Ares Management L.P., one of the largest global alternative asset managers with $106.4 billion in AUM, has decided to convert from its current structure as a limited partnership to a standard C corporation, as a result of the recent decrease in the US corporate tax rate. In doing so, Ares becomes the first publicly listed alternative asset manager in the US to take such a step, amidst growing speculation that some alternative asset managers would be making the conversion. Since Ares announced the news on February 15th, its stock has surged as much as 14%, as well as an increase of as much as 35% since the tax reform was announced on December 20th.
Under the limited partnership structure common among alternative asset managers, ordinary investors were mostly prevented from participating, due to the extremely complex Schedule K-1 tax reports. Institutional investors were also often restricted from investing, since partnerships are excluded from both index funds and exchange-traded funds. Ares’ conversion to a C-corp significantly expands this investor base and the overall valuations of the firm, as well as increasing its stock’s trading volume and liquidity. Additionally, Ares gains the ability to use its stock as a valuable currency, granting it a financing advantage in strategic M&A with other alternative asset managers.
Although Ares is one of the largest private equity investors, it is unique because it is also a world-class credit investor, managing multiple credit funds that do not generate the performance fees of private equity funds. Since the firm’s IPO in 2014, management fees have earned 4x more revenue than performance fees, generating over 80% of the firm’s revenue during that time. This substantial contribution from management fees makes a conversion much more beneficial for Ares than it would be for its peers, due to the favorable tax treatment of carried interest. Under the partnership structure, private equity firms only pay significant corporate taxes on their management fees; performance fees are largely shielded from corporate tax. However, under a corporate structure, private equity firms would have to pay corporate taxes on all of their revenues. For firms such as Carlyle and Blackstone, which are heavily reliant on performance fees, paying the corporate tax rate on their carried interest would negatively impact their earnings, much more so than it would for Ares and other firms more dependent on management fee related earnings.
With the official conversion taking place on March 1st, 2018, Ares has announced that it intends to begin paying a steady quarterly dividend, based on its after-tax fee related earnings, while retaining earnings from performance fees to invest in future growth. This policy of a regular dividend payment is also much more viable for Ares, due to its relatively stable earnings stream when compared to its peers. Traditionally, private equity firms have paid very large, yet volatile dividend yields. The volatility in yields stems from the nature of the business, where earnings may fluctuate based on the execution of profitable exits and the raising of new funds. This unpredictability in earnings has also deterred some investors from investing, leading to lower share prices and valuations for alternative asset managers. Ares has also declared that it will also consider paying special dividends in periods for which it has generated significantly higher performance fees.
It remains to be seen whether other alternative asset managers will take Ares’ lead and convert their structures to a corporation. One viable candidate is Apollo Global Management, with approximately 49% of revenues coming from management and advisory fees, compared to Ares’ approximately 57% of revenues in 2017. Apollo also possesses very strong credit funds that allow it to derive a substantial amount of its earnings from management fees. However, partnerships-turned-corporations face earnings erosion from the additional taxes, as well as the political risk that these tax changes will be repealed or amended in the future. Hopefully for Ares, the risks will be worth the reward.