Investors should be wary as private equity firms switch structures

It is only a matter of time before one of the big investment groups runs into trouble

Sebastien Canderle

In April, Blackstone announced it was converting to a corporation, ditching a partnership status that has shielded much of its income from corporate taxation © Bloomberg

Since Blackstone’s 2007 initial public offering, US alternative fund managers have scrambled to join the stock market, with the idea of giving their founders a way out — a notoriously challenging process in private partnerships.

As at accountancy and law firms, partners at investment firms are only offered the option to sell when they leave the organisation. Fellow partners are the main escape route — they buy the shares, preventing retiring partners from participating in any future upside.

Until recently, most private equity groups have retained a partnership structure to avoid the 35 per cent tax rate on US corporations. But now that US president Donald Trump’s 2018 tax changes have cut the corporate rate to 21 per cent, the advantages of a partnership are less clear. That has made a C-corporation structure a lot more palatable.

Ares and KKR were the first fund managers to take the conversion plunge last year. In April, Blackstone followed suit and in early May, Apollo Global Management made the same call. Blackstone’s Stephen Schwarzman said: “The decision to convert . . . should drive greater value for all of our shareholders over time.”

The advantages of switching seem obvious for founding partners, who are way past retirement age and need to buoy liquidity to ease future share disposals. Should public investors believe the argument that the new structure will also lead them to riches?

If history is any guide we can predict that it is only a matter of time before one of the big investment groups runs into trouble. There is a precedent: the Wall Street banks that morphed into corporations with hapless results.

Like today’s private capital firms, Salomon Brothers, Bear Stearns, Drexel Burnham Lambert, Lehman Brothers and Merrill Lynch were set up as partnerships and were avid dealmakers. They incorporated and experienced brisk, unrestrained growth in the 1980s thanks to deregulation. But it didn’t take long for things to turn sour.

In 1986 Drexel faced scandal when a managing director was charged with insider trading. Two years later, bond trader Michael Milken was accused of self-dealing and bribery. The bank settled criminal and civil charges, but by 1990 it had gone bust.

Within a decade of its own conversion, Salomon stood accused of market rigging when, in 1990, trader Paul Mozer submitted false bids in an attempt to purchase more Treasury bonds than permitted. Weakened by the criminal proceedings, the firm was acquired by insurance group Travelers. As for Bear Stearns, Lehman and Merrill, the extent to which their behaviour during the subprime mortgage bubble contributed to the end of their independence is well known.

Historically, partnerships led to more prudent decisions because partners were jointly and severally liable. To make it less risky to establish businesses, the concept of limited liability partnerships was introduced, providing separation between outside investors and liable executives running the business. The PE groups use the LLP model.

Even so, managers in a partnership are rewarded in illiquid shares that yield wealth only if the business creates value over time. Senior officers must consider the firm’s reputation and survival as paramount. By contrast, executives in a public corporation receive annual bonuses and share options that are exercisable and tradable within a few years.

Since the financial crisis, bankers’ pay has been under tighter supervision. Many deal junkies have migrated to private capital, receiving instant gratification through management fees that mount up, irrespective of performance.

As PE founders who set up shop decades ago prepare to exit by converting to corporations, prospective investors should stay vigilant. A corporate status can amplify unprincipled behaviour.

The writer is a lecturer in private equity at Imperial College

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