KKR & Co. Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. KKR completed its conversion from a Delaware limited partnership to a corporation on July 1, 2018; comparisons therefore include different tax and equity structures. Unless noted, dollar amounts below are in millions.
Financial results and key metrics
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| GAAP revenue | $1,129.7 | $749.7 | $2,573.9 | $2,533.2 |
| Net income attributable to KKR | $648.5 | $161.9 | $1,515.7 | $843.6 |
| Net income attributable to Class A common stockholders | $640.2 | $153.6 | $1,490.7 | $818.6 |
| Diluted EPS | $1.17 | $0.30 | $2.83 | $1.63 |
| After-tax distributable earnings (non-GAAP) | $496.7 | $409.5 | $1,137.1 | $983.0 |
Q3 revenue rose 51%, led by transaction fees and capital allocation-based income. Nine-month revenue increased 2%; higher fees were largely offset by lower capital allocation-based income. Q3 net gains from investment activities were $666.7, including $425.7 of unrealized gains, compared with $52.0 a year earlier. Nine-month investment gains were $2,256.1, including $1,829.9 unrealized, versus $893.1 in 2017. Results therefore remain sensitive to investment valuations and realizations.
Segment operating earnings were $621.9 in Q3 and $1,410.9 for nine months. Based on reported segment revenues, operating margin was approximately 52.7% and 50.6%, respectively; these are derived ratios, not company-reported GAAP margins. The company’s revised non-GAAP after-tax distributable earnings definition excludes mark-to-market gains and includes equity-based compensation; prior periods were recast for comparability. Nine-month segment results exclude approximately $729.4 of investment losses realized in Q2 ahead of the conversion, and exclude $11.5 of conversion-related nonrecurring costs.
At September 30, total assets were $50,343.9, investments $44,119.6, total liabilities $24,204.0, and equity $25,069.3. GAAP debt obligations were $20,266.2, down from $21,193.9 at year-end 2017; this includes substantial fund and collateralized-vehicle borrowings that are non-recourse beyond their respective assets. KKR’s segment balance sheet showed $2,907.7 of cash and short-term investments and $3,303.0 of KKR/KFN debt. GAAP cash and cash equivalents were $2,264.9; additional cash held at consolidated entities is generally not available for KKR’s general liquidity needs.
Nine-month operating cash flow was negative $5,240.0 (2017: negative $2,584.2), primarily reflecting investment purchases exceeding investment proceeds in consolidated funds and entities. Financing cash flow was positive $4,869.4, including net debt proceeds. Ending cash, cash equivalents and restricted cash totaled $3,294.6. KKR reported no material covenant noncompliance. Its corporate revolving facility had $1,000 available; separate capital-markets facilities were also undrawn and subject to use restrictions.
AUM was $194.6 billion and fee-paying AUM $139.3 billion at quarter-end, up from $168.5 billion and $117.4 billion, respectively, at December 31, 2017. Public Markets AUM growth included approximately $13.2 billion associated with the FS Investments BDC transaction. Uncalled commitments totaled $57.9 billion. Book value per outstanding adjusted share was $16.68, up from $14.20 at year-end.
Material changes and notable developments
- Q3 GAAP revenue increased $380.0 year over year; transaction fees rose $109.1 and capital allocation-based income rose $243.9. Compensation and benefits increased $191.9, partly reflecting higher fees, portfolio appreciation and equity compensation.
- Nine-month GAAP revenue was nearly flat year over year despite higher fees, as capital allocation-based income declined $142.7. Investment gains increased substantially, while total expenses rose $151.8.
- KKR’s conversion to a corporation created a partial tax-basis step-up and an estimated $257.1 net tax benefit/deferred tax asset. Q3 tax benefit was $129.4 and nine-month tax benefit $50.8; the company cautioned that the step-up estimate could change, potentially materially, when complete trading information becomes available.
- KKR and Franklin Square completed a strategic BDC advisory partnership in April. KKR holds a 50% interest in FS/KKR Advisor, LLC and accounts for it under the equity method. KKR also recorded an approximately $313 gain from contributing cash and advisory rights to the partnership.
- KKR changed to one reportable segment and revised its principal performance measure to after-tax distributable earnings. Segment presentation and comparable periods were recast; non-GAAP measures may not be comparable with other managers.
Outlook, risks and contingencies
The filing gives no formal earnings or revenue guidance. Management described fundraising, deployment and realizations as dependent on market conditions and said quarterly investment activity can vary significantly. Management expected approximately $580 million of realized performance and investment income from certain Q4 2018 realization activities, including transactions not yet complete and subject to closing conditions; there is no assurance they will close.
KKR cited increased equity-market volatility after quarter-end: the S&P 500 fell 7.2% from September 30 through October 25, 2018. Further market declines, widening credit spreads, higher financing costs, foreign-exchange movements and changes in energy prices could reduce portfolio valuations, investment income, fundraising or exit opportunities. Approximately 53.4% of investments measured at fair value were Level III, relying on significant unobservable inputs and management judgment.
KKR had $5,055.9 of unfunded commitments to active funds, plus $28.6 of purchase commitments and $1,041.7 of capital-markets commitments. These are subject to contractual conditions and may be funded in whole or in part. No carried interest was subject to clawback assuming fund investments were liquidated at reported fair values; a hypothetical liquidation at zero value would imply an approximately $2.0 billion clawback. KKR reported litigation, including a Kentucky Retirement Systems lawsuit, but said it could not estimate potential losses; it had not concluded the matters would materially affect the financial statements, while acknowledging an adverse outcome could be material in a particular period.
After quarter-end, KKR announced a $0.125 per-share Class A dividend and preferred dividends of $0.421875 per Series A share and $0.406250 per Series B share. KKR stated its intended initial annual Class A dividend rate was $0.50 per share, subject to board discretion and future performance. The share-repurchase authorization had approximately $419.3 remaining at September 30.
Important facts for investors to verify
- How much of reported earnings and distributable earnings is supported by realized cash proceeds versus unrealized investment marks, and how the excluded $729.4 of conversion-related realized losses affects comparisons.
- The final tax-basis step-up and related tax benefit, effective tax burden after conversion, and potential tax receivable agreement payments.
- The valuation assumptions and downside sensitivity of Level III assets, including portfolio concentration and the effect of post-quarter market volatility.
- Which consolidated debt and cash balances are non-recourse or unavailable to KKR, alongside commitments, liquidity needs and potential capital-markets funding obligations.
- Whether the anticipated Q4 realization transactions close, and the sustainability of AUM/FPAUM growth, fee income, carried interest and the stated dividend policy.