Document Text Content
MM
January 30, 2018 05:01 AM GMT
Alternative Asset Managers
Can Alts Unlock Value with
C-Corp Conversions?
We think APO could unlock the most value by converting to a C-corp with 26%
in our upside case vs. -14% in our downside case. ARES could be the first to
convert, but this is largely priced in. These firms have more sticky management
fee-related earnings vs. BX/CG/KKR that may see less benefit.
Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of
interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.
For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.
MM
Contributors
MORGAN STANLEY & CO. LLC
Michael J. Cyprys, CFA, CPA
Equity Analyst
+1212 761-7619
Michael.Cyprys@morganstanley.com
MORGAN STANLEY & CO. LLC
Alex D Combs, CFA
Research Associate
+1212 296-5221
Alex.Combs@morganstanley.com
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Contents
5 Executive Summary
6 C-corp Conversion Could Be the Catalyst to
Unlock Value and Drive Multiple Expansion
8 Impact to Current Valuations in Upside and
Downside Case
10 ARES Conversion Largely Priced In
11 Why Should Fee-Related Earnings Re-Rate
Higher?
11 1) Premium to Traditionals Asset Managers
13 2) Publicly Traded Alts Comps
13 3) Bond Yield Approach
14 What Is the Impact of Higher FRE Multiples
in a SOTP approach?
16 What Is the Appropriate Multiple for
Performance Fees?
22 Apollo Global Management SOTP and Sensitivity
Analysis
23 Ares Management SOTP and Sensitivity Analysis
24 Blackstone SOTP and Sensitivity Analysis
25 The Carlyle Group Management SOTP and
Sensitivity Analysis
26 KKR & Co. SOTP and Sensitivity Analysis
27 Oaktree Capital Group SOTP and Sensitivity
Analysis
28 Appendix B: Valuation of Alternative Managers -
What's in the Price?
29 Appendix C: Notable Alt Reports: In Case You
Missed Them…
30 Brokers & Asset Managers Comps Sheet
31 Valuation and Risks
18 Deconstructing Our Implied Carry Valuation:
What Is the Market Paying?
19 Upside Scenario
20 Downside Scenario
21 Appendix A: Company Scenario Analysis
MORGAN STANLEY RESEARCH 3
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Alternative Asset Managers
Can Alts Unlock Value with
C-Corp Conversions?
We think APO could unlock the most value by converting to a C-corp
with 26% in our upside case vs. -14% in our downside case. ARES
could be the first to convert, but this is largely priced in. These
firms have more sticky management fee-related earnings
vs. BX/CG/KKR that may see less benefit.
We believe ARES could be the first Alt stock to convert; we
would view that as a positive catalyst for the group that, if successful,
could lead others to follow. ARES reports 4Q earnings on
February 15, and we expect a potential announcement or indications
of mgmt's intentions and/or timing. C-corp conversion has dominated
our conversations with investors of late with increased
inbound questions including interest from some new to the Alts. As
a result, in this report we expand on prior work here, and here, creating
a C-corp conversion scorecard with qualitative pros/cons for
each company. We also evaluate the potential valuation impact if
Alts convert, and we take a deep dive into how the market might
value two earnings components in a C-corp structure: 1) sticky, recurring
management fee-related earnings and 2) performance fees.
We see an opportunity for Alts to unlock value by shedding the
partnership structure and converting to C-corps. Changing from
a partnership structure could help alleviate the complexities of current
K-1 tax reporting and expand the universe of eligible investors in
the Alts. Some investors today are restricted from investing in limited
partnerships, while others don't want the operational and tax
complexities of investing in a partnership structure.
Management fee-related earnings could re-rate higher toward
22.5x in our upside case, as we look at three different approaches
for valuing this sticky earnings stream: 1) traditional asset manager
comps vs. organic growth, 2) publicly traded C-corp Alts comps,
and 3) an approach looking at FRE as bond yield proxy with a credit
spread, to determinate an appropriate cap rate.
Performance fees appear cheap (at 6.1x) if management fees
re-rate to 22.5x in the context of Alts converting to C-corps and a
24% overall tax rate. This suggests the market is misvaluing performance
fees, and we could also see Alts performance fee earnings
re-rate higher if C-corp conversion expanded the investor base.
We see companies that have a greater skew to management fees
as best positioned for conversion, as we see the greatest potential
for multiple expansion on for this portion of the earnings. For stocks
under coverage, we see APO as potentially being able to unlock
the most value, with near-term upside to current prices of 26%,
if the shares re-rate. We see ARES as another winner from conversion
but the we belive this is priced with shares up 23.5% YTD. Our
analysis suggests a less favorable upside/downside scenario for conversion
for companies under coverage with lower taxes and/or
greater exposure to performance fees (KKR, CG, BX).
