In a rare television interview, KKR co-founder Henry Kravis spoke on Bloomberg Television about the cost of capital for leveraged buyouts, the private equity industry and KKR’s business strategy. Kravis appeared at Bloomberg Link Dealmakers Summit earlier this week in New York, where he sat down with Bloomberg’s private equity reporter Cristina Alesci. Excerpts from the interview can be found below, courtesy of Bloomberg Television.
Henry Kravis on how he is feeling about 2011 thus far:
“We’ve had a very active year across the board…Some people say, we haven’t read about what you’ve done lately. Interesting thing is, I was thinking about what we have done this year and it sort of creeps up on us. We made ten major investments this year. The larger ones of those would be Del Monte, the Capsugel, which was a subsidiary of Pfizer, and then the pending ‘Go Daddy’ transaction.”
“We’ve done several others in the US. We’ve made a few investments in China and in Europe as well. So we’ve been very active. We have a lot in the pipeline.”
“You mentioned our shale gas investments that we made. And fortunately they worked out fine for us. We were in early.”
“I was smiling sitting up here as I was listening to Dan Akerson talk about how fast General Motors is growing in China, for example. China has been a huge market for us.”
Kravis on the state of the financing market today:
“They’ve changed and obviously spreads have widened significantly…The Del Monte transaction was about a $5.7 billion transaction. We had it levered about 6.44 debt to EBITDA, so well leveraged, about 27% equity and the balance was debt. Our all-in cost to capital was 5.5%. Now that’s as low as we’ve ever had for all-in cost to capital on a covenant-light leveraged transaction. That was March of this year.”
“Fast forward in July of this year we did our financing and closed on Capsugel. The Capsugel was about a $2.5 billion transaction and that one was about 40% equity, 60% debt. And it was about 5.88 debt to EBITDA. Cost of capital at that point the all-in cost that we put in was 6.88%. Now we’ve gone from 5.5 to 6.88 and less leverage. Fast forward to today, if you take the same Capsugel transaction today, and I was just looking at some numbers recently, the cost to capital would have gone from 6.88 to just under 9.0%. So we’re about 200, roughly 200 and 200 to 250 basis points increase today in doing a transaction and probably can’t put as much leverage on as you could before.”
“Obviously, as the debt markets tighten and your cost to capital goes up, something has to give. You can’t pay the same price that you could if you got more attractive financing, but in a Del Monte case what would have happened is multiples would have come down, which is what’s happened to the market in the last two, three months. They’re as low as they’ve been in many, many years and so you have to look at the whole package.”
On private equity today and why KKR couldn’t buy a company like McGraw-Hill today:
“KKR can buy a McGraw Hill asset. There’s financing available for the right transactions. You just have to structure it properly, depends on the sponsor. The large well established private equity sponsors can still get financing. We can still get financing for our transactions. It’s just going to cost more.”
“[Rates] are low, but they’re high relative to where they were. So if you end up having to pay a big price for a company you say, I can afford to pay the big price if my cost of capital is going to be lower.”
On the outlook for private equity exiting deals:
“I say it, don’t congratulate us when we buy a company is because the easy part is buying a company. Any fool can buy a company. Just pay enough. You’ll own a company.”
“The hard part is what do you do with the business once you buy it? How do you create value? So we start right off with a 100-day plan and, look, we used to make some mistakes back in the ’90s. And we’d buy a company, and we thought management was going to go and turn right when in fact they went and turned left.”
“So we said we’ve got to stop that. So we start right now with a very detailed 100-day plan. It aligns the interests with management and KKR. And we agree together on what we’re going to do to improve the operations.”
“One the big focuses that we very much work on is putting the proper metrics in so you can measure. If you can’t measure every step of a manufacturing process or distribution process, productivity levels, you can’t manage the company.”
“It’s very important that management understands that we’re going to work with them. We’re their partner and we are going to look toward how to improve the operation.”
“Going forward in private equity those opportunities will still be there. In fact we’ve always thrived when there have been dislocations in markets. Everybody is looking at their navel and saying, oh, the world’s coming to an end.”
“As long as you’re cautious, and you’ve done your homework and you’re thoughtful about macro, the macro environment, and you have your financings flexible – if you’ve got your financing that’s so tight and any one thing goes wrong you’re going to have problems. So you have to have that flexibility.”
On KKR’s exits for HCA, Nielsen and others:
“These things go in cycles. Right now it’s harder to exit situations, but the reality is what goes down comes back up and what’s up comes down. And so there will be other times going forward. We’ve had a number of companies approach us.”
“Don’t forget today that we have a record amount of cash on corporations’ balance sheets in the US. It’s at an all-time high. Those people are trying to figure out what do I do with this money? It’s not earning anything for them. They’re not spending money on building plants and expanding in the US particularly. So they said, what are we going to do?”
“You saw Warren Buffett announce that he’s going to buy a lot of stock back. Maybe that’s a good thing to do, maybe not, but a lot of companies are now approaching the private equity world and saying you have such and such a company. We’d like to buy it.”
On why investors are still not buying the story of a publicly traded private equity firm:
“I think one of the reasons is it becomes a proxy on the stock market in reality. Private equity has a lot of private equity investments, but people like us, Blackstone and Apollo are also in other businesses as well. So we’re in liquid credits at KKR. We’ve got long/short equity business. We have a mezzanine business and so on.”
“I think most people look at it and say, are you going to be able to exit investments as fast or as readily as you could before? The answer is probably not today, but that will come back.”
“So as that comes back again, my guess is, you’ll start to see valuations go back up again, but there’s higher risk in investing today in a private equity firm. There’s no set dividend that any of us pay. It’s based upon what we will sell or what our fee paying assets are generating, et cetera.”
