KKR on Credit Investing in an Uncertain World

What prompted KKR to launch a credit business? What is the focus?

KKR entered the credit business in 2004, and that was the culmination of a couple of years of research. We found that there were a number of deal opportunities that we had that were sourced through our private equity relationships that had a great risk/reward but ultimately didn’t fit for a control-oriented buyout fund.

KKR Asset Management now has about $16.5 billion in assets under management. We are investing in two broad strategies. One is in traded instruments such as traded bank loans, traded high-yield bonds, and traded distressed. We’re also investing in privately originated transactions, direct loans, and senior secured loans. We’re also investing in mezzanine securities that we originate and a number of distressed or special-situation opportunities.

Looking forward, we’re planning to connect the different synapses of the firm’s brain. We will look for opportunities where the firm can add value to the business that we’re doing within credit, and vice versa.

What impact does today’s low-interest-rate environment have on the risk/reward considerations for investors trying to build a credit portfolio?

I would break them into two categories. When looking at low interest rates, you need to understand what interest rate movements may do to the particular credit or the borrower profile. Second, when looking at portfolio construction, you also must understand what interest rate movements may do to the value or the market value of underlying instruments that we may have in a portfolio.

Whenever we look to underwrite a particular credit, we look at the company, the industry that they’re in, interest rate movement, and foreign currency movement. We also investigate the macro environment, pending regulation, and what other factors may be specific to that business within the industry, whether it’s market share shifts or other things.

When you look at the market value of the different instruments in building a portfolio, and sitting here today in an environment where the 10-year is under two percent and the three-year Treasury is under 50 basis points, we’re very focused on the risk of rising rates. We have been trying to build up a significant exposure to that floating rate so we get the benefit of any interest rate reversal. The second is fixed-rate instruments where, in a rising rate environment, we think the correlation to rates is less than basis point for basis point.

What’s your view of the European credit situation?

You have to start with two facts. The first one is that the liquidity issue has been solved, so liquidity is flowing through the European Central Bank, and enough liquidity has come down to the banks so that liquidity is not an issue for them. The second point is capital. When you look at the European banks, they continue to be undercapitalized versus their U.S. peers. I say that as a backdrop, because it really gets down to the motivations for those banks going forward.

When we look at transactions that banks are willing to do, they focus on transactions that are going to be capital accretive, regardless of liquidity, rather than transactions that are going to be capital depletive. Where we see opportunities as a result is with banks that are very willing to sell assets where the assets have been written down, or the assets that have a book value below market value. A couple of deals that we’ve done as a firm reflect that. We bought a stake in a U.S. subsidiary of Banco Santander, which allowed them to realize some of the value in that subsidiary and effectively create capital at the bank level. More recently we bought a portfolio of distressed loans from a European bank. It was out of the bank’s footprint. The point is, European banks are looking more globally, lending more globally, and in this particular situation, those loans had been written down significantly. We were able to provide a little bit more capital and a little bit more value than they had those assets on their books for, and free them up to use that capital in different ways.

How have impending changes to tax code impacted dealmaking?

We’ve got some definition around the tax code, but there clearly is more work that needs to be done. That said, we think it’s great for the investing side of this business when you see volatility in the markets; it creates opportunity. If the world had perfect information and asset flows were consistent, everything would move in a very rational line. What creates the investment opportunity is when the market’s down 100 points. What creates the great selling opportunity is when the market’s then up 100 points. So we like that kind of fluctuation. We see that continuing for a reasonably significant period of time.