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Morgan Stanley | RESEARCH
NORTH AMERICA INSIGHT

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 decision-making 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.

• 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.
• 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.
• 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.
• 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

[Table Data]
Company | Rating | Core FRE % of Earnings | ENI Effective Tax Rate | Current P/E ratio (2018e) | Management Commentary | Average Overall Score
ARES (ARES) | Equal-weight | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon]
Apollo (APO) | Overweight | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon]
Oaktree (OAK) | Overweight | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon]
KKR (KKR) | Equal-weight | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon]
Carlyle (CG) | Overweight | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon]
Blackstone (BX) | Overweight | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon] | [Pie Chart Icon]

Source: Company Data, Morgan Stanley Research estimates

MORGAN STANLEY RESEARCH
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