Kohlberg, Kravis and Roberts: Can the buyout kings at KKR learn to be like Buffett?

This week Emily Thornton of BusinessWeek reports on the new activity at KKR. You may remember them from a long time ago. For those of us who were reading the business news back in the 80s, we all remember the leveraged buyout of RJR Nabisco. That was the largest buyout transaction ever (at the time, and remained so for 17 years) and the subject of the book Barbarians at the Gate, by Bryan Burrough and John Helyar.  For those of you who were paying attention to something else back then, KKR is Kohlberg, Kravis and Roberts, a trio who emerged from Bear Stearns, back when it was a great company. Henry Kravis and George Roberts are cousins. They went to college together in California, and worked at Bear Stearns, along with Jerome Kohlberg. Kohlberg was the senior statesman of the group. He eventually went his own way, and Kravis and Roberts carried the baton for the next twenty plus years.

Fast forward to 2009, and KKR is a leader in the world of private equity. TPG, Blackstone, Carlyle, Citadel and others are the other big players, but KKR has been around the longest. Who would argue with success? Well, looks like Henry Kravis would: he’d like to be more like Warren Buffett. BusinessWeek has a wonderful term for it: portfolio envy.

What does Warren Buffett and Berkshire Hathaway have that KKR might want? Berkshire Hathaway (BH) is a publicly traded company, and doesn’t have to go through the rounds of raising money to provide new capital for its investments. In the past KKR never had trouble, but the slowdown in 2007 made raising funds tougher for everyone. According to BusinessWeek, in the last two years 543 private-equity owned companies went bankrupt – ouch! That will slow returns, and all those institutions looking for a place to park their cash will be choosier in the future.

KKR will most likely be just fine and come out a winner on the other end, but being the bright people they are, they are using this slowdown opportunity to become a better player, ready to surge ahead when the economy turns around. For one thing, private equity has changed: it’s not just a world financed by debt anymore. For an explanation of private equity, see my previous post.

KKR now has a four-part plan which they divulged to BusinessWeek. The first part is an in-house investment bank to handle the underwriting, sales and other investment bank functions needed. Next, KKR is going public in the U.S. to have a ready source of investment cash.  The third part is to take a greater number of smaller investments in the form of minority stakes and joint ventures. The last part is new management techniques in their own company.

John Canning of Madison Dearborn partners has also said that things are changing, and firms must change with the times. Will other buyout firms follow the lead of KKR? John Mack of Morgan Stanley, now a commercial bank, also predicts wider options different from the usual previous situations.

Blackstone and Fortress, two other private equity firms, went public in 2007. However, they had the misfortune of going public at the peak of the market, and now have to live with their reduced share price.  KKR  - if it goes public now – will do so in a more favorable market, with an upward trend line.

How is KKR different from Berkshire Hathaway? The green gecko for one. BH is mostly an insurance company. And BH financed its acquisitions with equity, not debt, which matters over time.

KKR will encounter all the usual challenges when its takes the plunge into being publicly owned – compliance and scrutiny. But they must also satisfy the institutions who have invested with them and are looking for continued returns. BW points out KKR could lose focus on its main business. Six companies owned by KKR may have financial trouble.

Kravis and Roberts are handing over more authority to other managers within their company, which is appropriate given their long tenure at the firm.

KKR has been creating an in-house financial services firm, part one of their four part plan. It has taken an effort to get it going and sell the idea to the rest of KKR, but it seems to be taking flight now. Merrill Lynch, Lehman and Bear Stearns are now out of the picture, resulting in less competition, and in 2009, KKR was the lead underwriter for an IPO(Dollar General) for the first time. The deal was shaky for a while, but due to 11^th hour intervention, all ended well.

Warren Buffet apparently has no affection for the private equity industry. He says the industry piles on debt and burdens companies with fees. But KKR still wants to be like them. KKR wants to be public, so they can use their own stock to buy companies. Henry Kravis says, “ We’re not just a private equity firm…we’re an asset management firm”.

