Mumbai: In 1976, Jerome Kohlberg, Henry R Kravis and his first cousin George R Roberts, all of whom worked together at Bear Stearns & Co, in a division that was doing what was then called bootstrap acquisitions (now called leveraged buyouts, in which assets of the target company are used as collateral to finance a large part of the acquisition), founded Kohlberg Kravis Roberts & Co. Today, almost 33 years after it was set up, KKR, as the global private equity fund is popularly known, has made investments in 165 companies worth a total $445 billion. Its current portfolio of 48 companies include two that are Indian — the 2006 buyout of software firm Aricent Inc for $900 million and the early 2008 investment of $250 million in Sunil Mittal-promoted Bharti Infratel Ltd. But the fund has had to mark down its portfolio considerably in the aftermath of the global financial crisis.
Henry Kravis, who was in Mumbai on Monday says that private equity as an asset class is not dead, and the markdowns are more a reflection of the accounting rules than the inherent strengths of his companies. In a chat with Mumbai’s business press, he spoke of the economic crisis, how he sees a ray of sunshine now, regulation of the private equity business and his interest in India. Edited excerpts:
India focus: KKR’s Kravis says the PE fund is watching the market now. Bloomberg
Is this the worst economic crisis you have seen, and when do you see a turnaround?
It’s different. It’s bad and it’s global, and it happened so fast. It’s like somebody shut the lights off around the world. We haven’t decided yet whether the economy has turned around, but we’re seeing a few rays of sunshine. They are starting to show up in the US in particular, they’re starting to show up here (India) a little bit, in China and a few other markets around the world. If you take the US where this downturn started, the capital markets have actually started to open. About six months ago, they were absolutely shut. The equity markets have also opened a touch. Don’t take it as though it’s going to be straight up. It’ll probably trade within a range for a period of time, around the world.
What about the deal environment? When will that pick and how will it change?
It’s starting to happen again. Last week, $29 billion worth of mergers took place in the US. We may not get a lot of mega deals, like we had in the 1980s and from 2004-early 2007 when banks were throwing money. They did little due diligence and were using their balance sheet to underwrite transactions. They’d give you a commitment in two-three days. It didn’t matter to them because they were just going to chop, dice and sell the debt all over the world, so it wasn’t going to be on their balance sheet. Now, they will go back to the way it was in 1990s, where they would hold at least a part of it (the debt) on their balance sheets. Transactions up to $5-6 billion can still be done. Terms are obviously going to be different. You’re going to have real teeth in the agreements. And since the banks will be levering their balance sheets, the size of what they will be able to underwrite will come down to $1-5 billion or so.
Some of the recovery attempts that are being made by the American government, have come in for a lot of criticism. Do you think these attempts are going to help revive the American economy?
The government is trying its best to accomplish something that we’ve not faced around the world since the Great Depression. The first attempt was the Troubled Asset Relief Program (TARP). And some of the TARP is actually starting to work. Is it perfect? No. But you’re starting to see banks getting cleaned up, and credit starting to flow. Will all the banks pass the stress test? I don’t know. I doubt it. Will banks need more capital? Yes, particularly in continental Europe, and in the US as well. What really is much more important and has to get going is the securitisation market. So far TARP’s off to a rocky start there, but that doesn’t mean it wouldn’t be corrected and and fixed.
One of the biggest problems you have is on account of the accounting rule that went into effect a couple of years ago, called FASB 157, that has really changed how you mark to market the portfolios of these financial institutions. It would have been a lot easier obviously if you didn’t have to mark them to market. So part of the problem is pricing and getting buyers and sellers lined up. Once you clean up and once people know that the assets in these banks are pretty solid, you’re going to have a lot of money going towards that. But yes, I think all of these programmes have merit. They will all take hold eventually, but they need some tweaks. One of the other reasons why people are shying away is that they don’t know if you go in and buy some of these assets, will they be ensnared in government actions and get called down to the Congress because they made money.
How much has KKR marked its current portfolio down by?
Our portfolio has about 48 different companies in it. A lot of it (markdowns) has to do with FASB 157. It’s an accounting rule under which you picked between marking (your portfolio) to comparable companies in the stock market, and a discounted cash flow model, based on current earnings, projected earnings and then discounting back. It basically gives a snapshot of what you can sell the investment for if you have to sell at that point. As of December 31, 2008, we marked 80% of our portfolio down 41%. You might say that’s terrible. The other side of that is that 69% of our portfolio showed either increased or same earnings in 2008 versus 2007. I believe there’s something wrong with how this system (FASB 157) works. It will be changed sometime.
Is there going to be more regulation of the private equity industry?
There’ll be more regulation around the world and each market is going to be different. The government is pretty clear that the private equity industry doesn’t pose a systemic risk, whereas the hedge fund industry is a systemic risk. In private equity, you have a series of different investments and if one company goes under, that doesn’t mean the whole industry goes under. It doesn’t mean that KKR will go under if one of our 48 companies goes under. Each company is financed separately and there are no cross-guarantees against your entire portfolio. Taxes are going to go up in the US, in all likelihood. Right now, carried interest (share of profits that the fund takes home, usually fixed at 20%) in the US is treated as a capital gain. They’re talking about changing that to ordinary income. But right now they’re not rushing to do anything, probably because there’s not too much of profits, so it really doesn’t matter.
What is your interest in India, when scope for control transactions and leveraged deals are small?
India is a very special place for us, and we’re very high on this market. I don’t know how many companies there will be to buy (100%) in India. That’s not important. We can do a lot of other things including growth capital. There may be some opportunities to buy (100%) some companies, but we’re not worried about that, and we’re certainly not going to rush in and do anything. Don’t write six months from now, KKR hasn’t done anything. There’s a time to make investments and a time to wait. We’re sort of at the point where we’re watching now. We may not do anything. It’s by design. I don’t think leverage is going to be important in India. This market will need very little debt. If you’ve got a business that’s growing very fast, you want to use as little debt as possible as you’re going to need the equity to keep feeding the beast.