Fitch Affirms KKR at 'A' and KKR Financial Holdings at 'A-'; Outlook Stable
OREANDA-NEWS. Fitch Ratings has affirmed the long-term Issuer Default Ratings (IDRs) of KKR & Co. L.P. and its related entities (collectively KKR) at 'A'. The Rating Outlook is Stable. Approximately $2.0 billion of unsecured debt is affected by these actions.
Concurrently, Fitch has affirmed the long-term IDR of KKR Financial Holdings LLC (KFN) at 'A-'. The Rating Outlook is Stable. Approximately $1.0 billion of debt and preferred stock is affected by these actions.
A complete list of ratings is detailed at the end of this release.
Today's rating actions have been taken as part of a periodic peer review of the Alternative Investment Manager (IM) industry, which comprises seven publicly rated global firms. Fitch's outlook for the sector is stable, reflecting the relative stability of core operating fundamentals given the locked-in nature of a large portion of fee revenue; modest but increased leverage levels; manageable near-term obligations relative to available liquidity resources; increasing asset under management (AUM) diversity; and investors' increasing allocation to alternative investments, particularly those managed by alternative IMs with strong franchises such as those included in Fitch's peer review. While fund realization activity has increased significantly over the last three years, leading to the amortization of existing AUM, managers have continued to replace capital, and therefore fees, with follow-on funds and expansion into other product categories through step-out strategies, seed investments, and/or acquisitions.
The variable cost structure of the alternative IMs has contributed to relatively steady cash flows through cycles. Fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) margins had been trending down in recent years, given lower fee rates on new product categories, higher fundraising costs, and because the cost of doing business has risen with increased regulation and administrative costs associated with operating as public companies. However, FEBITDA margins have turned a corner more recently as many alternative IMs have begun to raise follow-on funds for newer strategies, which adds scale to the platform. The FEBITDA margin for 'A' category alternative IMs averaged 35.5% for the trailing 12 months (TTM) ended Sept. 30, 2015, which compared to a 34.9% average for 2012.
Leverage levels have increased across the industry, as issuers have taken advantage of the low interest rate environment to issue long duration funding and have also used debt financing for acquisition purposes. Average leverage, defined as debt divided by FEBITDA, was 3.54 times (x) for 'A' category firms for the TTM ending Sept. 30, 2015, which compared to an average of 2.55x at year-end 2012. Fitch believes the issuances have been largely opportunistic and views the reduction in refinancing risk favorably. Over time, Fitch expects leverage levels to migrate toward historical averages as cash proceeds are deployed into FEBITDA-generating opportunities and recent acquisitions begin to contribute to consolidated results.
While core issuer fundamentals remain solid, alternative IMs continue to have record levels of capital to invest at a time when conditions are increasingly challenging. Therefore, there is more capital chasing fewer deals, which could lead to significant fund underperformance if competition bids prices up further. Outsized vintage concentration could potentially exacerbate this issue. While most of the large managers have operated through a variety of market cycles, and have demonstrated investment restraint, pressure for returns from limited partners remains high, given the length of time that interest rates have been at low absolute levels. That said, a meaningful portion of the industry's uncalled capital is not-yet-earning fees, often referred to as shadow AUM, which could provide some material upside to alternative IM FEBITDA as the capital is deployed.
KEY RATING DRIVERS
IDRs AND SENIOR DEBT
The ratings affirmation for KKR reflects its strong competitive position as a global alternative investment manager, experienced management team, solid investment track record, relatively predictable fee-earnings stream, given sizeable fee-earnings assets under management (FAUM), incentive income-generating capability, ample liquidity, relatively low balance sheet leverage, and subordination of general partner interests to outstanding indebtedness.
Risks to the ratings which are common to the industry include 'key man' risk, which is institutionalized throughout many limited partnership agreements; reputational risk, which can impact the company's ability to raise future funds; and legal and regulatory risk, which could alter the alternative asset space. Risks more specific to KKR, include lower relative AUM diversity, higher cash flow leverage, and some sizeable investment concentrations on the balance sheet, the performance of which are highly correlated to KKR's investment management performance.
The affirmation of KFN's ratings reflects Fitch's view that the entity is strategically important to KKR, as outlined in its criteria, 'Global Non-Bank Financial Institutions Rating Criteria'. In accordance with the criteria, a subsidiary considered to be of strategic importance is rated one notch below its parent.
Supporting the view of KFN's strategic importance to KKR is the sharing of the brand; the high level of management integration, the expansion of KKR's credit business; and that during the recent financial crisis KKR provided explicit financial support to KFN by waiving management fees, backstopping an equity raise, and providing the firm with a $100 million liquidity facility.
That said, Fitch believes KFN's small size and more limited track record prevent the firm from being considered a core subsidiary, which would result in equalization of the ratings. Depending on KFN's size, strategy, and relative earnings contribution to KKR, Fitch's assessment of KFN's strategic importance could evolve over time.
