Early vintage

In 1978, Karol Wojty became Pope John Paul II, Jimmy Carter was in the White House, the first test tube baby was born in London, and Argentina beat the Netherlands to become soccer world champions.

In New York, meanwhile, a small merchant banking firm was in the process of making history as well: Jerome Kohlberg, Jr., Henry R. Kravis and his cousin George R. Roberts were busy raising the “KKR Investment Fund” – KKR's first ever limited partnership, which in its current marketing literature the firm refers to as the “1976 Fund”.

Nearly 29 years on, in November 2006, an historian of private equity not affiliated with the firm sent a copy of the memorandum used to market this fund to the offices of PEI in London. The title: “Private Placement of $10-20 million in Limited Partnership Interests for the purpose of making Investments in Management Buyouts”. Published: January 1978. We were intrigued – and got reading straight away.

WHAT'S A BUYOUT?
By today's standards, KKR's first PPM is simple and straightforward: 23 pages in total, single-spaced and in a 12-point font, plus a short appendix with the three principals' resumes. (By contrast, the PPM of the KKR 2006 Fund LP comprises 98 pages including seven appendices, with much more detail and many more words in a smaller font.)

In the 1978 document, the reader learns on page 1 that KKR is organising a “private investment partnership” to purchase equity securities in four to eight leveraged acquisitions of “substantial industrial companies” with at least $40 million of revenue and net earnings of $2 million. Messrs. Kohlberg, Kravis and Roberts will be responsible for investing the fund, having been “active in the management acquisition business, otherwise known as management buyouts, since 1965”. Having established KKR in 1976, the three men have invested “their own money” in approximately 20 such transactions thus far.

Management buyouts? In case readers aren't fully au fait with the concept, the authors of the PPM offer a carefully crafted “definition of a management buyout” on page 2.

In what follows, the phrase “alignment of interest” does not appear, but the principle is there: management buyouts are described as acquisitions for cash of profitable companies, where KKR thinks it “extremely important, and hence one of the reasons for KKR's successful record, that management be given the opportunity to own a meaningful equity interest in the ongoing corporation at an attractive purchase price.” Between 10 and 20 percent of the bought out company should therefore be held by management (a proportion that diminished over the years as KKR's deals became larger).

Why should potential investors be interested in this novel proposition? The document is remarkably forward in explaining this. It says that when executing an MBO of a privately owned business, a corporate division or a listed company, KKR will seek to obtain “maximum leverage” from institutional sources. Companies would be bought for eight to ten times net income, but “because of the leverage, the equity investors will usually pay only one to two times pro forma earnings for the common stock purchased in the new corporation”.

As a result, and crucially: “[Because] of the low price paid for the common stock purchased, the limited partnership would attempt to return to the investors a 500 percent to 700 percent return on the equity investments made by the Fund during a 5 year period. The principals of KKR have a demonstrated record of accomplishing these results.”

700 percent over five years – one imagines that at this point, KKR had the reader's undivided attention. Nowadays PPMs typically don't commit to a specific performance target. Instead they state, as the memorandum of the KKR 2006 Fund does, that private equity investing is risky and that there can be no assurance that the limited partners will get their capital back – let alone a return on their investment.

Another intriguing part of the 1978 text is the section discussing the compensation of the general partners. It states that the principals will contribute 10 percent, or up to $2 million, of the fund's total capital. To cover operating expenses – including the three general partners' annual salaries of $50,000 each – KKR will charge an annual management fee of $500,000, escalating 7 percent per year to adjust for inflation. However, annual retainer fees of up to $150,000 per acquired company will be used to offset the management fee.

In addition, the GP is entitled to 20 percent of the realised profit of the fund, payable on a deal-by-deal basis. The document does not talk about clawback of any carried interest paid to KKR.

Neither is there any mention of a key man clause or any language dealing with the removal of the GP, nor are there any rules regarding the transfer of limited partnership interests in the fund. It's the 1970s, remember: private equity is in its infancy, and the fancy terms won't be around for some time yet.

THEN AND NOWKey terms and conditions of two very different KKR funds.*