Exhibit 1:
Upside/Downside Scenario Impact to Alts' Share Price if They Convert
to C-Corps from Current Partnership Structure
Estimated Change to Curent Share Price
Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of
interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.
For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.
30%
20%
10%
0%
-10%
-20%
-30%
-40%
26%
-14% -15%
Downside
11% 11% 9% 10%
-21% -20%
-27%
Upside
8%
-8%
13%
-18%
APO OAK KKR BX ARES CG Avg.
Source: Company Data, Morgan Stanley Research estimates
Brokers & Asset Managers
North America Industry View
In-Line
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Executive Summary
Will the Alts simplify their structure and convert to
C-corporations from partnerships? What would this
mean for valuations? We think the Tax Cuts and Jobs Act
could accelerate cost-benefit analyses and decisionmaking
by management teams as a 21% federal tax rate vs.
35% previously implies less tax leakage and less expense in
moving from single-layer taxation to a double taxation
structure. While investors would give up economics in the
process, the new business structure would, we think, command
a higher valuation multiple.
For context, investor questions on the topic have picked up
recently, including from a number of long-only accounts,which
have historically avoided the Alts. Some investors have said they
currently cannot invest in Alts given the partnership structure but
would be interested and able to do work on them if they were to convert
to C-corps. We had conversations around conversion a year ago
as President Trump took office amid promises of tax reform, and the
subject came up on nearly every 4Q16 earnings call. Management
teams seemed to table the idea because of too many moving parts
that needed to be clarified before they conduct a proper cost/benefit
analysis. Post tax reform, conversion is at the top of investors' minds
and becomes a key debate/catalyst for the sector.
We believe Ares Management L.P. (ARES, Equal-weight) could be
the first Alt to convert to a C-corp, potentially sparking other
conversions within our coverage. We believe this prospect has
likely driven much of the stock's 24% return year-to-date and +16%
outperformance vs. the S&P 500 and +10% its Alts peers. Over the
past few months, ARES management has stated clearly that they
have been actively considered conversion. CFO Mike McFerran
recently told investors, "This topic has become clearly very elevated
in light of possible tax reform. Absent that and even before this
became so topical, this is the thing we've been thinking about. And
the overarching question is, can public traded partnerships attract
the breadth of shareholder base to support an appropriate valuation
notwithstanding some other obstacles." Even without tax reform,
the company was considering the structure change, and with a 21%
corporate statutory rate (vs. 35%), we believe cost-benefit analysis
may make sense for ARES. The company reports earnings on
Thursday, February 15, and we expect an update or additional
color on conversion. We think all Alts shares could benefit as
investors see a higher probability of others following in their
footsteps and/or investors re-rate Alts' FRE higher.
Against this backdrop, we've created a conversion scorecard
with qualitative pros/cons for each company. To be clear, these are
our views on where conversion makes the most sense and not calls on
which companies will commit or the timing of potential conversions.
We focus selectively on the factors we view as most important in
deciding whether to convert.
l FRE % of Earnings — We believe the higher fee related earnings
as a % of total earnings, the more likely for a re-rating of
the shares and therefore more likely to consider C-corp conversion.
l Effective Tax Rate — The lower the current tax rate, the
more tax slippage if companies convert and are subject to a
higher corporate tax rate, and lower EPS. Conversely, companies
with a higher tax rate today already have more tax
leakage, and thus could make sense to pay a little more tax in
a corporate structure for a broader investor base.
l Current P/E Ratio — The lower the current P/E multiple, the
more management may be inclined to take action to drive a
re-rating.
l Management Commentary — Lastly we look at management
commentary from earnings calls/conferences to assess
the extent that companies are evaluating conversion and seriously
considering it as a strategic option.
Exhibit 2:
Based on our qualitative scorecard, our work suggests APO and ARES
may be most likely to convert
Company
Rating
Core FRE % of
Earnings
ENI Effective Tax
Rate
Current P/E ratio
(2018e)
Management
Commentary
Average Overall
Score
ARES (ARES) Equal-weight 100% 25% 25% 100% 63%
0 0.75 0.75 0 38%
Apollo (APO) Overweight 75% 50% 50% 50% 56%
0.25 0.5 0.5 0.5 44%
Oaktree (OAK) Overweight 50% 50% 25% 50% 44%
0.5 0.5 0.75 0.5 56%
KKR (KKR) Equal-weight 25% 0% 75% 75% 44%
0.75 1 0.25 0.25 56%
Carlyle (CG) Overweight 0% 75% 75%
0
38%
1 0.25 0.25 1 63%
Blackstone (BX) Overweight 50% 0% 50% 50% 38%
Source: Company Data, Morgan Stanley Research estimates
0.5 1 0.5 0.5 63%
MORGAN STANLEY RESEARCH 5
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For Ares, we believe conversion makes sense, given the company
is largely a play on fee related earnings from draw down funds,
separately managed accounts, and their relationship with ARCC, the
publicly traded business development company. Earnings from performance
fees at ARES are a smaller portion of overall profitability,
which is furthered by relatively higher compensation payout on performance
fee revenues, which in turn approach 80% in strategies
such as private equity vs. peers typically in the 45-55% range. The
company could benefit as a first mover and if the stock price reacts
favorably, we could see other alternative peers follow suit.