But the investors who come to KKR for outsize returns are just as capable of investing in ordinary mutual funds, and if KKR takes too many small positions, they start to look a lot like a mutual fund. A mutual fund with outsize fees, that is. KKR has experimented with taking an active role in Kodak, without owning it directly. They’ve done this through providing needed financing, receiving seats on the Kodak board, and a role in management. But the Kodak stock price is still low, so the jury is still out on that one.

KKR has expanded, making it vulnerable to the challenges of a big, lumbering company. With a former McKinsey consultant on board, they are implementing changes to try to avoid this. Rajat Gupta, the advisor, says “The vision is to develop a premier global institution for alternative investments”.  BW follows with “More than anything, Kravis and Roberts want to create a mature, meritocratic company that will long outlast them”.

This has all come a long way from the days of RJR Nabisco. I give kudos to them for lasting so long, so successfully, and for being innovators in a ruthless field. BW closes with a great quote from Henry Kravis: “The days are long gone when you just buy a company and hope that financial engineering will work. Our job today is to create value. Private Equity to me, is thinking and acting like an industrialist”.

Private Equity 101

For those of you not familiar with private equity, here’s some background to help you understand the KKR post.

Private Equity is essentially that: equity investments which are not publicly traded. Equity investments are stocks, which represent shares of ownership, and debt investments are bonds, which represent lending. Over the past 20-30 years, private equity companies have multiplied. Generally large institutions invest in private equity firms. Other investors may be accredited investors, which are high-net-worth individuals who have met certain requirements for participating in alternative, higher-risk investments.

The Private Equity firms take the large investments (called “raising funds”) and make large equity placements in companies. Sometimes the placement is large enough so that the company is delisted, or taken off the public exchange and now privately owned either partially or in full by the private equity firm. Private equity firms usually prefer to take a majority stake so that they effectively own the company, and then put in their hand-picked management team.

Why invest in private equity? The institutions and accredited investors invest in private equity firms because they are looking for better returns than they can find elsewhere. They are sophisticated investors who understand the risks of alternative placements, and are under pressure to provide returns for their own investors. The institutions are usually pension funds, university endowments, insurance companies, banks and hedge funds to name a few.

Regulation D (Reg D) is an SEC regulation which means smaller privately owned companies can sell equity or debt on the private market without having to go through a public offering. Companies which sell securities must be either registered with the SEC or meet an exemption, and Reg D is one of them. Why avoid a public offering, also known as “going public”? Because of the enormous cost, hassle and ongoing compliance requirements of publicly owned companies. You can read my earlier post on Sarbanes-Oxley to see that a lot of smaller publicly owned companies – and even the largest ones – are not happy with the ongoing requirements of Sarbanes-Oxley.

For our last question, why the growth of private equity since the 70s? As with most developments, changed regulation led to changes in the marketplace. In 1974, ERISA was passed. ERISA is a comprehensive law regulating employee benefit plans and retirement plans. ERISA allowed corporate pension funds to invest in more risky securities, thus creating a supply of funds for investing and a demand for returns. In 1981, the Reagan tax changes went into effect, which lowered the capital gains tax and created new demand for investing in securities. Late in the 80s things slowed in the private equity market with the fall of Drexel Burnham and the S&L debacle. But of course, everything picks up again, and so it did in the 90s.

There was a temporary slowdown from the bursting of the internet bubble in 2000-2001 and then things rose again starting in 2002. Activity in Europe loosened up, providing even more supply of funds for investing and greater demand for alternative investments. The trend over time has gone from short-term benefits to long-term. In the 2000s many private equity firms hold their companies, put in a management team and plan for the long-term. This takes us up to the credit crunch starting in 2007 which put the brakes on debt financing and brings us to the following post on KKR.

What's going on at Dubai World?

Wikipedia describes Dubai World as “an investment company that manages and supervises a portfolio of businesses and projects for the Dubai government across a wide range of industry segments”. Well said.  Dubai World is new, existing only since 2006, but even in that short time it has become a major player in the global economy. It holds a variety of major businesses, including Nakheel, the real estate company that built the Palm development we all like to see from the air. When Dubai World sneezed in November 2009, the rest of the world felt it. Oil prices went down, and even the U.S. stock market was affected.

