It’s been two months since Ares Management’s conversion to a C-corporation for tax purposes became effective, and two of the firm’s top executives say they have already seen some of the benefits of the switch.
The Los Angeles-based firm was previously taxed as a publicly traded partnership, which meant the firm had limitations on how much in earnings it could retain, as well as a slimmed-down shareholder base.
“The execution of the decision was simple,” chief financial officer and chief operating officer Michael McFerran said. “You literally just fill out a form with the IRS, I signed one piece of paper, and that was it.”
A broader shareholder base has already materialised
Being taxed as a publicly traded partnership limited three key shareholder constituencies, McFerran said: foreign shareholders, retail investors, and certain domestic investors due to the tax preparation complexities of receiving K-1s.
“As a public partnership, if you think about the universe of potential shareholders, a lot were restricted from investing,” he said. “Foreign owners couldn’t own pass-through partnerships because it generated bad taxable income for them. So, international shareholders were essentially non-existent.”
Both retail investors and some domestic investors didn’t invest in Ares stock because of the headache associated with preparing taxes on any income received from investments.
“It was complicated to deal with the K-1 reporting, and many people struggled with determining their after-tax income,” McFerran said. “Now, it is unbelievably transparent. Absent capital gains or losses from trading in the stock, shareholders’ taxes will be based solely on the qualifying dividends they receive.”
The firm announced a follow-on equity offering just days after it officially changed its tax status to a C-corporation. Ares initially offered 15 million shares at $22 per share; the firm has since seen larger trading volumes, chief executive Michael Arougheti said.
“That’s a function of greater liquidity in the stock because we issued equity,” he said, “but it is also an indicator there are more people that are actively able to and willing to own the stock because of the corporate tax status.”
A new approach to capital management
As a result of changing its tax status, Ares now will have an easier time retaining earnings. The firm plans to set aside its realised performance fees, which will be used to fund the growth of its business, including expanding its current strategies, launching new strategies and making acquisitions.
“It gives us incremental capital,” McFerran said. “In our old world, we were able to fund growth through a mix of our income we retained – albeit you didn’t retain much because as a pass-through partnership, you pretty much pay out everything – and through the equity and debt capital markets.”
Ares had cash and cash equivalents of $118.93 million as of 31 December, according to its 2017 annual report filed with the Securities and Exchange Commission. It also had a $210 million outstanding on a revolving credit facility and $406.2 million in senior notes outstanding.
“Since 2014, the year we went public,” Arougheti said, “we have generated $463 million of realised performance-related earnings. The strategic value of that amount of capital and the types of things we could do with it are meaningful.”
Retaining performance-related income allows for larger GP commitments
Part of the greater retained earnings would be used to invest more of the firm’s own money in its private funds.
Currently, the firm commits up to 5 percent of the fund, according to Ares’ 2017 annual report. The contributions are normally funded with cash rather than a deferral of management or performance-based fees.
Asked how this has changed the firm’s relationship with its private fund investors, Arougheti said: “It gives us more capital to invest in our own fund product, which drives further alignment as well as further growth.”
A small GP commitment can be viewed as a downside.
In a manager evaluation San Bernardino County Employees’ Retirement Association, NEPC evaluated both positives and negatives about private equity manager SL Capital, to which it ended up making a commitment. One of the negatives, the consulting firm said in the memo, was a relatively small GP commitment: SL planned to commit $1 million to a secondaries fund with a $400 million target, with SL’s contribution amounting to 0.25 percent of the target.
A recent study from Investec shows that limited partners are putting more of a premium on GPs having adequate exposure in the game. The standard 1-2 percent GP contribution “isn’t enough to satisfy today’s LPs,” the report read. The study showed a majority of manager surveyed planned to contribute between 2-5 percent.
“If you are at 1 percent then you had better have a very good reason why it’s not higher,” Ontario Teachers’ Pension Plan director Joe Topley, who worked on the private equity desk, said in the study.