Publicly traded private equity firms are a little amusing because of the whole raison d'être thing. If you love private ownership so much why don't you want it for yourself? Also, if your business is top- and bottom-ticking public markets, why should anyone buy your stock?
I guess those are sort of outdated worries but KKR yesterday added a little extra fun by agreeing to merge itself (that is, KKR & Co. L.P., the publicly traded private equity firm) with its publicly traded debt-investing arm, KKR Financial Holdings LLC (KFN for short), with KKR paying 0.51 common units per KFN share. A KKR thing is being merged into another KKR thing, with KKR on all sides, which naturally raises the question: Who is being hosed?
You could I suppose gesture at an answer to that. You could start by asking, how much money should one pay for basically a pool of debt investments? You might answer to the effect of "take the value of the pool's investments and, y'know, pay that." Looooooooosely speaking that's how KFN investors have thought, and so for the last three years KFN has traded for about a 0.8 to 1.1 multiple of price to book. KKR is paying something like 1.2x, which seems to be a little on the rich side:1
Is it too rich? I mean, I don't know,2 you can read KKR's arguments for the deal (in press release and slide deck form), they seem perfectly plausible. There's some amount of "Additional balance sheet scale to support KKR's growth initiatives" and "Accretive to size and quality of distribution," things that would be more or less equally true of (1) issuing stock in a public offering and (2) spending the money to buy debt investments at, y'know, their prices. But there's also some amount of "complementary and known portfolio of assets" and "Minimal integration risk," and fair enough, KKR should be willing to pay a premium to get bonds that it already knows it likes.3
One might also consider a structural answer to the who-is-being-hosed question. Here you could start with the fact that a law firm has already called dibs on suing KFN, worrying aloud that KFN's directors might have "breached their fiduciary duties by failing to maximize shareholder value in the proposed merger with KKR." But, while lawyers are already lining up to sue KFN for taking too little, no one seems to be lining up to sue KKR for paying too much. Even though KFN's stock is up, and KKR's is down, on the deal.
That's partly because of how mergers work generally: You can always sue the target for getting too little, but it's much harder to sue the acquirer for paying too much.4 (This presumably encourages overpaying and is thus an explanation for why mergers are often bad for acquirers.)
But it's also partly because of how KKR works: KKR is organized as a limited partnership, and its management has no fiduciary duties to its shareholders (technically, unitholders) for anything that the partnership agreement leaves to its "sole discretion." That includes issuing additional KKR equity units "for any Partnership purpose at any time" and "for such consideration and on such terms and conditions" as it wants, and to "do all things and on such terms as it determines, in its sole discretion, to be necessary or appropriate to conduct the business" of KKR.5
So, basically, KKR can do whatever it wants and no one can sue it. KFN, on the other hand, is practically a regular company. Anyone can sue its directors and lots of people probably will.6 And their lawsuits will have a certain surface appeal because, after all, KFN is being bought by its namesake and investment manager, so, sure, there's probably a conflict somewhere.
You might imagine this creating a weird negotiating dynamic. There KKR is, more or less negotiating with itself. (I mean, there are lots of independent directors involved on both sides, but still, there's plenty of self-ness; it's right there in the names.) If KKR pays too much, it is absolutely excused from any shareholder criticism for all time. If KKR pays too little, it will be sued endlessly and plausibly. Might as well pay a lot, no? Being more or less immune from lawsuit sounds like a nice superpower, but there are times when it can make your life harder and more expensive.
1 KKR says "the implied transaction value reflects a multiple of 1.15x KFN’s GAAP book value per common share of $10.42 as of September 30, 2013." Okay!? They also say that the implied transaction value is $12.79 per KFN share, and $12.79 divided by $10.42 is 1.23. There are references to volume weighted average price elsewhere so that's probably what it is. At a KKR unit price of $24.27 at around 2 p.m. today you get about a 1.19x multiple.
2 The fact that KFN's stock is up today and KKR's is down is ... unsurprising for a merger? I guess it says the market thinks KKR is overpaying, but the stock is only down around 3 percent so the market doesn't seem all that broken up about it.
3 KKR also seems fond of KFN's capital structure, which involves issuing a lot of on-balance-sheet securitizations and a lot of very long-dated debt, so, okay, sure. KKR is KFN's manager and so put that capital structure in place, so it's not surprising they like it.
4 The short version is that selling yourself is often subject to various flavors of legal review involving "entire fairness" or "Revlon tests," while buying a company is mostly subject to the "business judgment rule," which reads, approximately, "do whatever you want."
5 There's also a "conflicts committee" that can approve any conflict-of-interest transaction, though KKR is not obliged to submit any conflict to that committee. There seems to be no mention of it in this deal, presumably because the KKR/KFN dynamic doesn't rise to the level of conflicts-committee conflict. Only a KKR/KKR management conflict would.
6 Technically it's an LLC but "The operating agreement provides that, except as otherwise provided therein or otherwise required by the Delaware Limited Liability Company Act, the fiduciary duties of our directors will generally be consistent with those of a director of a Delaware corporation."