KKR's business model continues to evolve in a differentiated manner relative to other Fitch-rated alternative investment managers, as the firm increasingly uses its balance sheet to make investments and generate cash yield. The size of its investment portfolio has grown from $4.8 billion at the end of 2012 to $9.3 billion at the end of 3Q15, as the balance sheet is used to seed new investment strategies and finance co-investment commitments to the funds. As a result of this evolution, Fitch assesses the firm's leverage profile on both a cash flow and balance sheet basis.
At Sept. 30, 2015, KKR's cash flow leverage (debt/FEBITDA) was 4.84x, on a TTM basis, adjusting for cash fees received for the management of KFN, but eliminated in consolidation. KKR's leverage was above the 'A' category peer average of 3.50x at 2Q15, but Fitch's calculation does not give credit for the interest income the firm has been able to generate from its balance sheet investments, which is expected to be a somewhat stable, recurring, source of cash income. Interest income also has the potential to grow, as KKR continues to rotate the balance sheet away from private equity co-investments and individual portfolio company investments and towards more credit-oriented fund co-investments.
On a balance sheet leverage basis, KKR's debt to tangible equity was 0.20x at Sept. 30, 2015, which is low on an absolute basis and at the low-end of the peer group.
Following KKR's acquisition of KFN, on April 30, 2014, Fitch began evaluating consolidated leverage metrics as part of its assessment of KKR's credit profile. At Sept. 30, 2015, KFN had approximately $844.2 million of debt, providing 50% equity credit for KFN's perpetual preferred securities. If KFN's debt is added to KKR's debt and KFN's recurring EBITDA is added to KKR's FEBITDA, consolidated cash flow leverage was about 4.56x and consolidated balance leverage was 0.27x at 2Q15. While Fitch expects KFN will continue to service its own debt and recognizes that the debt is nonrecourse to KKR, the agency also believes that there is the possibility that the parent would provide support to its subsidiary should KFN have trouble meeting its debt payments. The potential is reflected in Fitch's designation of KFN as a strategically important subsidiary of KKR and the resultant one notch differential between KKR's ratings and KFN's ratings.
While KKR's stand-alone and consolidated cash flow leverage ratios are higher than Fitch's general tolerance of 2.5x for alternative investment managers the 'A' category, this is mitigated by the very low balance sheet leverage which results in substantial asset coverage for outstanding debt in addition to contractual management fee streams. The expectation of increased FEBITDA and interest income generation over time and KKR's superior liquidity position are additional mitigants.
KKR's FAUM amounted to $82.9 billion at June 30, 2015, up 1.9% year-over-year, driven by strong fundraising in both the private markets and public markets segments. The increase in FAUM is noteworthy given the offsetting impact of a strong exit environment. KKR's total FAUM distributions to the limited partners of its funds amounted to $9.2 billion over the TTM ending Sept. 30, 2015, net of redemptions, as the firm took advantage of a competitive credit environment and strong equity market valuations to exit legacy positions. Fundraising is expected to remain solid, given the increasing diversity of KKR's product offering and the fact that the firm's current vintage private equity fund was approximately 60% committed at 2Q15, indicating the potential for a follow-on raise in the near term.
KKR's core operating performance was down in the first three quarters of 2015, as declines in management and transaction fees were only partially offset by an increase in monitoring fees, resulting from sizeable termination payments in 1Q15. While monitoring fees will be lumpy, Fitch believes management fees are positioned to grow as KKR had approximately $11 billion of uncalled capital at Sept. 30, 2015 that was not yet earning fees.
Despite some variability in the revenue components, operating margins are expected to remain relatively consistent, given KKR's variable-cost structure and the expectation that follow-on funds will provide higher margins, given the absence of more meaningful start-up costs. KKR's FEBITDA margin was 39.4% for the TTM ended Sept. 30, 2015, which compares favorably to the peer group.
Net interest and dividend income continued on a positive trajectory in 2015, due to the KFN acquisition and a growing proportion of yielding investments on the balance sheet. This revenue item amounted to $174.7 million through 3Q15, up 13.6% from the prior year. Fitch believes this revenue stream is likely to become more reliable and predictable over time as a greater proportion is linked to contractual payments (interest and preferred dividends). Fitch will assess the consistency of this earnings stream over time to determine whether some portion should be included in FEBITDA for the purposes of calculating firm leverage.
Carried interest and investment income year-to-date in 2015 were down 19.4% and 49.1%, respectively, relative to the comparable period in the prior year due largely to unrealized valuation movements in 3Q15, particularly in the private markets segment, given declines in publicly-traded holdings. In year-to-date 2015, realized carry and investment income were down 17.6% and 26.1% relative to the prior year. These revenue categories will be lumpy over time due to deal activity and market volatility. Accrued carried interest was $1.3 billion at Sept. 30, 2015, net of associated compensation expense. Fitch does not view the accrual as a liquid asset, but it does point to potential future income generation and cash flow.
