KKR's distressed loan alchemy

One of the more interesting, and arguably useful, developments since the financial crisis has been the evolution of the much-maligned private equity sector.

While the sector is sometimes depicted as having vulture-like characteristics, since the crisis it has played a largely positive role in recapitalising companies that conventionally would have been forced into messy and value-destructive formal insolvency.

Alinta, Centro and most recently Nine Entertainment were all recapitalised by private equity and distressed debt funds buying their debts from traditional banks at discounts and then converting much of that debt into equity to recapitalise them and create more stable balance sheets. In those situations the private equity and distressed debt investors provided an elegant solution to problems that could otherwise have had very crude and unpleasant outcomes.

The most recent deal in this space, KKR's acquisition, in partnership with small Sydney-based fund manager Allegro Capital, of an Australian portfolio of distressed debt from Lloyds Banking Group's BOS International, is somewhat different to those transactions.

KKR and Allegro bought a portfolio of loans rather than buying debt in a particular company at a discount. The portfolio of more than 15 loans had a face value of about $350 million but was reportedly acquired at a discount of at least 50 per cent. Other bidders for the portfolio are thought to have included Goldman Sachs' distressed debt fund and Macquarie.

By itself the deal might be unremarkable. KKR and Allegro could be pursuing a simple yield arbitrage, betting that the combination of the big discount to face value and the proportion of loans in the portfolio that could be salvaged would compensate for those that weren't recoverable. By itself that could, if their assessment of the portfolio were sound, produce attractive returns.

KKR's interest in the portfolio was acquired by its ‘'special situations'' unit, while Allegro specialises in investing in mid-market private companies. Both the KKR unit and Allegro take a hands-on approach to the situations they invest in – they are turnaround specialists that take an active role in management.

That makes them more suitable and potentially company-saving owners of the debt than a foreign bank with its own issues. They can provide new capital, if necessary, and management expertise. KKR has a specialist business, KKR Capstone, which has a large pool of experienced executives and consultants it brings to bear on companies it invests in.

That produces the prospect of over-sized returns from creating value beyond simply buying debt at a discount and either holding out for its repayment or converting it to equity.

The deal reflects the evolution of private equity and of KKR as competition for private equity deals has intensified and the external environment has changed. While KKR started investing in credit in 2004 it didn't create the global special situations business until 2010, in the aftermath of the global financial crisis.

It now has about $US2 billion devoted to global ‘'special situations,'' about 90 per cent of it invested, and has announced that it is raising capital for a dedicated fund to invest in them. At its third quarter analysts' call recently KKR said the unit's portfolio of investments was generating internal rates of return of about 17 per cent or 18 per cent, non-annualised, for the first nine months of this financial year.

So far this year KKR has been involved in half a dozen of those special situations investments, most recently exiting a 2011 investment in the debt of arts and crafts catalogue retailer Oriental Trading Company.

It sold the business to Warren Buffett's Berkshire Hathaway last Friday for about $US500 million, reportedly doubling its investment. It had bought Oriental Trading debt while the company was in bankruptcy and gained control by converting the debt into equity.

KKR is a very large organisation and the special situations unit has a team of about 35 people and there are another 65 within KKR Capstone it could call on. It appears to have partnership with Allegro, however, both because of the number of companies within the portfolio that will have to be managed – Allegro adds manpower – and because of Allegro's particular expertise in turnarounds in this market.

There are still a number of foreign banks holding leveraged or structured loan portfolios they built in the balmy pre-crisis period and which are now a distraction and a burden on already-stretched balance sheets and work-out groups within those banks, particularly the Europeans.

Clean portfolios are relatively easy to exit but the more exotic ones, particularly those studded with non-performing loans, are harder to sell, which suggests there will be more transactions of this type in future.