KKR & Co. Inc. annual report, FY2012

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KKR & Co. L.P. — 2012 Form 10-K

Reporting period: Fiscal year ended December 31, 2012. The supplied filing is an annual report, not a quarterly filing. KKR is a global alternative investment manager and capital markets firm. Its results consolidate certain funds, so consolidated totals include substantial amounts attributable to fund investors and other noncontrolling interests. The filing’s registrant is KKR & Co. L.P.

Business context and performance

KKR reported $75.5 billion of assets under management (AUM) at year-end, across Private Markets and Public Markets. Private Markets AUM was $49.1 billion; Public Markets AUM was $26.4 billion. Public Markets AUM increased substantially with KKR’s October 2012 acquisition of Prisma, a hedge-fund-solutions manager.

  • Fees: GAAP consolidated fees were $568.4 million, down 21% from $723.6 million in 2011. Lower transaction and monitoring fees more than offset higher management fees. The 2011 comparison included $76.6 million of infrequent monitoring-fee termination payments.
  • Profit: Consolidated net income was $8.03 billion, but $7.43 billion was attributable to noncontrolling interests. Net income attributable to KKR & Co. L.P. was $560.8 million, versus $1.9 million in 2011; diluted earnings were $2.21 per common unit versus $0.01.
  • Investment results: Consolidated investment income was $9.10 billion, including $7.87 billion of net gains from investment activities and $940.9 million of dividends. Net gains were driven mainly by private-equity fair-value appreciation; they are volatile and substantially include fund-investor interests.
  • Management measures: Segment fee-related earnings (FRE), a non-GAAP measure, were $319.8 million, down from $417.2 million. Economic net income (ENI), also non-GAAP, was $2.13 billion, up from $750.9 million. These segment measures are not equivalent to GAAP income attributable to KKR.
  • Cash flow: Consolidated operating cash flow was $6.20 billion, compared with an outflow of $208.6 million in 2011; investing cash outflow was $220.9 million and financing cash outflow was $5.59 billion. Operating cash flow includes large investment purchases and sales by consolidated funds and is not a direct measure of cash generated for KKR unitholders.
  • Liquidity and debt: Segment cash and short-term investments were $1.53 billion, including $303.8 million of short-term investments. Consolidated cash and cash equivalents were $1.23 billion; cash held at consolidated entities is generally unavailable for KKR’s general liquidity needs. Consolidated debt was $1.12 billion, including $625.0 million of investment-vehicle financing and approximately $498.4 million carrying value of 2020 Senior Notes. Segment debt obligations were $500 million.
  • Distributions: Distributions declared were $1.22 per common unit for 2012, versus $0.74 in 2011. A $0.70 per-unit distribution was declared after year-end, payable March 5, 2013. Future distributions remain at the Managing Partner’s discretion.

Material changes versus 2011

  • KKR-attributable net income improved from $1.9 million to $560.8 million, principally reflecting stronger investment income and realizations. The result remains highly sensitive to investment valuations and carry.
  • Private Markets AUM rose from $43.6 billion to $49.1 billion, supported by new capital and appreciation, partly offset by distributions. Public Markets AUM rose from $15.4 billion to $26.4 billion, primarily due to Prisma’s acquisition, new fundraising and valuation gains.
  • Private Markets committed dollars invested fell to $3.0 billion from $5.0 billion. Management said transaction activity slowed; 2012 private-market fee-generating investments totaled approximately $6.5 billion in transaction value, compared with $24.9 billion in 2011.
  • Capital markets fees declined to $129.2 million from $170.5 million, although KKR completed more transactions (102 versus 72); lower syndicated transaction size reduced fees.
  • Consolidated total assets increased to $44.43 billion from $40.38 billion. Total KKR & Co. L.P. partners’ capital was $2.00 billion; this is distinct from the much larger consolidated equity that includes noncontrolling interests.

Outlook, risks, contingencies and unusual items

  • Management did not provide earnings guidance and stated that it does not intend to provide earnings guidance. It described ongoing uncertainty in global markets, weak European conditions, cautious portfolio-company spending, and reduced 2012 transaction activity. KKR said lower activity can reduce transaction fees and potential future investment gains.
  • KKR’s earnings and cash flows are inherently variable: carried interest depends on realizations and fund hurdles, while a substantial share of reported gains can be unrealized. At year-end, 72.4% of investments measured at fair value were Level III, relying on significant unobservable inputs and management estimates.
  • At December 31 fair values, KKR reported no clawback or net-loss-sharing obligation. Under a hypothetical zero-value liquidation of applicable funds, potential clawback exposure was $1.10 billion and potential net-loss-sharing exposure was $616.7 million.
  • Other material risks include leverage and refinancing needs at portfolio companies and funds; fundraising, redemption and fee pressure; concentrated and illiquid investments; valuation uncertainty; key-person and retention risk; conflicts of interest; and extensive, changing regulation and tax rules.
  • KKR disclosed pending litigation and regulatory inquiries, including matters involving Bruno’s, Primedia, alleged private-equity antitrust conduct, Del Monte, sovereign-wealth-fund relationships and fee waivers. Management estimated aggregate losses of approximately $32.5 million for matters where loss was considered probable and estimable, believed insurance or indemnity could reduce losses, and said ultimate outcomes remained uncertain; it had not concluded that the matters would materially affect the consolidated financial statements.
  • Prisma was acquired for $200 million cash, with contingent payments tied to performance in 2014 and 2017; the year-end fair value of the contingent consideration liability was $71.3 million. In January 2013 KKR acquired a 24.9% interest in Nephila. KKR also issued $500 million of 5.50% Senior Notes due 2043 on February 1, 2013; this post-year-end borrowing is not included in the December 31, 2012 debt balance.
  • The independent auditor gave an unqualified opinion on the financial statements and internal control over financial reporting. The assessment excluded Prisma’s controls, which management was still evaluating; Prisma represented 0.6% of consolidated assets and 3.0% of consolidated fees.

Most important facts for investors to verify

  • Reconcile reported consolidated income and cash flows to KKR-attributable results, segment FRE/ENI and cash actually available for distributions; consolidated fund amounts are not all KKR’s economic share.
  • Assess how much of 2012’s investment gain and carry reflects realized cash proceeds versus unrealized Level III marks, and test key valuation assumptions and portfolio concentration.
  • Check the sustainability of fee revenue and AUM growth after separating Prisma’s acquisition contribution, fundraising, fund distributions, redemptions and changes in fee bases; compare transaction activity with 2011.
  • Review liquidity after funding KKR’s own commitments, debt service, acquisition-related contingent payments, capital-markets obligations and tax-receivable-agreement payments. Distinguish corporate resources from fund-held cash.
  • Monitor fund performance hurdles, netting holes, clawback and net-loss-sharing exposures, and the discretion and conditions governing future per-unit distributions.
  • Review subsequent events and capital structure, including the 2043 Senior Notes issuance, Nephila investment, unit exchanges and potential dilution from exchangeable KKR Holdings units and equity awards.