Fitch believes KKR has a solid liquidity profile. At Sept. 30, 2015, KKR had $2.1 billion of cash and liquid short-term investments and approximately $1 billion of available revolving capacity, excluding outstanding letters of credit. KKR continues to have amounts earmarked to fund, acquire, and develop new strategies, including the recently announced minority investment in Marshall Wace LLP, a U.K.-based long/short equity hedge fund manager with $22 billion of AUM at Aug. 1, 2015, but Fitch expects the firm to remain in a negative net debt position over the long term.
KKR also has a significant amount of investments on its balance sheet with about $9.3 billion at Sept. 30, 2015, including KFN; a meaningful portion are liquid, and an increasing portion is generating a contractual cash yield for the firm.
Unfunded commitments to the funds and Merchant Capital Solutions amounted to approximately $1.4 billion at Sept. 30, 2015, and the clawback obligation, assuming all positions were liquidated at their current fair values, was zero.
Distributions for the first nine months of 2015 were $1.23 per common unit, consisting of: $0.25 of after-tax fee-related earnings, $0.59 of realized cash carry, and $0.39 of realized investment income. The payout ratio was 78.7%, which was at the low-end of the peer group. However, KKR plans to alter its distribution policy beginning with 4Q15 earnings to a flat $0.16 per share per quarter, which approximates quarterly fee and yield earnings. As a result, the firm will retain all net realized carry earnings and realized investment income going forward in order to support continued growth in the business, including the seeding of new strategies, co-investment commitments, and other strategic opportunities. Fitch views the lower payout favorably as it further strengthens the firm's liquidity profile, although it does signal a likely meaningful expansion of KKR's already sizeable balance sheet, which would further differentiate its business model from peers.
In concert with the change in the distribution policy, KKR also established a $500 million share repurchase program. While execution of the program will reduce balance sheet cash, Fitch believes cash balances will be replenished in relatively short order with the retention of realized carry and balance sheet gains. Longer-term, Fitch expects KKR to operate in a negative net debt position.
The Stable Outlook for KKR reflects Fitch's expectation that KKR will continue to generate consistent management fees, interest income, and fee-related earnings, grow FAUM through follow-on funds and expansion into new private equity and fixed income products, manage cash flow leverage down over time with the generation of incremental fees and cash yields, and maintain solid balance sheet leverage and liquidity profiles. The Stable Outlook incorporates an expectation that leverage may remain above the peer average and Fitch's general tolerance level of 2.5x, for 'A' rated alternative investment managers, offset by the company's very low balance sheet leverage, consistent with Fitch hybrid approach to the assessment of the company's credit risk profile.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
The affirmation of KFN's preferred stock rating at 'BBB' maintains the two-notch differential between the long-term IDR and preferred stock rating, and reflects the instrument's non-performance risk and loss severity, consistent with Fitch's 'Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis' criteria published on Nov. 25, 2014.
IDRs AND SENIOR DEBT
Positive rating momentum for KKR could be driven by an increase in fund and fee diversity, growth in permanent capital under management, which would enhance the predictability of management fees, a decline in the proportionate contribution of transaction and monitoring fees to total fees, as they tend to be more volatile/cyclical, increased stability in balance sheet earnings, a decline in key man risk, and a sustained reduction in cash flow leverage.
Negative rating action for KKR could be driven by declines in investment performance that negatively impact the company's ability to raise FAUM and generate fees, sustained meaningful increases in cash flow or balance sheet leverage as a result increased debt issuance, a failure to generate additional FEBITDA and interest income, or balance sheet asset impairment and/or material reduction of the firm's liquidity profile. Additionally, a material increase in leverage and/or significant deterioration in the operating performance of KFN could become a constraining factor for KKR's ratings.
KFN's ratings are directly linked to KKR, as Fitch considers KFN to be a strategically important subsidiary. Any change in Fitch's view on the relationship between KFN and its parent could alter the rating linkage. Absent a change in the perceived relationship between KKR and KFN, Fitch would expect KFN's ratings to move in step with any changes to KKR's ratings. Founded in 1976, KKR is one of the largest alternative asset managers in the world with $82.9 billion of FAUM at Sept. 30, 2015. The company's common units are listed on the NYSE under the ticker 'KKR'.
Fitch has affirmed the following ratings:
KKR & Co. L.P.
--Long-term IDR at 'A'.
KKR Management Holdings L.P.
--Long-term IDR at 'A'.
KKR Fund Holdings L.P.
--Long-term IDR at 'A'.
KKR International Holdings L.P.
--Long-term IDR at 'A'.
KKR Group Finance Co. LLC
KKR Group Finance Co. II LLC
KKR Group Finance Co. III LLC
--Long-term IDR at 'A';
--Unsecured debt at 'A'.
KKR Financial Holdings LLC
--Long-term IDR at 'A-';
--Unsecured debt at 'A-';
--Preferred stock at 'BBB'.
The Rating Outlooks are Stable.