Apollo in our view may stand to benefit the most from conversion
with the best risk reward skew in our analysis using a SOTP
framework. Why? Similar to ARES, the company has meaningful
fee-related earnings as a percentage of overall operating income.
This is largely driven by their advisory relationship with Athene,
where APO earns a fee on ~$74b of assets and should benefit from
additional management fees from the company's most recent $24b
flagship private equity fund.
Our deep dive suggests Apollo has relatively longer-duration
stickier assets under management vs. peers, which gives us
greater confidence in APO's fee-related earnings stability,
growth, and potential for a re-rating. Apollo's AUM has a 12-year
duration on average (measured as outflows and realizations as a percentage
of beginning of period AUM). This is noticeably better than
HLNE's at 9.1 years, which trades at 23.4x P/E, and below Partners
Group of 16.7 years, which trades at 28x P/E.
We see Blackstone as potentially less likely to convert, but see
a more nuanced story at KKR given their token dividend policy;
for both we do not see as much valuation upside from a re-rating
of FRE multiples. BX and KKR have larger concentration to performance
fees and as a result we see less of an impact to potential upside
should fee related earnings multiples re-rate. Our estimated tax rates
for KKR and BX are also significantly lower than the group given the
earnings mix and other offsets. We see a greater downside to current
share prices if there was a conversion that had a higher tax drag and
multiples did not expand. That said, KKR has a history of making
major changes, such as its payout policy change in 2015 that
sharply reduced the dividend with a shift in strategy to grow book
value. At the time we thought such a change by KKR was a prelude
to converting to a C-corp, as we wrote here. However, the stock has
lagged and KKR's limited/token dividend means investors do not
receive the full benefit of a flow through partnership structure
with single-layer taxation. So we again raise the question, Why not
convert to a C-corp with a token dividend that is effectively single
layer taxation?
C-corp Conversion Could Be the Catalyst
to Unlock Value and Drive Multiple
Expansion
The alternative asset managers trade at a steep discount to
broader financial peers. We believe this is largely due to 4 factors:
1) volatility of the earnings (particulary performance fees) and questions
as to alpha persistency going forward by public market investors,
2) complicated business models, 3) corporate governance
concerns, and 4) corporate structure as a partnership. We do not
expect to see the first three factors change, but conversion could
make a meaningful difference by:
1) Expanding the universe of eligible investors in the Alts,
2) Alleviating the tax complexities of current K-1 tax reporting,
3) Unlocking value via multiple re-rating, particularly for management
fee-related earnings in the widely used sum-of-the-parts valuation
for Alts. We could also see incremental upside to current
valuations if multiples on performance fee earnings adjust upward
(more details below).
Exhibit 3:
Alts trade on average FY2 of 10.5x, a 28% discount on average to other
financials subsectors
Alts vs. Financial Subsectors P/E
30.0x
25.0x
20.0x
15.0x
10.0x
5.0x
0.0x
1%
24.1x
-4%
22.1x
-10%
-13%
-15%
18.5x 17.7x -28% -21%
16.0x -27% 15.4x 14.9x 14.7x
13.6x 12.7x
-33% 12.4x 12.0x -26.0%
11.2x 10.6x 10.8x
-42% -39%
-51%
-55%
2018 P/E Alts % Discount/Premium (RHS)
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
Source: Company Documents, Morgan Stanley Data
Note: P/E multiples for other financials subsectors aside from brokers and asset managers are based on
Morgan Stanley Estimates as of 1/18/2017
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On average the group currently
trades at 10.8x on 2018e EPS with
an average effective tax rate for
economic net income (the metric
used for EPS calculations) of
9.6%. The low tax rate is a result of
favorable treatment of passthrough
performance fees and tax
offsets. This is well below broader
financials peers and on average, a
26% discount to P/E multiples.
Exhibit 4:
Breakeven P/E multiple expansion of 2.1x required to offset 16% lower earnings in a C-corp on average.
