The private equity business has always been largely inaccessible to all but the most elite investors. Firms such as The Blackstone Group (NYSE: BX) and Kohlberg Kravis Roberts & Co. (NYSE: KKR) raise billions of dollars primarily from institutional investors and use the capital to invest in situations that would not typically be available to the average investor.
Many private equity firms have built large funds around real estate holdings. Others use their deep pockets and clout to take entire businesses private, often fixing problems within the companies before once again issuing shares to the general public through an IPO.
When this type of transaction is successful — taking over a company at an attractive price and selling it at a premium — the institutional investors who own portions of the funds managed by these private equity investors do very well.
While these funds offer investors opportunities to invest in ways that would not typically be attainable, there is a significant drawback to these vehicles. Specifically, liquidity is usually constrained so that the affluent investors are not allowed to exit their positions until an agreed upon period has been reached.
Recently, KKR announced it is working with Nasdaq OMX Group (NASDAQ: NDAQ) to set up a market where investors in private funds managed by KKR can sell their holdings to retail buyers. While this arrangement is particularly attractive for the institutional investors who hold positions in the funds, a market for these funds also works to KKR’s advantage.
Initially, the private equity firm could potentially collect fees for the transactions that take place on this new market. But more importantly, the added liquidity for investors that put capital into KKR’s private equity funds should make the investment programs much more attractive. This could help KKR raise more capital for its funds and lead to higher fees and incentive allocations.
Today, we’re going to participate in this elite market in our own way, by setting up an income trade selling puts on KKR. Shares are currently trading just below $23, and the KKR July 23 Puts are trading near $0.95 per share. I would use a limit order at $0.85 to ensure you get an attractive price.
By selling these puts, we are obligating ourselves to purchase 100 shares of KKR per contract at the $23 strike price if they are still trading below $23 when the puts expire on July 18. I expect the stock will be above this level and our puts will expire worthless, but if shares are assigned, our net cost will be $22.15 ($23 strike price minus $0.85 option premium). This would be an attractive spot to initiate a position in KKR, as I think it is likely to rally into the end of the year.
If KKR is above $23 at expiration, we will be able to keep our $85 per contract free and clear. This income represents a 3.8% return over the $2,215 in capital we would need to set aside to cover our potential obligation. Since we would earn this over 50 days, our per-year rate of return works out to be 28%. Knowing the per-year rate of return is important in order to accurately compare this trade to other opportunities for your portfolio.
There is the risk that shares of KKR will continue to drop, but given the steady recovery in the economy and the strength of the company’s investment team, I expect it to continue to raise capital, collect attractive fees and grow profits. These factors should boost investor confidence and send the stock higher over time.
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