Waiting for a meeting at Kohlberg Kravis Roberts’ New York headquarters, you’re unlikely to get bored. Perched high above West 57th Street with dramatic floor-to-ceiling windows, the office has breathtaking views of Central Park and Manhattan. The interior is equally grand – traditional dark wood accents are offset by an eclectic modern art collection. Massive paintings of knees, clowns and clocks (by Francis Alys, Cindy Sherman and Edward Ruscha, respectively) were just a few of the items encountered while waiting for one of the private equity industry’s most renowned and influential people: George Roberts.
KKR’s 67-year-old co-founder, co-chairman and co-CEO has long called California home and is based in the firm’s Menlo Park office. On this occasion he had flown to New York for PEI’s and the UN PRI’s Responsible Investment Forum. Scheduled to give the opening keynote address at the forum on the following morning, Roberts begins our meeting by asking for input on what the audience might want him to discuss. “I hope it’s what I’ve already prepared,” he quips. “But just in case.”
It would not be the only time during the conversation that others’ opinions would be sought by the direct but soft-spoken Roberts, whose slight drawl, utterance of the occasional “ain’t” and use of folksy phrases call to mind his Texas roots. Despite leading one of the world’s most storied and powerful private equity franchises alongside his cousin, Henry Kravis, Roberts doesn’t come across as a leader wishing to pontificate. When talking politics, for example, he is careful to follow up strong statements by noting they are “just one man’s opinion”.
Encountering a friendly, straight-talking Roberts wasn’t exactly a surprise. “He’s very candid and a very nice guy,” one large investor in KKR’s private equity funds previously told PEI. It’s an example Roberts wants the firm’s nearly 700 employees to follow: according to a source inside KKR, one of the catchphrases Roberts uses most with colleagues is, “People do business with people they like and trust.”
Ahead of the puck
Another catchphrase Roberts is fond of using is this: “We want to go where the puck is going, not where it’s been.” It’s a concept he associates with why hockey great Wayne Gretzky was able to achieve such heights, and he refers to it often to illustrate the importance of anticipating change.
Sure enough, it’s the Gretzky analogy Robert uses when asked why KKR suddenly seemed to have become swept up over the past year or so with the growing trend among fund managers to develop responsible investment programmes pursuant to environmental, social and governance (ESG) issues at portfolio companies.
“We started doing a lot of this over five, six years ago,” Roberts says, adding that he personally has been involved in such initiatives for more than 20 years. In addition to The Roberts Enterprise Development Fund, a San Francisco-based venture philanthropy organisation he founded, he and his late wife Leanne Bovet (he was remarried last year to Goldman Sachs partner Linnea Conrad) helped establish the Roberts Environmental Center at Roberts’ alma mater, Claremont McKenna College in Claremont, California. One of its initiatives is publishing sustainability scores on companies’ self-reported ESG efforts.
Today, six full-time employees at KKR track and integrate ESG management into KKR’s private equity investment process. Their efforts are complemented by KKR Capstone, a 60-strong affiliate that focuses on operations and management at portfolio companies. The firm is a signatory to the UN Principles for Responsible Investment and a member of CSR Europe, a European business network focused on corporate responsibility. It has also started publishing information on its efforts and results in an annual ESG report and a dedicated website, http://green.kkr.com.
Private equity’s size and scope – Roberts estimates that if roughly $900 billion in private equity capital has been raised globally, it equates to about $3 trillion of purchasing power with leverage – requires that it pay attention to ESG issues, he says.
“If you just look at KKR alone, we have more than 60 private equity investments, and these companies have over $200 billion of revenue. There’s 900,000 people employed in nine different countries. And we’re indirectly responsible, at the last count I made, just in the US alone, for the retirement benefits of nine million people. You can’t be of that size and substance and not pay attention to what the world’s telling you, what’s really important and what are the right things to do.”
The “right thing to do” is a phrase Roberts returns to repeatedly when discussing the firm’s ESG initiatives. “What does it mean to us? It means doing the right things by the environment, to the extent you can do that without putting yourself out of business. It means making sure – now that we’re a global world and you can make investments in all parts of the world and you can buy products and services from everybody in the world – that the people you deal with [have] the right kind of human principles. It also means trying to engage in a constructive dialogue with labour.”
Not just PR stunts
Roberts acknowledges that the firm has had issues with labour unions in the past. “I can’t tell you how many meetings I’ve gone to where there’ve been pickets outside,” he says, noting however that times have changed. At the firm’s investor day earlier this year, for example, KKR invited Andy Stern, former head of the Service Employees International Union, to join a discussion panel. Years prior, Stern would have been more likely to picket the event than be a part of it. Earlier this year, Stern told US newspaper Politico that KKR “has been a leader in trying to promote a more partnership, shared-value type of business model”.