“So with that you can’t plan quarter to quarter. Thank God you can’t. I’m so opposed to analysts just focusing on what’s happening next quarter. I’m a believer and I always ask CEOs when I meet with them, you’re here today. Where do you want to be five years from today and how are you going to get there?…Unfortunately today in my view corporations are pushed to tell me what the quarter is going to be. And as a result of that they end up not making some good long-term investments. They can’t.”
“That plays right into our hands in the private equity world because a lot of CEOs will say to us, I want to take the company private. What we need to do is to reorganize our company. It won’t look pretty for the next year or so, or we want to spend money on some new development, new products, new areas where we want to grow the business. And the analysts aren’t going to give us the time to do that, whereas in a private setting you of course have time to do that.”
On KKR’s efforts to diversify outside of private equity and into strategies like lending and now equity trading:
“I wouldn’t say anything is possible. That’s not what we’re going to do. We’re very disciplined in what we do. And everything has to tie together. So if you think about our first non-private equity move it was in the credit space…not investment grade.”
“If we don’t understand credit, then we’ve got a real problem at KKR. So this was a natural for us from that mezzanine finance, again, a natural extension for what we do in the private equity world. Capital markets business, our capital markets business focus is primarily on our own portfolio, but does third party business as well where it’s in an area of the smaller to mid-size companies that banks aren’t paying attention to today. They can’t afford to cover all of these smaller companies so these companies can’t get financing. So that’s a natural for us.”
“Probably it will surprise you, it may surprise you in the audience that when we went public and George Roberts, my partner, founded the firm with me. And I told all the employees at KKR that every one of you, it didn’t matter whether you worked in the mailroom or whether you worked as a partner’s firm, you were going to become an owner of KKR.”
“I think when we first said it they weren’t quite sure. And then all of a sudden they got their units distributed to them and they said they’re serious about it. And that’s what makes us different.”
“We’re really a big believer that everybody participates in everything. We’ve done this for 35 years, so whether you worked on a transaction or not you’re going to participate in how that company does, whether you live in Asia, or you live in Europe or you live in the US, and a transaction is done anywhere in the world you are going to participate in that transaction.”
On return expectations for investors in private equity:
“Right now, they just want returns. So they start with that and they say just give us something more than what you gave you and because they’re not doing too well in the rest of their investments.”
“On top of that, if you’re dealing with the pension funds they’re all underfunded now and they’ve got defined benefits that have to be paid out. So they’ve got the issues they have to deal with.”
“What we’ve always said to people we’re not going to promise anybody any set return, but what we have always said to people, and this has been we’ve beaten this. We should get you 500 to 600 basis points over the Standard & Poor’s, or pick whatever indices you want to pick because everything’s relative.”
“To say that, gee, everything has to be 30% because it used to be. Well, you might had had the stock market growing at 15 or 20% for a period of time every year in and year out. The reality is, it’s relative to what?”
“There are the outliers. There are firms that are going to have 20%, 15% net returns. And the difference between gross and net the gross is before the profit participation of typically 20% carried interest and the fees and so forth. So you look at a net number and that’s what we always look at. It’s that net number.”
On whether private equity firms are becoming systemically more important, to the point where government should be paying more attention especially with more pension funds investing in PE:
“[The government is] paying attention to what we’re doing, and that’s fine and that’s good…Right now private equity as an industry is about $2.5 trillion today. You have thousands and thousands of private equity firms, so if you take some of the larger state pension funds they may have 200 different general partners that they’ve given money to.”
“They’re trying to [shrink those relationships]. They finally have awakened and said this doesn’t make any sense. We’re offsetting each other. And by the way we’ve been telling them for a long time you don’t even know the names of the people at those firms for the most part….and you certainly don’t know anything about the portfolio. Yet you’re giving them money. So we are very big believers in more focused concentration by the pension funds.”
“We talk to the pension funds all the time. And you’re right. They are shrinking the numbers, but most of these are defined benefit plans. And you look at their assumptions that they have and they have assumptions of six, seven, eight percent that you have to return in order just to pay their beneficiaries.”
“What is it that’s going to get them that? The stock market hasn’t. The bond market hasn’t. There are some other areas that might in any given time might get you those kind of returns, but certainly private equity over a long period of time has been able to beat, certainly beat the eight percent by far. And so that’s the reason for doing it.”
“I think oil and gas is another area that we’re seeing more and more institutional investors saying we want to put money in natural resources, not just buy the stock of companies, but actually put money in the ground with operators. Why? One, they get a good solid return and, two, it’s a hedge against inflation. They’re owning the asset and that over time that just the supply/demand equation for the demand for energy is going to go up large part because of emerging markets. So that’s why they’re putting a fair amount of emphasis today on that.”
“They need stability. That’s what these institutions need. That’s why a number of them are investing in infrastructure, lower returns, but they can get a ten to twelve percent return. And again it beats that eight percent or seven percent that they need to beat.”
On what the U.S. needs to do to get companies hiring again:
“It’s a difficult problem and it’s a difficult set of answers. From my perspective I think the most important thing that we can what we need above everything else is we need certainty. And right now unfortunately there is so much uncertainty around the world. There’s uncertainty in the US. There’s uncertainty in Europe by all stretch.
“I don’t see what the incentive is in raising taxes to get people to hire more people, to get people to spend more, et cetera.”
“Specifically related to private equity [President Obama] wants to tax carried interest as regular income. Look, I happen to believe and my own thought is we have a spending problem in America. We don’t have a revenue problem. We’re spending too much.”
“Households have been spending too much. They put too much debt on, one of the reasons we have the problems we have. And the government has been spending too much.”
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