This Fund will suit some, but it’s complicated

Co-founder of the Switzer Report
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There is an old but trusted adage in investing – don’t invest in something that you don’t understand. And for many investors who contemplate investing in the new $750m KKR Credit Income Fund, this could well prove to be the case because this is a complex investment.

The investment objective, however, is relatively straightforward. This ASX listed investment trust aims to provide investors with attractive, risk adjusted returns and access to a diversified portfolio of income generating alternative credit investments with a focus on capital preservation through geographic and asset class diversification. The trust targets a net return of 6% to 8% pa. with a target cash yield of 4% to 6% pa through the market cycle.

But the complexity comes from the Trust investing in two quite different KKR (Kravis Kohlberg Roberts) managed funds, different times as to when the funds are deployed, the second fund being quite illiquid, and the delay investors will face in being appraised of the fund’s true NTA (net tangible asset value). Further, it is riddled with conflicts of interest.

On the flipside, investors are essentially backing the credit expertise of the KKR team and arguably, conflicts are unavoidable. Further, KKR argues that a strength of the proposition is its alignment with the interests of unitholders as KKR and its employees use their own capital to invest in the managed funds.

Here is our road test of the KKR Credit Income Fund.

The fund

The KKR Credit Income Trust will be listed on the ASX and trade under ticker code KKC. It is seeking to raise a minimum of $200m and up to $750m (although it can take another $75m in over-subscriptions) through the issue of units priced at $2.50.

The Fund will initially invest the proceeds in KKR’s Global Credit Opportunities Fund, before deploying up to 50% into KKR’s European Direct Lending Fund. By the end of 2020, it is expected that the split between the two funds will be roughly 50/50.

The Global Credit Opportunities Fund, KKR’s flagship fund, seeks to invest opportunistically in relatively liquid credit investments based on KKR’s assessment of risk-adjusted returns. It invests globally, focussing on traded loans and bonds in a senior position. Currently, the fund size is $2.1bn (in an overall market size estimated to be $3 trillion). Over its 11 years since inception, it has returned an average of 10.8% pa.

The European Direct Lending Fund invests in non-traded loans. Primarily, these are sought by middle market companies with earnings of around €50m to €100m. KKR argues that the major European banks have abandoned this space, and the loan size is too big for the regional players. The market size is estimated at $118bn and KKR is targeting 30 to 40 loans when the fund is fully operating in 2020. A target size for the fund is around $1.5bn. Because the lending is direct, the loans won’t be liquid and nor is the fund.

When the KKR Credit Income Trust is fully established, it is expected to be invested 50% in traded credits (through the Global Credit Opportunities Fund) and 50% in private credits (through the European Direct Lending Fund). Traded credits are loans, bonds or other debt securities issued by larger companies that are syndicated to a group of lenders, and which can be traded in a secondary market. Private credits are bilateral loans between a lender and a borrower, with no or limited syndication. They are not typically traded.

Senior debt will make up 86% of the portfolio (subordinated 14%), with a geographic split of 56% to European domiciled companies and 44% to North American. The following diagram shows an illustrative portfolio.

Distributions (unfranked) will be paid quarterly, with the first distribution targeted for April 2020 and covering the March quarter. The target distribution return is 4% to 6% pa.

The manager

KKR (Kohlberg Kravis Roberts & Co. L.P.) is a leading global investment firm. A  pioneer in private equity, KKR established KKR Credit in 2004 to invest in attractive risk adjusted opportunities across the credit spectrum. In 2008, KKR Credit started accepting institutional investment mandates. Today, KKR Credit has nearly US$70 billion of assets under management of which approximately US$38 billion fall within its traded credit strategies and US$32 billion within alternative and private credit strategies.

The Manager is an Australian domiciled subsidiary of KKR. It has appointed a subsidiary of KKR Credit as its investment adviser. The Responsible Entity is a wholly owned subsidiary of Perpetual Limited.

The fees

The base management fee is 0.902% pa, including GST. Recoverable expenses, indirect costs and a fee to the Responsible Entity add approximately another 0.31% pa, taking the “base” costs to approximately 1.21% pa.

The Manager is also entitled to a performance fee of 5.125% of the total return when the Trusts exceeds a hurdle return of the RBA cash rate (currently 1%) plus 4%. If the Trust’s total return is 7%, the Manager would receive a performance fee of 0.368% (including GST).

In this scenario, total fees are estimated to be 1.58% pa.

The offer

There are 3 offers: a cornerstone offer for investors intending to subscribe at least $2m, a  broker firm offer and a general offer. The general and broker firm offers are due to open on 14 October. Broker firm closes on 31 October, and the general offer on 6 November.

Trading of the units is expected to commence on the ASX on 18 November (under stock code KKC).

Units are being issued at a price of $2.50. The minimum application is 2,000 units (or $5,000) and then in multiples of 500 units. Potentially, $825m could be raised.

KKR is meeting the costs of the offer (estimated to be up to 3% of the amount being raised). This means that upon subscription, the NTA (net tangible asset value) of each unit should also be $2.50.

Brokers and banks involved in the deal include Evans Dixon, Morgan Stanley, Morgans, NAB, Crestone, Ord Minnett, Wilsons, Bell Potter, Patersons and Shaw and Partners. A stamping fee of 1.25% is being paid.

Our view

This is largely about investing in KKR. Although the fees are high, you pay for what you get and it is hard to argue with their track record. The return targets look to be achievable.

That said, it has a complex structure with the Trust investing in two underlying (but very different) KKR funds, phased deployment over potentially 12 to 18 months into the second fund, and the latter’s illiquidity.

Higher risk, with a medium to long-term time horizon required.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.

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