The world’s biggest private equity fund has announced plans to become a C corporation as part of a bold new strategy to bolster its stock market valuation. But the first funds to make this move were Ares Management and KKR. The two companies restructured in 2018 to eliminate the deterrent of filing tax returns for investors.
“We believe the decision to convert will make it significantly easier for both domestic and international investors to own our stock and should drive greater value for all of our shareholders over time,” said Stephen Schwarzman, founder of Blackstone.
The profits of certain partnership models are taxed at the point of distribution, rather than as corporate income. As a result, the partnership model has traditionally offered a way of keeping taxes lower on such earnings. Investors would put up the cash to help fund operations in exchange for quarterly returns.
Such arrangements generally allow entities to pay higher sums at a lower tax rate, but these rewards mean investors must file a 30-page form for the IRS every year. So, many institutional investors avoid partnerships for the sake of convenience.
Although the conversion will be effective as of July 1, Blackstone has already seen its share price climb 8.4 percent to $38.95 in pre-market New York trading. If this is anything to go by, the group may have placed its bets well.
Why Blackstone has gone for a higher tax rate
The Tax Cuts and Jobs Act (TCJA) may have made doing business in the US cheaper as a corporation than ever before, but it was still much more tax-efficient to operate as a partnership. Blackstone may have made its decisions having watched the market for a year.
KKR converted from a master limited partnership (MLP) to a corporation on July 1 2018. The company has estimated that it will pay 7% on its income as a result, and the rate will gradually rise to 22% over the next five years. This is after paying 2.8% in US tax in the first quarter of 2018.
KKR CEOs Henry Kravis and George Roberts claimed that the conversion was “designed to broaden our investor base, simplify our structure and make it easier to invest in our shares”.
Wall Street tax advisor Robert Willens told International Tax Review at the time: “A lot of institutional investors were loath to invest in MLPs because it would create more tax headaches.”
“The short-term costs of a massive restructuring of your operations would not be justifiable if the tax structure is not there in the long term and the company won’t benefit,” he warned.
While the corporate tax rate cut from 35% to 21% helped KKR make its decision, the risks might outweigh the rewards for some companies. However, investors responded well to the decision in the case of KKR.
The company’s shares jumped 8.5% after its conversion went ahead. Apollo, Blackstone and Carlyle watched the move closely. It was clear investors were happy to invest in such a fund once the onerous tax filings associated with the partnership model were out of the way.
Blackstone said it was considering its future status in its 10-K filing last month. The company acknowledged that it might have to adopt a new structure if US law changes and the tax advantage of partnerships becomes void.
“Past legislative proposals would treat certain publically traded partnerships as corporations for federal income tax purposes,” Blackstone said on March 1. “If similar legislation were enacted and applied to us, we would not qualify as a partnership for US federal income tax purposes.”
“If we were taxed as a corporation our effective tax rate could increase significantly,” the company added.
Even with more than $500 billion in assets under its management, Blackstone had an effective tax rate of 7.1% in 2018, up from 5.6% in 2016. The group saw its effective rate spike in 2017 after US tax reform first came into force. The partially offset damage was 18%.
“The exact impact of the [TCJA] is difficult to quantify, but these changes could have an adverse effect on our business, results of operations and financial condition,” Blackstone said.
The company has plenty of reason to worry about the future of the US tax system. Congress still could still introduce measures to raise the corporate rate, limit interest deductions and raise taxes on carried interest. Nevertheless, this restructure suggests Blackstone is willing to put aside such concerns, at least for the short-term.