RICK - 1 Main Capital - KKR & Co.: Doubling Down

• KKR was the largest detractor to the Fund’s performance in the first half, costing us around 6%.
• Scaled Alts such as KKR enjoy meaningful operating leverage, allowing them to earn operating margins of greater than 60% on fee revenues and 40% on performance revenues.
• By 2026, I believe that KKR will earn more than $10 of distributable earnings per share and will trade for a higher multiple than it does today.

The following segment was excerpted from this fund letter .

KKR & Co. ( KKR )

KKR was the largest detractor to the Fund’s performance in the first half, costing us around 6%. It was our largest position coming into the year and is down nearly 40% through June. It also remains our largest position today, as I have used weakness in the company’s share price to add meaningfully to our investment. In fact, it is approximately 2x the size of our next largest holding. The only other time I have had this type of outsized position in the portfolio was with RICK in late 2019, which went on to quadruple over the next two years.

KKR is an alternative asset manager that manages around $500 billion for clients. It gets paid a management fee and share of profits on much of the capital it puts to work. Importantly, KKR is very well positioned within its field.

For one, alternative asset managers (“Alts”) have been taking share from traditional strategies. On top of that, the largest of these managers have been taking share from smaller ones. Given its size, strong brand, and impressive long-term track record, KKR has been able to grow its AUM and fees at double-digit CAGRs for decades and should continue capitalizing on the above trends for the foreseeable future.

Additionally, scaled Alts such as KKR enjoy meaningful operating leverage, allowing them to earn operating margins of greater than 60% on fee revenues and 40% on performance revenues.

Despite these attractive attributes, KKR and the Alts more broadly are perceived as cyclical and get hit every time the prospect of an economic slowdown enters the picture. The thinking is that their underlying portfolios are leveraged, so when the market declines their investments will be hit disproportionately, which will negatively impact performance and inevitably future fundraising.

I believe that these worries are misplaced. In fact, I believe that Alts are better positioned than any other asset manager to thrive through market volatility due to their long-term capital commitments, which allow them to not only hold onto investments during bad times, but also use their massive pools of dry powder to lean into attractive new opportunities as well.

The illiquid nature of their investments also prevents them from trying to time the market like much of active management does unsuccessfully, selling when things are scary and buying back when skies look clear, which in most cases detracts from long-term performance. In essence, the Alts plant more seeds when things are scary and harvest more crops when things look great – exactly what you want stewards of your capital to be doing for you.

It is for this very reason that there are so many high-profile billionaires associated with alternative asset managers: Steve Schwartzman, Henry Kravis and David Rubenstein are just a few of the high-profile ones.

On top of ordinary cyclical worries, there is an additional worry now that higher rates will be lethal for the Alts as well. The only real test we have for this thesis is the performance of private equity funds in the late 1970s through the late 1980s, when rates were double digits. For KKR, its 1976, 1980, 1982, 1984, 1986, 1987 funds returned 17x, 5x, 4x, 6x, 14x and 2x, respectively. Sure, there may be more capital chasing deals now than back then, but there is also much more market capitalization to go after than back then, and with higher rates all that capital will demand higher returns, so deals will be priced accordingly.

While I think concerns of rising rates and a lingering economic slowdown are misplaced as it relates to the Alts, I am also comforted by KKR’s strong balance sheet and predictable fee-related earnings. The company holds net cash and investments representing approximately 40% of its market capitalization. It also has significant visibility into its management fees for the next 5+ years, especially since its most significant flagship funds just completed their large capital raises within the last year. The combination of these items provides us with significant downside protection.

At the same time, I think KKR should be able to grow its distributable earnings ((DE)) per share meaningfully in the coming years. When we first bought KKR shares, it was earning less than $2 of DE per share. This year, DE is expected to exceed $4 per share. By 2026, I believe that KKR will earn more than $10 of DE per share and will trade for a higher multiple than it does today as investors get more comfortable with the Alts cycle risk.

Additionally, employees and management are highly incentivized to see KKR succeed. Insiders own a lot of stock. The compensation of the company’s investment team is heavily tied to fee and performance revenues. Lastly, the company’s recently appointed co-CEOs were each granted 7.5 million shares of KKR, which fully vest when the stock reaches $136 per share (3x current levels). They each stand to make >$1 billion if they get the stock there by 2026. I think that they will.

To summarize, KKR is an extremely valuable franchise that benefits from secular tailwinds, has capable management, and generates solid earnings and cash flow. I have a tough time seeing how we lose here, and can easily see us making multiples of our capital in this investment in the years to come.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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