Ticker Current 2018E 2018E
Price Tax Rate EPS P/E Tax Rate Pro-Forma EPS EPS % P/E ∆P/E
@ 24% Tax Rate
Change
APO $36.42 11.5% 3.68 9.9x 24% 3.15 -14.3% 11.5x 1.7x
ARES $24.70 8.7% 1.73 14.3x 24% 1.42 -17.7% 17.4x 3.1x
BX $36.78 5.3% 3.26 11.3x 24% 2.62 -19.8% 14.1x 2.8x
CG $25.60 17.8% 3.03 8.5x 24% 2.80 -7.7% 9.2x 0.7x
KKR $24.40 3.8% 2.74 8.9x 24% 2.16 -21.3% 11.3x 2.4x
OAK $45.20 10.5% 3.55 12.7x 24% 3.01 -15.1% 15.0x 2.3x
Average 9.6% 3.00 10.9x 2.53 -16% 13.1x 2.1x
Source: Thomson Reuters Company Data, Morgan Stanley Research estimates
If the Alts converted to C-corps,
there would be tax leakage as a result no pass-through of earnings for
carried interest and investment income. We estimate an effective tax
rate of 24% (21% federal + 3% state and local). The companies may
be able to keep some of the tax offsets in place; however, we conservatively
use a full 24% to evaluate the earnings impact. As a result of
higher taxes and -16% lower earnings on average in a C-corp, the
stocks would need to re-rate upward by 2.1x turns to maintain
their current valuations.
Exhibit 5:
On average we estimate a -16% hit to EPS using a 24% tax rate in a
C-corp structure. This would require 2018e multiples to expand 2.1x on
average in order for shares to hold the current price
P/E Multiples for Alts: Current vs 24% taxed EPS
20.0x
18.0x
16.0x
14.0x
12.0x
10.0x
8.0x
6.0x
4.0x
2.0x
0.0x
% EPS
Change
P/E Multiple Expansion required to Maintain Current Valuiton @ 24% Taxed EPS
Current Multiple on 2018e EPS
17.4x
3.1x
14.3x
14.1x
2.8x
11.3x
11.3x
2.4x
8.9x
15.0x
2.3x
12.7x
11.5x
1.7x
9.9x
9.2x
0.7x
8.5x
13.1x
2.1x
10.9x
ARES BX KKR OAK APO CG Avg
@24% Rate -17.7% -19.8% -21.3% -15.1% -14.3% -7.7% -16.0%
Source: Thomson Reuters Company Data, Morgan Stanley Research estimates
MORGAN STANLEY RESEARCH 7
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Impact to Current Valuations in Upside and Downside Case
In the sections following we explain in greater detail our
approach to potential Upside/Downside scenarios and the
impact to valuation under potential conversion. The actual
impact is very difficult to quantify given the variety of moving pieces
and the reliance on investors to drive the a re-rating. We have presented
it as a scenario analysis to evaluate conversion on a risk
reward spectrum. Upside/downside scenarios show a positive skew
for companies that have higher earnings contribution from management
fees vs. more downside skew for companies with more performance
fees (less certain re-rating of performance fees).
As the examples herein illustrate, we see significant value in the
re-rating of fee-related earnings that could unlock share value
and result in higher stock prices. We believe these stable and
growing fee earnings can support higher multiples and broader own-
ership of the Alts and be the catalyst for the re-rating (explained in
greater detail in the sections that follow). In both our upside and
downside approaches we look at a Sum-of-the-Parts that values at 1)
fee-related earnings, 2) balance sheet investments and net cash, 3)
the net accrued carry balance, and 4) future value of carry. In both the
current and upside case we use a fully taxed fee-related earnings at
a 24% tax rate and our value for the balance sheet remains
unchanged in both scenarios as well.
However, we make several adjustments to our upside and downside
case to reflect a C-corp structure with full tax rate on all earnings: 1)
Tax the net accrued carry receivable balance at a 24%. 2) Tax our estimate
for average net carry earnings at a full 24% rate. Further, in the
upside case we also adjust the multiple upwards for fee related earnings
driven by broader ownership of the stocks, and we conserva-
Exhibit 6:
Potential Upside Scenario SOTP Valuation for APO. We see potentially significant value from a re-rating of fee-related earnings driving higher valuation
Apollo Global Management (APO)
Fee Related
Earnings
+
Balance
Sheet
+
Accrued
Carry
+
Market
Implied Carry
Value
=
Valuation
Sum-of-the-Parts Components
(APO)
Current
Price
SOTP
Downside Case
C-Corp
Conversion
Change
Upside Case C-
Corp
Conversion
Change
2018e Pre-Tax Core FRE / Sh $1.66 $1.66 0% $1.66 0%
Tax Rate 24% 24% 0% 24% 0%
2018e After-Tax Core FRE / Sh $1.26 $1.26 0% $1.26 0%
FRE Multiple 15.0x 15.0x 0.0x 22.5x 7.5x
Core FRE Value $18.94 $18.94 0% $28.40 50%
Balance Sheet Net Cash and
Investments / Sh (as of 3Q17)
Net Accrued Carry / Sh (as of
3Q17)
Avg Net Carried interest / Sh
(2018e-2020e)
$2.72 $2.72 0% $2.72 0%