Dubai World is now in the middle of a mess. Rachel Ziembe, senior analyst at research from Roubini Global Economics, says that “Dubai World…is too big to fail but too big to guarantee”. Roubini Global Economics(RGE) is an impressive group.  Nouriel Roubini, the founder, is one of the few economists who predicted the great recession we are experiencing now. Many refer to RGE’s website as one of the best news sources on economics. So Rachel Ziembe may know what she is saying. But some holdings at Dubai World need to be sold, and real estate and retail are possibilities.

Dubai World does not have a clear boundary between it and the rest of Dubai. Dubai World is still in the hands of the Sheikhs and their families who have ruled the area for over a hundred years.

I am most curious as to why the bankers loosened their standards when it came to lending to Dubai World. Eckhart Woertz, an economist at the Gulf Research Center in Dubai, said “lenders weren’t looking too hard into what entity was actually backing the debt”. The lending institutions believed all would go well, and seem to have been fooled by the aura of wealth lurking everywhere.

No one could figure out Dubai World, it is so complicated. And, Dubai World is ultimately owned by the Dubai government so it seemed safe. “Seemed” is the operative word. Most shocking of all, Chris Turner, a former director of risk and asset management at Istithmar World, says that “Western banks gave Dubai World at least $15 billion in 2006 and 2007 without looking at the numbers”. And, audited reports were not requested and not provided. Almost like being a “Friend of Angelo” at Countrywide! (Angelo Mozilo was the CEO of Countrywide mortgage, and his F.O.A. list had special privileges).

Chris Turner goes on to say, “being a risk officer there was like nailing jelly on a wall”. Moody’s reported a “limited availability of information” and yet the lenders kept lending. Lenders thought the debt was guaranteed by the Dubai government, and yet when times got tough, they found out it was not guaranteed at all. Lucky for all parties, wealthy Abu Dhabi came to the rescue, and the price Dubai has to pay is increased dependence in the future. Not unlike all the bailout situation in the U.S. where the bailee becomes more dependent on the one doing the bailout. Remember when you were a teenager and you had to ask your parents for a quick loan because you were out of cash? Made you feel sheepish and not so grown-up. Now you know how Dubai feels – trying to keep its dignity while receiving a handout from the next-door neighbor.

Because all the buying took place during the boom, assets were bought at top-of-the market prices. Now that cash is short, the assets must be sold at a discount. Buy high, sell low – not a good way to do business.

Both the European and U.S. stock markets took a hit when Dubai asked its financiers to “extend maturities” because presumably there are many companies and investors in Europe and the U.S. who are now left holding downgraded securities. This is yet another example of how interconnected the world economies are – when one goes down, there are ramifications on the other side of the globe.

But one entity’s downfall is another’s opportunity. Buyers are gathering, particularly private equity firms, looking to do deals in a down market. I predict in a few years we’ll be hearing about the next wave of investment opportunities in Dubai. 

Why Dubai Matters

What’s going on in Dubai? The week BusinessWeek put Dubai on its cover, and subtitled, "Why It's No Mirage". On December 14, Dubai received a lifeline from its neighbor, Abu Dhabi. How did it get to the point where it needed a lifeline? In late November Dubai hit its limit: it had to reschedule payments on $26 billion of debt. BusinessWeek describes Dubai as “the most dynamic business hub in the Gulf” and “a model for its neighbors”.

Dubai is unusual in the region because it is not dependent on the energy economy and has a more open economy than its fellow emirates. It is true that Dubai must be more innovative than its neighbors; it does not have the oil and gas reserves and must find other ways to be an important economic player.

Dubai experienced a real estate boom not unlike the one in the United States. Rules were looser, prices went up and the cycle fed on itself. Dubai first let foreigners buy real estate in 2003 and the buyers streamed in.

Nakheel, a subsidiary of Dubai World, suffered the most in the economic downturn. It created the iconic palm island development seen in so many photos. Nakheel currently has approximately $21 billion in debt.

