Private equity chiefs face conversion dilemma
Groups agonise over whether to follow Ares to become a corporation and pay less tax
Javier Espinoza
The US government's recent tax overhaul has potentially major consequences on how private equity firms choose to structure themselves © FT montage / AP
Private equity bosses are facing an uncomfortable choice: do they seek to benefit from US president Donald Trump’s tax cuts with a corporate rejig that would potentially boost valuations? Or do they stay as partnerships, which have proven a reliably lucrative means of keeping taxes lower on earnings?
The dilemma comes at a time of a wider change at private equity groups, where ageing founders at Blackstone, KKR and Carlyle are looking to anoint the next generation of leaders.
Private equity bosses have long complained that their stocks are undervalued, in part because of the lack of inclusion in big indices that would be solved through the shift in structure.
Only one firm has so far made its choice. Los Angeles-based Ares Management said last week it would be the first major private equity group to switch from a partnership tax structure to become a corporation. This means it can benefit from the Trump administration’s tax cut for corporations from 35 per cent to 21 per cent.
Apollo and KKR said they would consider the switch, which would allow them to join major stock indices that block the sort of publicly traded partnerships typically used by buyout groups.
“There is potential for increased ownership because the additional red tape and costs under a partnership structure is prohibitive for some investors,” says Jerry O’Hara, a private equity analyst at Jefferies in San Francisco.
“Ultimately if Blackstone wants to be eligible for inclusion in an index like the S&P 500 it would mean a broader investor base and ultimately a higher multiple on its share price.”
But the partnership structure — which has been used for more than a decade as private equity groups sought to list their shares — has proven lucrative. As partnership structures, companies such as KKR and Blackstone benefit from lower tax rates than a standard corporation.
Crucially, it allows them to shield their performance fees, known in the industry as “carry”, from corporate taxes, passing them all the way to shareholders.
If private equity firms convert to a corporation from listed partnerships, their performance fees are suddenly subject to a 21 per cent tax charge.
Last year Blackstone, the largest alternative asset manager in the world with more than $400bn in assets under management, made $3.7bn in performance fees, representing more than half of total fees. Rival Carlyle took $2.2bn in such fees for 2017 — or about 65 per cent of overall fees.
Ares has become the industry’s first test case. Mike McFerran, Ares’s chief financial officer, says the conversion “will simplify our structure, broaden our potential investor base, improve our liquidity and trading volume and provide a more attractive currency for strategic acquisitions”.
But it relies less on performance fees than some larger groups, which means that its shift is regarded with some scepticism among rivals. A conversion makes more sense for alternative asset managers where a large portion of earnings comes from management fees, which face the statutory tax rate.
The stock jumped as much as 14 per cent after the announcement.
Executives at the largest listed private equity groups have said they are taking their time to understand the implications.
“[These large private equity groups] need additional data points. Having one of their peers make the jump first would help,” says Jefferies’ Mr O’Hara. “Everybody is waiting for somebody else to do it so they can sit back and watch.”
KKR said this month that its management was “seriously considering” the switch and would update the market in three months’ time.
But it warned that had it been organised as a corporation last year under the new 21 per cent tax rate, its net profits last year would have been 17 per cent lower. In order for its stock price to have stayed constant then, its price-to-earnings valuation multiple would have needed to expand from 10 times to 12 times.
Despite this, some analysts expect KKR will be next to convert. And that might lead to Blackstone making the move. Following Ares’s announcement, analysts at Credit Suisse said “if Ares and KKR’s valuations improve meaningfully under the C-corp structure . . . this would increase the probability of Blackstone converting too”.
Blackstone’s vice-chairman Tony James says there would be “tax leakage” if the firm chose to convert, however. And his company is still not certain on whether the share price will rise sufficiently to make the conversion worth it.
“This is a decision we can make once,” he says, “and we want to make it deliberately.”
The advantage of converting to a corporation comes down to being able to access equity indices that have deemed listed partnerships are off-limits because of the bookkeeping burden they create. Partnership tax forms sent to investors called K-1s are complex enough that institutional investors cannot easily process them.
The corporation change also opens share ownership to foreign investors, says Christopher Schenkenberg, a tax partner at Grant Thornton. “Under the partnership structure an investor sitting in London that owns units in a listed private equity group needs to file a US tax return. That is not the case in a corporation.”
Credit Suisse said in a note that the Russell, the FTSE and the MSCI indices could also add alternative asset managers, triggering “significant passive buying (and active buying from investors who are benchmarked to these indexes)”.
Leon Black, chief executive of Apollo, described the decision to switch as “classic game theory”, whereby the actions of each player affect the rest.
Private equity can also look at other alternative asset managers for guidance, as their share prices have benefited from being in a corporate structure. An analysis by Credit Suisse showed companies such as Partners Group in Europe, Brookfield in Canada and Hamilton Lane in the US appear to have thrived. Their stocks trade at about 25 times earnings per share compared with listed partnerships in the US, which trade at roughly 11 times on average, the bank estimated.
But others have decided against converting to corporations for now. Lazard, the global investment bank headquartered in New York but domiciled in Bermuda, said in its recent earnings call that switching status would lead to its tax rate jumping roughly 10 percentage points. Other aspects of the new tax law related to taxation of foreign earnings were also unfavourable to Lazard.
Even with clear benefits from the conversion there is little advantage in moving quickly, multiple industry executives have said.
As Glenn Youngkin, co-chief executive of Carlyle, puts it, converting “is a no-going-back kind of decision”.
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