The KKR/SUNW Deal Telegraphed Today's PE Environment

The KKR/SUNW convertible preferred PIPEs deal, an oddity in the private equity world up to that point, in retrospect looks like the harbinger of things to come. When I wrote about the deal in March 2007, I saw the following as being the principal reasons for such an investment:

• 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.

And look at what we've been seeing recently. TPG/Washington Mutual. Corsair et al/National City. Couple this with Carlyle's David Rubenstein's recent thoughts on the matter:

The co-founder and chief executive of private equity giant Carlyle Group said on Monday that struggling financial institutions are the "single biggest opportunity" for investment in the U.S.

Speaking during a conference of the Society of Business Editors and Writers here, David Rubenstein said financial institutions have enormous balance sheet holes in them and the amount of capital that is needed is more than has been publicly announced. While large, big-name institutions have made headlines, he noted that there are many lesser-known financial institutions around the country that need help.

Please note that due to regulatory restrictions, these investments are, by necessity in most locales, minority shareholdings. So at the end of the day the deals will look a lot like the Washington Mutual and National City deals. Very un-private equity-like. Highly unlikely to generate the kinds of returns private equity investors have gotten accustomed to.

I recently posted about my fears that fund size is leading to bad risk/reward decision-making on the part of leading private equity firms, and the two bank deals mentioned above were the marquee examples in my post:

And I know that these private equity firms and the SWFs say that they are getting quality assets on the cheap. But I worry about the conflict between the ability and desire to write a big check and the best time to write such a check.

Because it seems to me that some funds are a little trigger-happy, pushing money out the door while they can in order to justify their existence and to spend time managing dollars instead of deploying them. And if I am right, this is a very worrisome trend, indeed.

Equity Private recently weighed in on the topic, arriving at a conclusion similar to mine, which is not entirely surprising since she and I tend to be pretty blunt, sarcastic, cynical and generally rational:

What do you do when your private equity returns are dwindling because you have billions of idle cash sitting around and no deals to invest in? Invest in public equities, of course. Well, "of course," is sort of strong, particularly when your core competency isn't public equity analysis.

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I would say I'd be selling my Blackstone shares, if I owned any. I'd say short Blackstone, but, well, it's probably a bit late for that.

Funny, yet accurate stuff. Bottom line, my thesis of thirteen months ago is playing out pretty much as expected. It should be a very interesting (read: crappy) few years for the private equity industry. Gigantic asset pools that need to be deployed. Broken credit markets making leverage prohibitively expensive or unavailable. Existing portfolio companies in dire need of fixing (read: de-levering). So what's a survival-oriented PE banker to do? Put tens of billions in lower risk, lower return deals in public companies, or to massively step-up the foreign investing activities which frequently have smaller ticket sizes. In short, those pension funds that have been the largest backers of the top PE firms are going to see their returns go down, down, down. There is nowhere else for them to go. Because I don't care how good a PE banker you are: you can't fight gravity.

Comments

[MD]

From the standpoint of a junior professional entering private equity, do you think the best place to work over next 2-3 years is in a strong middle-market shop? Compensation at the megafunds is still (currently) much higher, but do you believe that is going to be countered by (1) larger deal flow (= more experience) and (2) higher co-invest returns?

[Anuj]

It's an interesting approach for PE shops to utilize convertible investments, as it really changes the complexion of their portfolio.

Looking at this on a more simplistic basis, KKR bought a call option on Sun shares (strike of $7.21). It also bought an option to either keep the option on the Sun equity, or choose to bypass it for a low-coupon piece of straight debt.

I'm pretty sure that KKR's Managing Directors are not as experienced in managing a portfolio of this type (although it would be presumptuous to say that they're not capable of it).

Nonetheless, KKR upon investing in the convertible has to be either 1) fully convinced of its long-term view that Sun is a great equity investment (which has clearly not been the case to date) or 2) actively manage it's investment to take advantage of the swings in Sun's stock.

As a sometimes convertible investor myself, even if you are convinced of a long-term investment thesis, you cannot profitably ignore the medium-term swings in a mark-to-market environment. If you do ignore the swings, then you're taking pretty large mark downs.

This could be great for private equity shops, or extremely painful. I would be curious to know how they are managing their risk for this type of investment vehicle.

[Eddie LeBreton]

"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."

Really? You think they're investors are going to pay 2/20 (guessing there) for a 12% return? <10% after fees?

Time will tell whether the PE shops can create such "stable" returns , but there are certainly much cheaper options for that type of reward, no?