KKR & Co. L.P. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. KKR is a global alternative investment manager spanning private equity, real assets, credit, hedge funds and capital markets. Financial amounts below are U.S. dollars; “millions” or “billions” is stated where useful.
Financial performance and position
- Third-quarter GAAP results: Fees and other revenue was $687.1 million, up from $188.6 million a year earlier. Net income attributable to KKR common unitholders was $352.2 million, versus a $190.6 million loss; basic and diluted earnings were $0.79 and $0.73 per unit, respectively.
- Nine-month GAAP results: Fees and other was $1.427 billion, versus $735.8 million. Net income attributable to common unitholders was $116.1 million, down from $456.2 million; diluted earnings were $0.24 per unit versus $0.95. Net investment gains were only $9.1 million, compared with $3.475 billion in 2015.
- Management measures: Third-quarter economic net income (ENI) was $669.3 million, compared with a $286.0 million loss; fee-related earnings (FRE) were $142.3 million versus $127.5 million; after-tax distributable earnings were $461.5 million, or $0.57 per adjusted unit, versus $331.1 million, or $0.40. For nine months, ENI was $411.2 million versus $1.153 billion, FRE was $421.0 million versus $429.6 million, and after-tax distributable earnings were $1.138 billion, or $1.41 per adjusted unit, versus $1.284 billion, or $1.57. These are non-GAAP measures defined by KKR and are not substitutes for GAAP results.
- Drivers: Q3 investment gains were $735.1 million, including $446.5 million of unrealized gains. Private equity appreciation and carried interest supported the quarter; the nine-month result was weighed down by investment losses earlier in the year and lower carried interest. Q3 segment ENI was $279.4 million in Private Markets, $63.1 million in Public Markets, $34.9 million in Capital Markets and $291.8 million in Principal Activities.
- Cash flow: For the first nine months, operating cash flow was negative $555.8 million, versus positive $1.733 billion in 2015; investing cash flow was positive $23.2 million. Financing provided $1.682 billion, including debt proceeds, preferred-unit issuance and other capital flows. Cash and cash equivalents ended at $2.197 billion, up from $1.048 billion at year-end 2015. Operating cash flow is affected by investment purchases and sales and consolidated fund activity, so it is not a direct measure of recurring fee cash generation.
- Balance sheet and liquidity: Total assets were $38.0 billion and liabilities $21.2 billion at September 30. Investments were $31.3 billion, down from $65.3 billion at year-end, and total equity was $16.4 billion. The asset decline largely reflects deconsolidation of investment funds, not simply asset sales. KKR’s segment measure of cash and short-term investments was $2.825 billion; it excludes fund and collateralized financing entity balances.
- Debt: Reported debt obligations totaled $17.6 billion, including $13.2 billion of consolidated collateralized financing entity debt and fund-related borrowings; those obligations are generally supported by the assets of the relevant vehicles and are not equivalent to parent-company recourse debt. KKR’s segment balance sheet reported $2.0 billion of KKR (ex-KFN) debt and $657.3 million of KFN debt. No amounts were outstanding under the $1.0 billion corporate revolver or $500 million KCM facility at quarter-end.
Material changes and comparability
- KKR adopted ASU 2015-02 on January 1, 2016, deconsolidating most investment funds. The change reduced reported assets, liabilities and noncontrolling interests and brought previously eliminated management fees and carried interest into “Fees and Other.” KKR said adoption did not affect KKR-attributable GAAP net income or partners’ capital, but prior-period figures were not restated; year-over-year GAAP line items therefore are not directly comparable.
- The nine-month 2015 comparison benefited from $3.475 billion of investment gains, particularly private equity gains, while 2016 recorded $9.1 million of net gains. In 2016, gains on realizations were offset by unrealized losses, including in First Data and certain credit and energy investments.
- KKR issued 13.8 million Series A preferred units at 6.75% and 6.2 million Series B preferred units at 6.50%. It repurchased about 21.4 million common units for $291.9 million during the first nine months; the $500 million repurchase authorization had approximately $46.2 million remaining at September 30.
Outlook, risks and unusual items
- KKR provided no quantified company-wide earnings guidance. Management intends to make quarterly common-unit distributions of $0.16, subject to board discretion; a $0.16 distribution was declared after quarter-end. Preferred distributions are discretionary and non-cumulative.
- Private Markets AUM was $75.2 billion, while fee-paying AUM was $44.0 billion; Public Markets AUM was $55.9 billion and fee-paying AUM $49.1 billion. Management noted Private Markets fee-paying AUM fell during Q3, including from distributions, fee-base changes and termination of a third-party management-fee arrangement. Approximately $15.9 billion of Private Markets and $4.8 billion of Public Markets commitments were not yet generating management fees; fee generation depends on deployment or investment-period commencement.
- Management expects recurring Private Markets monitoring fees to continue declining absent offsets from new portfolio companies. It estimated that Americas Fund XII’s commencement could initially increase management fees by about $95 million when considered together with North America Fund XI’s post-investment fee reduction; timing and realized benefit are uncertain.
- Market risks include volatile equity and credit valuations, Brexit-related currency and market uncertainty, foreign exchange exposure, and low or declining commodity prices. Level III assets were 53.4% of investments measured at fair value, making valuations sensitive to unobservable assumptions. KKR estimated a hypothetical 10% decline in its directly held energy investments’ fair value would reduce investment income by $56 million and KKR-attributable net income by $31.1 million.
- Carried interest is recognized using estimated fund fair values and may reverse. At quarter-end, no carry was subject to clawback assuming funds were liquidated at reported fair values; a zero-value liquidation scenario would imply a $2.311 billion clawback obligation. A $121.6 million netting hole existed in European Fund IV, which can delay cash carry distributions.
- After quarter-end, KKR modified certain market-condition awards to remove price hurdles and use five-year service vesting. The modification is expected to add about $260 million of compensation expense over five years beginning in Q4 2016; KKR said it will not affect segment ENI. KKR also expected a future realized write-off of its already fully written-down Samson Resources investment to reduce after-tax distributable earnings by about $250 million, without significant future ENI impact.
- KKR disclosed ongoing legal and regulatory examinations and proceedings but had not concluded that their resolution would materially affect the consolidated financial statements. It stated adverse outcomes could nevertheless materially affect results in a particular period. Debt covenants were reported in material compliance.
Important facts for investors to verify
- Separate underlying operating trends from the ASU 2015-02 consolidation change when comparing GAAP revenue, assets, debt and noncontrolling interests.
- Assess the sustainability and cash realization of carried interest and investment gains, including fund netting holes, potential reversals and clawback exposure.
- Track fee-paying AUM, fundraising and deployment, fund fee-base step-downs, redemptions, and the timing of Americas Fund XII’s investment period.
- Distinguish parent and KFN debt from nonrecourse fund, CLO and CMBS obligations; review collateral, maturities, interest costs and the announced KFN note redemption.
- Monitor Level III valuation assumptions, concentrated holdings such as First Data, energy-price exposure, and the expected Samson Resources impact on distributable earnings.
- Confirm future common and preferred distributions, remaining unit-repurchase capacity, the $260 million award-modification expense, unfunded commitments and developments in legal or regulatory matters.