view" or the "inside track" to a possible buyout are smoking crack, as they will come under brutal (and hostile) regulatory scrutiny if this scenario comes to pass.

So, the key take-aways from my perspective:

• KKR knows that deal sourcing is going to get increasingly difficult. They are seeking to build a track record in the PIPEs space and to gain experience with the management of these types of investments. This is very, very different than the stuff they're used to. And they are acutely aware of this. The hope is that by being successful and by working well with Managements and Boards of Directors, that they'll ensure a steady source of deal flow tomorrow and beyond.

• KKR knows that deal return risk is increasing. You know those Blackstone guys? They see the same thing. KKR's approach (though an IPO is possible) is to put less risky assets into their portfolios to prepare for rainy days ahead. From a portfolio management perspective, this is smart.

• KKR, besides putting on an implicit portfolio hedge by booking a convertible debt structure versus straight common equity, is putting on a management and performance fee hedge. If KKR is moving down the risk/return continuum by shooting for lower risk, 10-12% total returns versus higher risk, 30-40% total returns, they are betting that shellshocked investors won't be offended by paying premium fees for stable, low double-digit returns. And they're probably right.

• KKR knows that private equity is coming under increasingly regulatory and PR scrutiny, and wants to be the firm wearing the white hat. By supporting company management's in PIPE deals, they burnish their image as a concerned corporate citizen that is a supporter and not a raider of industry. No asset stripping. No debt-funded dividends 3 months after taking a company private. Only good, wholesome, long-term investment. This isn't your father's KKR, my friends.

I could go on, but I think this is quite enough.

And in Conclusion...

Is this investment approach a one-off or a trend for KKR? Inquiring minds want to know. My guess is that they'll do more of this - patient, less risky, strategic capital - versus the Coniston Partners-type toehold investment-then-agitate model of the late 1980s (which failed miserably). They are smart, just like the Blackstoners, and I would posit will likely use PIPEs more frequently as a vehicle to hedge both portfolio returns and GP returns (fees, get it?).This is a great deal for Sun - which I didn't talk about. They get cash, a supportive, high-profile, smart investor willing to help, and a security that just gives them a little more runway to invest in their business. Btw, the structure is actually pretty cool, because Sun is synthetically rolling up the strike to around 60% over spot at the time of issuance versus the 25% embedded in the convertible sold to KKR. Anyway... sorry I had to derivatives geek-out on you for a minute there. Bottom line - good for KKR, good for Sun. But good for KKR investors? I'm not so sure.

ADDENDUM

My friend Paul Kedrosky pointed out to me that he had blogged about this earlier (he was quick and efficient about it, as always). After reading his post(s) I wanted to highlight a few key issues. I find his deterrence argument interesting but not quite spot on. Firstly, the $7.21 strike really isn't the strike from Sun's perspective: they invested a portion of the $700 million offering proceeds in a derivatives deal. They effectively "rolled up" the conversion price, by repurchasing the $7.21 strike call options embedded in the convertible(s) (actually there are two separate tranches with 2012 and 2014 maturities), and selling higher strike call options with strikes of approximately $9.23 and $10.09, 60% and 75% premiums to spot, a far cry from the 25% premium in the actual convertible notes. This shows that Sun's price targets are far above those implied by the convertibles (or Paul's analysis), meaning that Jonathan and the Board don't see $7.21 as meaningful but only prices at least $2-$3 above that. Investing some of the proceeds in this manner is an undeniably bullish signal from Sun, and should be interpreted as such. In any event, thanks to Paul for shining a light on this issue. Hopefully this is helpful in the context of the overall dialogue.

Comments

[Roger]

Jonathan, I think you are a little confused. You need to isolate the unlevered return of the asset and figure out where it resides on the risk/reward continuum. KKR could buy a portfolio of Treasuries, bank loans, convertibles or subordinated interests in ABS vehicles and lever them up. That's not the point. They can even do an LBO, commit equity to close the deal, and almost instantaneously strip out their original equity and more via a debt-funded dividend, yielding a theoretically infinite return. This is not the point.

The point is that the SUNW investment represents a materially different point on the risk/reward continuum then where they usually play, indicating a material change in strategy.

[jonathanm]

Im sure that KKR leveraged their investment, so the return profile is likely to be much better than the numbers you indicate above. The amount of leverage for a relatively stable instrument like a convertible bond can be pretty high and resonably priced. If they can't buy the company and pour a pile of debt on it, they can replicate the strategy by buying assets linked to the company's performance and levering that up. By getting a board seat they don't control the company as in a regular PE deal, but they have some influence.

[Yaser Anwar]

Sir-

Can shareholders expect KPE to pay dividends in the future? The BW article made it sound (probably is true) as if they couldn't loose money.

This sounds a lot like Pension Fund investors demands. Its almost as if they have taken a liability driven investing approach where you get low double digit returns with less volatility.

MW has a good policy for its public funds- they will buy the shares at offering price (to the public) if at a certain time they are below that, at least they have that underlying option.

Can we also expect PE funds to offer such loans/terms to companies with good FcF? They could probably offer a better rate than the banks, sort of like Mezzanine financing, or maybe I'm just getting ahead of myself...

Interesting stuff nonetheless.