If you were offered the choice of $1 or $0.83, no strings attached, I suspect you'd make the rational choice and take $1. After all, $1 is more than $0.83, and having more money is better than having less money, right?
Well, some companies like KKR & Co. (NYSE:KKR) think that the answer isn't necessarily that obvious. The private equity giant is thinking about changing its corporate structure so it pays more in taxes, resulting in lower earnings, which might actually be good news for its stock. Maybe.
Sometimes finance makes no sense
Companies are valued based on their earnings, so a company that earns more should theoretically be worth more than a company that earns less, all else equal. That's the obvious, mathematical and logical conclusion. But the real world operates under different rules where sometimes things don't always make sense.
KKR and its private-equity peers including Blackstone (NYSE:BX) and Apollo Global Management (NYSE:APO) aren't normal corporations. They're partnerships, which gives them certain controversial tax benefits that result in exceptionally low tax rates. KKR's effective tax rate is normally in the neighborhood of 5% to 10%, much less than the 35% rate most corporations paid last year, and still less than the current 21% tax rate.
Paying almost nothing in taxes is cool, but being a publicly traded partnership (PTP) has its disadvantages, of which the biggest is that some investors simply won't own them. Individuals don't like them because they don't want to deal with K-1 tax stuff. Mutual funds won't own them because pass-through entities make their funds score poorly for tax efficiency.
Plus, most stock market indexes exclude partnerships for much of the same reason: The funds that track the indexes don't like the marketing problem of passing on a tax burden to people who invest in index funds. The people who make the indexes get paid by the people who run the funds that track them, so index makers largely serve the interests of the funds who pay them big licensing fees. No surprise there.
Making money by losing it
Stocks are priced based on earnings, but they're really priced based on supply and demand. If more people can buy your stock, then maybe your stock might trade at a higher price. At least that's what KKR, Blackstone, and Apollo -- as well as the analysts that follow them -- have been trying to figure out.
KKR explained the issue pretty succinctly in its most recent conference call. In order for it to justify the conversion from a partnership to a C corporation, and thus pay higher taxes, its price to earnings ratio would have to increase from roughly 9.3 times earnings to about 11.2 times earnings to basically break even for its investors.
In other words, if earnings drop 17%, the price-to-earnings multiple has to go up about 24% for the stock price to stay the same. Of course, it's entirely possible that KKR's valuation actually goes up even more after converting, in which case its existing shareholders are made wealthier by the fact the company will actually earn less money.
Look, I know this all sounds really silly, but I'm not going to rule out the possibility that private equity stocks might trade at higher prices if they were ordinary corporations. After all, if they could get into stock market indexes, all the index funds that track the indexes would have to buy shares of the private equity companies. Since index funds do more holding than buying or selling, they'd take a lot of stock off the market, and would be forced to slowly increase their holdings as more money piles into index funds with each passing day.
Index funds have become a powerhouse in the market, so it's not entirely unrealistic. Funds managed by Vanguard, State Street, and BlackRock are commonly ranked as the top three owners of public companies. (For perspective, funds managed by the "big three" own about 14% of Apple.)
Actively managed funds obviously own a lot of stock, too, though like index funds they also tend to shun publicly traded partnerships, but they might buy KKR or Blackstone stock if they were structured as your everyday corporate entity. No one can say for sure, though.
Barriers to the switch
For now, the one thing standing in the way of a corporate conversion is that no private equity company wants to be the first one to take the plunge, preferring to wait for someone else to be the lab rat test subject for a study on whether making less money is actually a good thing.
Who will go first? Some think Ares Management is a likely candidate to convert, since more of its income is derived from management fees, which don't get the preferential tax treatment that incentive fees do. Since this is the topic-of-the-hour in private equity, I'm sure we'll hear more about this issue on Ares Management's next conference call.
Truthfully, this whole ordeal wouldn't be as interesting if it involved any other industry. Private equity firms are often portrayed as ruthless number crunchers who will do anything to turn $1 into $2, so it is kind of funny that KKR is starting to wonder if its next act should be turning $1 into $0.83.