Active stakeholder engagement, responsible sourcing and encouraging more environmentally conscious portfolio companies are the key areas KKR has been focused on, the latter in partnership with Washington DC-based non-profit group the Environmental Defense Fund (EDF). Their relationship was established in 2007, when EDF and a number of other environmental groups including The Natural Resources Defense Council collaborated with KKR, TPG and Goldman Sachs prior to their $45 billion buyout of Texas utility.
The environmental groups – which had previously criticised TXU’s environmental policies – endorsed the deal after the private equity sponsors killed plans for eight of 11 new coal-fired power plants that were in TXU’s pipeline, agreed to reduce the company’s carbon emissions to 1990 levels by 2020 and endorse a federal carbon cap.
The sponsors also pledged to double the company’s purchase of wind power and efficiency expenditures, explore new coal generating technologies, devote $400 million to demand-side management initiatives, tie executive compensation to climate protection goals and create a sustainable energy advisory board.
“These things are genuine and substantial changes, and we wouldn’t have been interested in supporting the buyout if it were just a PR stunt,” Dave Hawkins, director of the Natural Resource Defense Council’s Climate Center, said at the time in response to critics’ claims the sponsors were simply ‘greenwashing’ the deal. His organisation had been negotiating with the potential buyers for weeks, he said, and wouldn’t have bothered doing so if the private equity firms weren’t serious about improving TXU’s policies.
Irrespective of the financial difficulties the TXU deal has since suffered, it was in many ways the catalyst for KKR’s “Green Portfolio” programme launched in partnership with EDF in 2008. Meant to help reduce greenhouse gas emissions and waste, and save money in the process, the programme initially started with three portfolio companies and quickly expanded to include 16. In two years, EDF and KKR say it has resulted in a savings of $160 million in operating costs and the elimination of 345,000 metric tons of CO2 emissions, 8,500 tons of paper, and 1.2 million tons of waste.
“It’s the equivalent of taking 20,000 cars off the road, it’s the equivalent of taking 37,000 houses off the grid,” says Roberts. “And that’s with only 25 percent of our companies in the portfolio.” While he says those results may be “peanuts” compared to what’s needed on a national and global scale, individual companies taking action is how Roberts believes real change will be effected. “I think that private equity has a real chance to be a leader here.”
KKR plans to roll out its “Green Portfolio” programme more widely, but wanted to first make sure what it was doing was making a measurable impact and being embraced fully throughout the firm and at the portfolio companies, Roberts says.
In July 2010 KKR listed its management company on the New York Stock Exchange and the firm has been pleased with its performance. At press time, its units were trading at around $15.86 each, up more than 50 percent from its $10.50 listing price and representing a $3.4 billion market capitalisation. (KKR rival The Blackstone Group, by comparison, had a market cap at press time of just over $20 billion based on a $16.26 share price, down nearly 50 percent from the $31 per share price of its 2007 IPO. Other large private equity firms to have listed their management companies include Fortress Investment Group and Apollo Global Management. At press time, Oaktree Capital Management had just registered its intent to list on the NYSE, while the Carlyle Group was widely expected to do the same in the near future.)
The public listing, which Roberts and Kravis did not use to “cash out” their stakes in the business, gave KKR a multi-billion dollar balance sheet to invest directly in its portfolio companies, making KKR its own largest investor. It also created another mechanism to pay and reward employees.
Roberts shies away from saying the way forward for all private equity firms is to become a large diversified asset manager with a publicly listed management company. Some private equity firms may wish to “stay a smaller, regionalised, specialised investment firm and you know, crank away, raise money, invest it and do what you’re going to do”.
There’s nothing wrong with that model, he says. “But there’s some disadvantages to it. One, you don’t have permanent capital and secondly, you don’t have a third way of paying your people. So for us, and for Henry and me, in terms of what we want to do and perpetuating our firm way past us, you know, I think it was essential that we do this.”
Every single KKR employee is a unitholder in the company, a fact KKR professionals often cite when discussing how the firm’s various divisions work together. KKR and KKR Capstone employees own 70 percent of the firm, with the balance owned by public unitholders. Kravis and Roberts, each of whom owns a 13 percent stake, note in the firm’s annual report that KKR has held back more than 30 million units “to compensate rising stars as they grow at the firm”. Equity ownership, the pair note, is “the ultimate aligner of interests”.
Daily thoughts about succession
Roberts says KKR rejects the notion that the best private equity houses are driven by a small group of founders. “We’ve got a pretty broad bench of pretty capable people around here,” he says. “The idea that Henry and I are sitting around making all the decisions – that passed a long time ago.”
