John Rogers, chairman and chief executive officer of Ariel Investments LLC. Photographer:... [+] Christopher Goodney/Bloomberg
Coming in July, the private equity world is in for a big change that could reshape the contours of the industry a decade after most blue chip firms began to join public stock markets.
On Sunday, private equity pioneer KKR & Co. is set to convert from a publicly traded partnership into an ordinary corporation. As a corporation, KKR will be able to take in a whole new spectrum of shareholders and manage its purse strings more like an ordinary company, instead of a pass-through vehicle like a master limited partnership, which distributes the bulk of its profits to partners and shareholders.
Some respected stock pickers who are relatively new to the PE sector believe KKR's corporate shape shift augurs well for its long-term prospects. Take value investor John Rogers of Ariel Investments, who in recent quarters has anointed KKR as the top holding of hisstrong performing $2.3 billion Ariel Fund. In a recent visit to Ariel's Chicago headquarters overlooking Millennium Park and Lake Michigan, Rogers lauded KKR and its co-founders Henry Kravis and George Roberts for being the first bigprivate equity shop to take the plunge and switch to a corporation.
"Here at the firm, we were pleasantly surprised by the decision and the courage to do it," says Rogers of the conversion. He holds over 4% of his flagship Ariel Fund in KKR shares, its top holding according to Morningstar data. "We think that it's a good decision and we're very supportive of it," he adds. "They had the feeling that if the market does not continue to value them appropriately, this would help to get them get a appropriate valuation."
As Forbes has argued, PE firms' partnership status has so far attracted yield-oriented investors, who’ve given minor benefit to the industry's asset growth and advantaged economics and abandoned stocks when performance fees aren’t being paid out. Furthermore, as partnerships, PE firms are excluded from most stock market indices.
Rogers is mostly bullish on KKR due to its best-of-breed brand and the tailwinds the PE industry has enjoyedin recent years. Pension funds and endowments continue to increase their allocations to alternative investments. When they do so, they're increasingly choosing to put their money into PE funds. "I've been saying this for 10 years, so I was early in this discussion, but I think you're going to find that a lot of that hedge fund money will be flowing into private equity," says Rogers. When it comes to the business model he adds, "We don't see any real threat to the 2 and 20 concept."
Another recent Ariel buy is Oaktree Management, one of the pre-eminent distressed investors in the world. In recent quarterly letters, Rogers and his team have talked up the counter-cyclical nature of Oaktree. After all, it is a firm that typically does well when financial markets get overheated and inevitable restructurings abound. However, Rogers admitted he was surprised by Oaktree's recent public comments resisting a conversion to a corporation, especially after competitor Ares announced such a moveearlier this year.
If the smart, long-term money like Ariel is beginning to pay closer attention to PE stocks it doesn't mean investors have missed the boat. Many large PE firms like Blackstone, Apollo and Carlyle have said they want to see how the market responds to conversions before they makeany moves. You can only switch once, they note. And truth is, it's still unclear whether first movers like Ares and KKR will get an expected benefit, or not.
KKR won't be effecting its switch until July, so the new potential investors who resisted filing K-1 partnership tax forms haven't yet shown up at its door, or in the stock.
Ares, is slightly further ahead, having recently done a secondary offering in its new corporate status. According to research analysts at Jefferies, "early indications have been positive with 60% of the recent secondary offering comprised of new-to-alternative investors and almost 20 new entrants at the most recent filing. Additionally, even ex the recent spikes, average daily volume is up a multiple (2x-to-3x) of pre-conversion levels... Ultimately, we view the reduced "friction" of the c-corp structure as a positive that should lead to broader ownership and potential index inclusion down the road."
Ares will be moving to a fixed 28-cent quarterly dividend, roughly a 5.5% dividend yield. Ares'15% compound annual fee related earnings growth over the past two decades gives plenty of room for it to tide investors over with a fixed dividend, Jefferies expects. Performance fees may now be used to grow the business - for instance seed capital and M&A - or in capital allocation decisions like repurchases and special dividends. Since its IPO in 2014, Ares has generated $450 million in performance fees; Jefferies forecasts a 7% dividend increase in 2019.
KKR's conversion may be more profound.
It generates far more incentive income than Ares, thus the decision to be taxed as a corporation carries more risk. But for years, the firm has been on a trajectory that made it the most likely LBO shop to shed its partnership status. In 2015, KKR set a fixed dividend in order to reinvest its retained earnings into its own funds and deals like
"We believe conversion has the potential to significantly expand the investor base and lead to a higher valuation over time," said Keefe Bruyette & Woods analyst Robert Lee when increasing his price target for KKR to $30 a share. "[T]he decision to convert was driven by management's belief that they have a compelling business model that has been demonstrating strong growth, but after exhaustive study and eight years of trying to expand their shareholder base, concluded that structured as an MLP and in light of the tax, operational, and other complexities that limited ownership, it would be exceedingly difficult, if not impossible, for the value of the stock to ever reflect KKR's strong secular outlook," Lee added, in a client note when the conversion was announced.
As well, the tax trade-offs may not be that big after all. "The tax hit from conversion is also less, at least in the early years, than we had anticipated," he says. "Due to some tax benefits related to step-up in basis upon conversion, the tax rate for the new C-corp will go from 7% in the short term to 22% over the course of 5 years. This results in effectively 0% tax dilution in the 1st year." KKR will pay a 50-cent annual dividend, less than the current 17-cent quarterly distribution. On an after-tax basis, Lee believes shareholders may find the payout to be more bountiful since they won't be paying takes on pass-through PTP income.
"The lower dividend and initial payout ratio also reflects management's desire to build a track record of strong dividend growth from a conservative starting point, while also giving KKR more capital to reinvest back into the business to continue to compound book value over time," says Lee.
Bottom Line: If other PE firms say they are watching the market's response to KKR's conversion, it appears a verdict is beginning to trickle in. Since announcing its conversion on May 3, KKR shares are up over 15%, outperforming peers and the broader financial sector by a wide mark.
For more on Forbes coverage of private equity stocks and the potential of a conversion, see our analysis:
April 2018: It's Time To Pay More Attention To Private Equity Stocks
June 2017: Inside Tiger Global's Decision To Become Apollo's Biggest Fan
Dec. 2016: Why Trump's Tax Reform Pitch Will Alter Wall Street And PE Stocks
Feb. 2016: Trading At Book: Why PE Stocks Like KKR Are A Better Bet Than Goldman