The problems in Dubai have been simmering under the surface for a while. The ruler of Dubai is Sheikh Mohammed bin Rashid Al Maktoum. Sheikh Mohammed likes to protect the image that everything is okay. But Dubai is still tightly ruled. Finances are not transparent. Apparently, no one really knew the debt picture.

In spite of this, Dubai is still tolerant of foreigners, does not tax income and has some fun amenities. Many multi-national companies have located in Dubai because of the “open culture, top-notch infrastructure and hassle-free business climate”.

Dubai is home to the Dubai International Financial Center, just a few years old. Why have the investment banks chosen to locate here? The emerging market for Islamic Financial Services, now about $1 trillion worldwide.

Companies native to Dubai are doing well also. There are real estate companies, ports and airlines. The leading private equity firm is Abraaj capital. Qatar also has a financial center. Abu Dhabi has a joint venture with GE and Saudi Arabia is trying to get into the game.

BusinessWeek says that the Emirates region has provided wealth but few jobs. This is an issue of concern because it is important to employ young people. BW reports that young people “risk being drawn toward Islamist extremism if they don’t get it (a better life)”. 

Abu Dhabi is apparently the financier of the Emirates region, but Dubai is the business center.  Dubai needs to strengthen its infrastructure and is having trouble lining up bank credit. Because of Dubai’s dependence on Abu Dhabi, it may become more conservative socially and politically and may not be so independent in its foreign policy.  If Abu Dhabi has the funds for a bailout that means the region will gravitate toward Abu Dhabi.

What does the future hold for Dubai?

Many think Dubai will land on its feet and do just fine. Many of the excesses will be tamed. Development will slow down. Dubai needs to “tighten up regulations” and “improve governance” according to BW.  A major part of Dubai’s role as a business leader is its openness to foreigners. Other countries in the region do not want foreigners. BW cites Singapore as an “inspiration” to Dubai. If that is the case, we’ll be seeing more of it in the future.

Cap & Trade 101

Back when Henry Ford was cranking up the assembly line and Pittsburgh’s steel mills were going full force, the air was still relatively clean and no one dreamed of the environmental fix we’d be in now. After years of spewing all kinds of things you shouldn’t breathe into the air, we find ourselves at a crossroads as to how to handle the question of who gets to pollute and how much.

Because there is no way we are going to give up our beloved internal-combustion engine or big factories in China, emissions trading seems to be here to stay.  What is emissions trading? It is a way to control pollution by assigning an economic cost to polluting and then regulating the amount of pollution. In an emission trading system, a central agency sets a cap on the level of pollution that is emitted. If a company emits more than that level, they have to pay a central agency. If a company emits less than its allowances, it can sell the allowances, producing a trading market for those who exceed their limits. Hence the name “cap and trade”.

This system has been called “free market environmentalism”. However, that is a misnomer, because the entire system is dependent on central agency regulation – hardly a free market. Over time, the emissions limits are supposed to be reduced, and emitters will adapt with changing technology over time. The idea behind cap and trade is that it gives economic incentives to reduce pollution, and freedom to control how to reduce emissions and how much emissions.

Critics of Cap & Trade say that the central agency has too much power, may set the limits at an unattainable level, and the fees are not set by the market. The system also requires robust regulation to  measure and regulate the amount of emissions. Otherwise, if a company decides to let out a few more emissions than it is paying for, who’s to know?

Supporters of Cap & Trade say that it is the only system we have, and we need a system so let’s go with it. The EPA says on its website “Successful cap and trade programs reward innovation, efficiency, and early action and provide strict environmental accountability without inhibiting economic growth.” Let’s hope all government programs work that well.

It seems that Cap & Trade works best on a large scale, and we hope resulting in large offsets. Paul Krugman however, points out the significant disparity between the efforts to reduce sulphur dioxide emissions in the United States and in Germany. The United States has a cap and trade program which hopes to reduce emissions by 35% over twenty years. Sound good? Compare that to Germany which has reduced sulphur emissions by 90%. Why the difference? In Germany, there was regulation which demanded the reduction of Sulphur dioxide emissions with stiff penalties for exceeding limits. Seems like regulation has worked in Germany.  It’s debatable whether it will work in the U.S.