KKR: C-corp conversion is like moving to ‘the big ocean nearby’

KKR cited the potential to attract a broader range of investors and concern for its lagging stock price as reasons for its conversion from partnership to C-corporation, dismissing the idea the move was motivated by lower corporate tax rates.

Co-president and co-chief operating officer Scott Nuttall outlined the firm’s rationale during its first-quarter earnings call. “Our intention with all the changes we’re announcing today is to make us easier to understand, buy and own, so that over time our stock reflects that,” he said.

Over the past five years, KKR’s stock has changed little, compared to the gain of more than 60 percent for the Standard & Poor’s 500 Index. Thursday’s news gave the stock price a boost, rising 3 percent to $22.14 at the close.

KKR highlighted during the call the advantages of becoming a C-corporation, including widening the firm’s investor base and a simplified method of tax reporting that eliminates the need for shareholders and partners to file Schedule K-1s. Investors instead will receive Form 1099s.

As a result of the conversion, which goes into effect on July 1, KKR will allocate capital to shareholders in the form of a 50-cent annual dividend per share in the third quarter, and it plans to increase the share buyback to $500 million. The company also expects to realize about $650 million in distributable earnings losses for the second quarter, largely due to “old energy and credit investments.” About 20 million units will be set aside by KKR executive officers for charity.

Nuttall said there were too many metrics for the company, and it would be better for KKR to focus on four: assets under management; management fees; total distributable earnings, which excludes equity-based compensation; and book value per share, which reflects the mark to market of its balance sheet and portfolio.

Nuttall said it would no longer need to highlight economic net income on its earnings calls, which means it would do away with unrealized gains or losses. Instead it will focus on total distributable earnings, which it says are its realized earnings.

Even though the new tax law lowered the corporate tax rate to 21 percent from 35 percent, chief financial officer William Janetschek said KKR’s effective tax rate on distributable earnings will go up from 7 percent today to about 22 percent over the next five years.

In terms of the financial impact of the conversion, its fee-related earnings are already taxed at the corporate rate, Janetschek said. Changes in structure would affect its carried interest and investment income and whether these income streams are taxed at the corporate or unitholder level, he added.

In its conference call with analysts today, Ares Management chief executive officer and co-founder Michael Arougheti said early results in its conversion to a corporate structure “have been quite positive.”

Fitch Ratings said while KKR’s move to C-corporation status wasn’t a surprise, it sees other firms as less likely to make the switch.

“Absent material equity valuation improvements for Ares and KKR, we expect further conversions of Fitch-rated alternative investment managers to be decreasingly likely, given that the remaining managers generally have more incentive income which would not benefit from the lower tax rate,” said Meghan Neenan, head of North American non-bank financial institutions at Fitch Ratings.

Apollo Global Management co-founder Josh Harris said during the firm’s first-quarter earnings call that it was reviewing the switch from partnership, citing the implications of tax costs and the tax efficiency of its current structure.

However, he echoed KKR’s view that conversion would help boost investor ownership. KKR outlined in its presentation that 31 percent of mutual funds owned KKR shares in 2017, down from 34 percent the year before.

“One of the items we are continuing to monitor very closely is the sustainability of any value creation, since converting to a C-corp is essentially a one-time decision, and permanent decision,” Harris said.

Nuttall said the conversion would be a whole new investor ecosystem for the firm.

“We’ve been fishing in a small pond, with a slow leak, and wondering why we weren’t catching anything,” he said. “So, it was pretty clear that [there was] the big ocean nearby, with a lot of fish that might like our bait. So, we started thinking about moving over to the ocean, and then we asked our larger shareholders, what do they think? What’s their advice? And that was virtually all consistent, that moving to the ocean was a good idea.

“That’s really the background,” Nuttall added. “It’s got nothing to do with tax planning or anything else. It’s really coming from a place of what I said before, that we really like what we’ve built, and we want to keep building for the very long term.”

-Additional reporting by Isobel Markham and Chris Janiec