Ever wonder how the super-rich manage their investments and retire on that private island with afternoon mojitos? A big part of it is investing in the assets not available to regular people like you and me.
I'm talking about private equity. Yes, the same asset class that made Mitt Romney and Carl Icahn mega-superstars of finance.
The problem is, unless you have a net worth in excess of seven figures or a salary above $200,000, then you are not allowed to invest in private equity deals.
These investments in struggling or new companies can go bust or can produce triple-digit returns in a matter of years, but you and I are not allowed on the playground.
An analysis of 146 public pension funds over the past year showed that private equity investments have earned a 10% annualized return over the past decade, well above the 5.8% return the funds made on the general stock market. The pension for Texas' Teacher Retirement System scored a whopping 15.5% annual rate over the past 10 years.
In fact, even the worst quartile of private equity returns outperformed almost all (75%) of manager returns for stocks by 2.9%.
I am not saying private equity is the only way the smart money makes its fortune. This chart illustrates an important tenet of investing: asset diversification. Stocks have done poorly over the past 10 years, but the diversified investor has been able to keep making money through other assets like bonds and private equity.
But what happens when you are shut out of an entire asset class? It turns out you may actually be able to get in on some of these deals after all.
Kohlberg Kravis Roberts (NYSE: KKR) is one of the few private equity firms with shares available to regular investors. The company has more than $90 billion in assets under management and operates in three segments: private equity, public markets and capital markets (broker-dealer and balance sheet investments).
The company reported earnings recently, beating Street estimates on higher fees on private equity deals and strong growth in Asia and real estate. Shares pay a 7.2% dividend yield and have returned an annualized 37% since it started trading in 2010.
Economic net income (ENI), which is the sum of the company's income from fees, carried interest and investments, is the preferred metric to measure worth for private equity firms. This is generally what the companies report instead of the standard earnings per share like companies in other sectors.
KKR had economic net income of $2.38 over the past four quarters for a current price-to-ENI multiple of 9.8. ENI could improve next year on stronger merger and acquisition activity as private equity looks to unlock the huge amount of cash held by corporations. My conservative estimate is for an increase of 15% in ENI to $2.74 and a target price of $27.40 a share for a 17% gain on top of the 7% dividend yield.
Growth in alternative investments has added a lot of strength to private equity earnings over the past few years, and this should continue in the near term. Real estate has rebounded, but new construction is still significantly below its historical average, and household formation has yet to recover.
One of the biggest drivers for KKR is the stock market and a strong reception for IPOs. The life cycle for a private equity deal is around 5 years, meaning that the companies bought or financed at the lows of the recession are going to be ready to come to market -- which should mean big profits for the firm. Management noted in the third-quarter conference call that the company has $2.5 billion in deals in the pipeline, which should translate to good fee growth as well.
Risks to Consider: There is a reason only accredited investors are allowed to directly invest in private equity. Returns can be volatile, and the same goes for stocks of the private equity companies. Economic net income and sales vary more than traditional companies and may not necessarily trend upward.
Action to Take --> Direct investment in private equity deals might be off-limits, but you can still get a piece of this high-risk, high-reward asset class through the shares of firms like KKR. A position in the shares can help diversify a portfolio otherwise focused only on bonds and stocks.