Is KKR a better buy than Blackstone?

(breakingviews.com) -- Henry Kravis has made billions of dollars for himself and for those privileged to invest in the buyout funds his firm, Kohlberg Kravis Roberts, has managed over the years. Now ordinary investors might have a chance to grab his lucrative coattails.

KKR merged this month with its Amsterdam-listed vehicle, KKR Private Equity Investors, or KPE. This company, now officially renamed KKR & Co (Guernsey), remains publicly traded, so the 30% of KKR it owns gives the entire buyout firm an implied public market valuation. KKR expects to list in its entirety in New York within months.

With that in mind, a comparison with KKR's closest rival, New York-listed Blackstone (BX), is instructive. The asset manager run by Steven Schwarzman makes money four ways: on flat fees from running private equity, real estate, and hedge funds; on the portion of the profits it takes from those funds; from its principal investments; and from an advisory business.

In the 12 months to June, Blackstone made, after costs, about $450 million in the first and last categories. The firm didn't do as well on collecting performance fees and investment gains because its holdings have been falling in value. But if history is any guide, its investments should rebound.

Blackstone's funds have about $25 billion invested in illiquid assets -- marked down from the $35 billion they cost. Its historical annual returns (excluding current unrealized valuations) for 1987 to 2009 have been above 30%.

So although it sounds generous given the past year's market conditions, it's not unreasonable to assume those assets might gain 20% annually from their current valuations for the next five years.

Blackstone would collect a fifth of the appreciation above cost. After accounting for the share of this that would go to employees, shareholders would see an average of about $650 million a year in pre-tax profits.

The firm also manages some $33 billion in liquid investments. If those make 12% a year -- roughly the average for hedge funds between 1990 and 2008, according to Hedge Fund Research -- Blackstone shareholders might see another $500 million in annual pre-tax income.

Blackstone also has $28 billion of additional, uninvested commitments from fund investors. If invested soon those could provide another $1 billion or so of annual profits for shareholders. Finally, gains on some $1.7 billion of its own investments could add another $300 million annually.

Chalk it up and potential pre-tax profits are around $3 billion a year. Blackstone's $17 billion enterprise value is about six times that figure.

Now turn to KKR. It made about $235 million in fund management fees in the year ended in June.

Applying similar calculations to its $19 billion private equity fund portfolio -- which originally cost $25 billion -- as well as its $15 billion in uninvested commitments and $13 billion in liquid holdings, KKR's shareholder might see pre-tax profits in these areas of some $1.3 billion.

The merger with KPE also left KKR with $3 billion of principal investments on its books. If those also rise in value by 20% each year for five years, KKR would add an average $900 million to its annual profits.

Combine all that, put it on the same multiple as Blackstone and strip out a few hundred million of net debt, and KKR's equity market capitalization should be around $14 billion. That's more than double the valuation implied by KPE's share price in Amsterdam.

Looked at simplistically another way, Blackstone's enterprise value is about 18% of its total assets under management. Based on the KPE share price, KKR's is only 12% right now.

Investors might be discounting KKR's valuation partly because it is a somewhat riskier proposition than Blackstone. It hasn't yet marked down its private equity fund investments quite as much and it is also, at least for now, less diversified. It would suffer more dramatically than Blackstone if it can't match historical private equity returns in the future.

But there could also be technical reasons for the valuation gap. A partial Amsterdam listing doesn't reach as big an investor universe as one in New York, and the disclosures required for an American float could make investors happier, too.

As KKR's United States market debut approaches, the valuation gap with Blackstone could narrow. That would give regular investors a rare chance to let Kravis make them some dough.