KKR today has a management committee of 11 people in addition to investment committees for all of its asset classes and funds. Both Kravis and Roberts sit on the management committee as well as the private equity investment committee and have the overarching responsibilities that correspond to their roles as co-chairmen and CEOs. So in some respect the duo retain veto power, but Roberts indicates that he and Kravis no longer make all the decisions at the firm like they might have 20 or 30 years ago.
The best-run businesses are those that attract, retain and empower employees to further grow the business, he says, noting that often some of the best ideas are generated from younger staff. “Traditionally around here, when we have an investment idea, we ask the younger people what they think first. You know, we were both in that position at one point in time, and we didn’t have any Solomon up here telling us what to do, or sprinkling holy water. We basically just went out and did it. And I would hope that we will always be able to keep that culture around here – that we’re not risk-averse, and that [the next generation will] speak up and be able to take the firm even further than we’ve gone.
Roberts says he and Kravis are still enjoying what they do, but admits he thinks about succession “every day”. “That’s part of being a CEO and doing the right things: you’ve got to think about who’s going to replace you and how it’s going to be. And we need to put people in positions, which we have, where they’re actually running businesses in KKR. We all have pretty thorough evaluations every year, in terms of what our strengths and weaknesses are, and I know you’ll be shocked to realise that we all have some weaknesses around here and areas to work on. We try to address those, and everybody tries to get better. So I think when the right time comes, if we’ve done our job right, we’ve groomed the next succession, next group of leaders.”
He refuses to be drawn on potential contenders to run the firm. “We really don’t have a short list … and there could even be somebody within the firm nobody’s even thinking about today. So like I said, we’ve given people a lot of rope to go do things – we’ll see how it all takes place.”
Part of the reason why succession is such an interesting topic for the 35-year-old firm is that KKR is no longer just about buyouts. Since 2004 it has been expanding its franchise to include platforms for infrastructure, natural resources, special situations, China growth equity and high yield and mezzanine investments. It has also started putting teams in place to focus on real estate and long/short equity opportunities.
Its assets under management, between 2004 and the end of March 2011, grew by more than 300 percent to $61 billion. Asked if private equity would continue to be the firm’s core focus, Roberts responds affirmatively, saying “that’s really the girl that brought us to the party”. He continues: “If you just look at where our assets are, we’ve got $46 billion today invested in private equity, and $15 billion, plus or minus, in credit and other things – so that’s always going to be the engine that drives the other things we’re doing. We’re basically going to stay within our core competencies and where we think we have got competitive advantages; we’re not going to go out and do things that don’t really relate to what our strengths are.”
One of the firm’s core strengths is adding operational value to portfolio companies, Roberts says, noting that was particularly crucial during and post-financial crisis. “We’ve sort of had a mantra here for the last four years: ‘portfolio, portfolio, portfolio.’”
But he fails to see that as any different from how the firm previously operated (KKR Capstone was founded in 2000, for example). “I mean, what you have to do on every investment is you have to create value that wasn’t there before, right? So the way to go about it has changed over the last 35 years that we’ve been in business, and it’ll change again. It’s not going to be a static kind of thing. And the firms that stay ahead of it and anticipate the changes you have to make, and how you have to go about doing it, are the ones that will continue.”
Roberts and Kravis open KKR’s 2010 annual report by noting that “two years ago, just about every measure of value and health in global markets was in freefall”.
The uncertainty and dislocation resulting from the credit collapse and global financial crisis in 2008 was followed in 2009 by market unpredictability and upheaval. A dearth of leverage brought buyout markets to a standstill; too many of GPs’ portfolio companies were showing severe signs of distress; fund valuations were written down dramatically; limited partners kept tighter grips on their purse strings; and critics once again were taking aim at an industry whose core tenets were being called into question.
The situation prompted a number of industry insiders and observers to question whether the private equity model still worked. But Roberts says those discussions weren’t really taking place internally at KKR – they had their heads down working on the portfolio. “Look, when you’re up to your ass in alligators, you don’t think about draining the swamps,” he laughs. “We had plenty enough to do, with managing what we have.”
Roberts hopes critics and investors alike will indeed judge the firm by how its handles itself – its performance, portfolio work and communications with investors – “when things are really, really bleak”. In the past three years or so, KKR grew its “client and partner group”, or the investor relations unit charged with LP communications and fundraising, from five to nearly 40 people. It also instituted more regular “market update” calls, on top of regular quarterly reporting, to discuss broad macro topics together with limited partners.
