KKR's IPO supposes big profits are endless

The Baltimore Sun

Henry Kravis has been doing deals for three decades. He has swung the largest leveraged buyouts in the United States, the Netherlands, Denmark, India, Australia, Singapore and France, say regulatory documents. He has more than doubled his company's assets under management to $50 billion in less than five years and has made himself a billionaire twice over.

Now he's offering to cut you in on the action. But on this one you might take a cue from Groucho Marx: If the private equity club wants somebody like you as a member, you don't want to join.

The rush by Kravis' KKR & Co. and similar firms to usher public investors into their once-secretive confines may mark the peak of the private equity boom that has enriched a small elite beyond its wildest dreams.

Private equity buyout firms acquire businesses, make them more profitable through downsizing or revenue growth and resell them only after there are few new efficiencies to be gained. Now they're selling themselves, and that ought to tell you something.

KKR filed to sell public shares last week. This followed an announcement by Och-Ziff Capital Management Group, another private equity outfit, that it would issue shares. That followed recent public offerings by Blackstone Group and Fortress Investment Group. Carlyle Group, the Washington private equity firm that agreed last week to buy Annapolis-based ARINC, is rumored to be pondering its own sale of public stock.

Private equity has grown at amazing speed, thanks to low interest rates and a slump in the stock market after 2000, which made companies affordable for buyout artists.

KKR's assets under management increased from $18 billion at the end of 2002 to $53 billion this year. At Blackstone, managed assets went from $14 billion at the end of 2001 to $88 billion this year.

That's a 40 percent compound annual growth rate for Blackstone. By the laws of mathematics such expansion cannot continue unless these types of firms eventually control most of Earth's economy and a few meteorite refineries on Mars, too.

For investors, the more relevant question is whether they can continue to increase profits, which have also ballooned. At KKR net income went from $100 million in 2002 to $1.1 billion last year, and at Blackstone it rose from $39 million in 2002 to $2.3 billion last year.

Blackstone's public shareholders don't own pieces of the companies that it has invested in. Instead they hold stakes in an umbrella that manages the investments for very large fees (2 percent of assets, 20 percent of gains).

At KKR, it looks like public shareholders are buying into management fees as well as portions of the buyout deals.

In either case, however, the public shares will live or die on the performance of the underlying investments, and these are far from likely to grow at historical rates, either.

Competition intense

Interest rates are rising, which will cut into gains. KKR, Blackstone and other buyout firms employ large amounts of borrowed money to take control of companies.

Competition for deals has gotten extremely intense. There are fewer buyout candidates and more money circling them, which reduces chances that firms such as KKR will buy at favorable prices. The big increase in assets under management raises the odds that Kravis and other deal makers will get distracted and register mediocre results.

At the same time, productivity growth in the U.S. economy seems to be slowing, which raises questions about whether the efficiencies that have stoked private equity gains can continue.

And if Congress decides to tax private equity more heavily, as it is contemplating (and as it ought to), that also will reduce future gains.

After a June debut that had them trading at more than $35, Blackstone's shares slumped below $30 and closed last week at $31.50.

At least KKR's partners don't seem to be using the public offering to cash out their own stakes, in contrast to those at Black- stone.

Staying with company

Founders Stephen A. Schwarzman and Peter G. Peterson took out more than $2 billion as a result of Blackstone's flotation and the simultaneous sale of a stake to the Chinese government. All the money raised by KKR's offering will stay in the company, supporting new buyouts, investing in companies it already owns or financing entry into new business lines.

Even so, the deal suggests the bloom is off the petunia. If sinking new money into KKR is a great idea in 2007, KKR's partners would be putting up their own dollars and those of their friends.

Henry, why didn't you call us 30 years ago?

jay.hancock@baltsun.com

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