Private equity firm KKR & Co. L.P. reported a sharp decline in fourth-quarter earnings as a drop in carried interest, driven by mark-to-market valuations of its assets, offset revenue from higher fees.
The earnings fell short of analysts' expectations and are a reminder of the challenges private equity groups face once they are public. Even when cash flows are growing, the firms may show weaker profits on paper, all because of the different nature of their sources of revenue.
Like its peers, KKR has two main streams of income: fees it charges its fund investors to manage assets and execute transactions, and its share of the investment profits of its funds, known as carried interest.
Management fee income tends to be stable and grow as the firm accumulates assets and spends more on deals. KKR's fee-related earnings were $116.6-million (U.S.) in the fourth quarter, up from $95.1-million a year ago.
But carried interest can be notoriously volatile. It is accrued, meaning it is realized when a deal is completed, and is tied to the performance of the assets, which is partly based on the accounting of their valuation.
KKR's private equity portfolio was up 33 per cent in 2010 but rose just 4 per cent in 2011. Carried interest fell to $54.1-million in the fourth quarter from $222.7-million a year earlier.
This is not just because economic headwinds eroded the profitability of its companies, but also because market volatility held back its funds from appreciating at the same fast pace as in 2010.
In turn, this weighed on economic net income (ENI), a measure of a private equity firm's profitability. KKR posted ENI of $285.5-million in the fourth quarter, down from $714.6-million a year ago.
After-tax ENI per adjusted unit was 33 cents, down from $1.02 a year ago. Analysts polled by Thomson Reuters expected 74 cents.
Had its public companies alone been valued at Wednesday's prices, its fourth-quarter ENI would have been $300-million more, double what was actually reported, KKR said. Some 30 per cent of its assets are in public securities, it said.
"We continue to see good progress in 2011, but the funds grew less in 2011 than in 2010 and that is why you see the ENI down," Scott Nuttall, head of KKR's Global Capital and Asset Management Group, told reporters on a conference call.
Nevertheless, realized cash carry rose to $83.2-million from $69-million as KKR cashed out on deals.
In conjunction with higher fee revenue, this led to a fourth-quarter distribution of 32 cents per common unit, up from 29 cents a year ago and bringing its 2011 dividend to 72 cents per common unit, an all-time high.
KKR, whose investments include retailer Toys "R" Us Inc., internet domain registration firm Go Daddy Group Inc. and hospital operator HCA Holdings Inc., moved its listing from Amsterdam to New York in 2010.
Unlike its listed rivals Blackstone Group LP and Apollo Global Management LLC, KKR shares are trading above the level at which they were floated. However, KKR shares are up 16.6 per cent year-to-date, while Blackstone is up 19.1 per cent and Apollo is up 21.6 per cent based on Wednesday's closing prices.
Assets under management were $59-billion at the end of 2011, down $2-billion from a year earlier. This does not include some $6-billion raised by KKR's 11th North American private equity fund, which has been on the fundraising trail for less than a year and expects to be fundraising for another year.
More than three quarters of investors who have committed to that fund were existing relationships, KKR said. It has just started fundraising for a new direct lending fund, a second Asian private equity fund and a special situations fund, while it is mulling the launch of a real estate fund.
Its investor base has grown from 275 investors two years ago to about 400, KKR said. It returned $4-billion to its limited partners in 2010 and over $6-billion in 2011.
In November, KKR led a consortium that bought oil and gas group Samson Investment Co. for $7.2-billion. It was the second-largest private equity deal of 2011, after Blackstone's $9.4-billion agreement to buy nearly 600 shopping malls from Australia's Centro Properties.
Blackstone, the largest publicly listed alternative asset manager, reported lower fourth-quarter earnings last week as performance fees declined, while management fees increased from assets that grew to a record $137 billion.
Apollo is due to report Feb. 10.
KKR was founded in 1976 by Jerome Kohlberg, Henry Kravis and George Roberts. Mr. Kravis and Mr. Roberts are joint chief executive officers. They became widely known through their $25-billion leveraged buyout of RJR Nabisco in 1988, a battle that was immortalized in the 1990 bestseller "Barbarians at the Gate."