The game’s not over
Pundits were too quick to trumpet the shortcomings of the private equity industry during the credit crisis, Roberts says. “It’s easy to write something [critical] when you’re in the first or second inning and the home team’s getting killed,” Roberts says, likening a market cycle to a baseball game. “But it’s nine innings; it’s not one or two. And so write the articles in ‘14, ‘15, when the cycle has completed itself. And you’re going to know how a particular investment fared.”
Figures so far are largely positive, according to KKR’s first quarter earnings report. In the past two years, KKR’s private equity funds rose 90 percent in value, equivalent to an $18 billion gain. Revenue at portfolio companies rose 8 percent while EBIDTA grew 12 percent over the 12 months ended in March. Since the beginning of the year, KKR has returned $3.5 billion in capital to investors, compared to $4 billion for all of 2010 and less than $1 billion in 2009.
The firm’s capital markets team has also worked hard on debt refinancing and maturity schedules. In 2009 and 2010, roughly $46 billion of debt was refinanced. At the end of 2010, according to remarks made during the firm’s first quarter earnings call by Scott Nuttall, head of KKR’s Global Capital and Asset Management Group. Some $56 billion of portfolio company debt was due to mature in 2014. “Over the course of the last four months alone, we’ve been able to reduce that number by 40 percent to $33 billion,” Nuttall said.
The firm has also had eight companies go public in the past two years. “Our IPOs are performing well with average price to current of 49 percent,” Nuttall said during the call in May. “Nielsen, HCA, and Far East Horizon completed so far this year (and they are up 26 percent on average).”
It has also had some blockbuster exits stemming from its investments in the US shale gas sector. In June 2010, it scored a 4.5x return on its investment in East Resources when Royal Dutch Shell bought the company for $4.7 billion. It recently repeated that success this June with a 2.7x return on its investment in Hilcorp, sold to Marathon Oil for $3.5 billion.
It’s the firm’s deals done pre-credit crisis, however, which remain under a microscope given the investment climate at the time allowed for very large deals to be agreed at high valuations and with large leverage components. But a lot of critics that predicted the failure of deals done at the height of the lending boom between 2005 and 2007 may be proven otherwise. Hospital operator HCA, for example, the subject of a $32.7 billion buyout by KKR and Bain Capital, is estimated to have earned sponsors nearly four times their money so far. Semiconductor company Avago Technologies, taken private by KKR and Silver Lake Partners in 2005, is estimated to have returned 5x. Dollar General, a discount retailer KKR took private in 2007 for $7.3 billion, is thought to have returned 4x.
That’s not to say all of the deals done in that era will be winners. “The biggest issue is no big secret – it’s TXU,” acknowledges Roberts.
A steep decline in natural gas prices has severely impacted what remains the largest-ever LBO on record, agreed by KKR, TPG and Goldman Sachs for $45 billion in 2007. It’s currently marked at 0.2x cost. The radical change in Texas’ power prices – at one point dipping to $3 per MMBtu from the roughly $11 per MMBtu when TXU was purchased – has put the utility company’s capital structure under intense pressure. The 2007 club deal was agreed with a $40 billion debt package, $28.7 billion of which was due to mature before 2016.
The sponsors have worked hard to amend and extend that debt, pushing out approximately $20 billion-worth so that only $8.4 billion remains due prior to 2016. They’ve also increased the company’s power generation with two low-cost coal fired power plants going online in the past year and implemented KKR Capstone programmes in plant operations and mining to help optimise operations. Another crucial initiative helping TXU to survive is a hedging programme employed to offset natural gas prices. Ultimately, the investment will depend on what happens when the hedges roll off and where natural gas prices are in four to six years’ time.
investors’ best-performing asset class
Roberts believes generally that the private equity industry will “really surprise people on the upside”. Already, KKR funds have shown they outperform public markets: since 1976, its funds have booked 26 percent gross and 19 percent net IRRs and outperformed the S&P 500 index by about 8 percent on a net basis, according to documents from its investor day in March 2011.
“Investors are starting to realise, you know, despite all the hiccups, this is the best performing asset [class] they have,” says Roberts.
The private equity industry didn’t create the financial crisis, he continues, noting most firms have done well managing their debt maturities and have largely shown the benefits of being control investors even with leveraged capital structures. “All the institutions who were over-allocated and angry and frustrated all through the tough times … between now and ’14, there’s [going to be] a wall of money coming back to them.”
It’s just too soon to judge many of these deals, or indeed the industry itself in the wake of the financial crisis, Roberts says. “I think we’re in the fourth or fifth inning…we’ve got to wait ‘til the game’s over before we can decide who wins, what the final score was.”