Morgan Stanley research on C‑corp conversions for alternative asset managers

Morgan Stanley | RESEARCH Alternative Asset Managers NORTH AMERICA INSIGHT | ¥ Can Alts Unlock Value with C-Corp Conversions ? e think APO could unlock the most value by converting to a C-corp with 26% in our upside case vs. -14% in our downside case. ARES could be the first to convert, but this is largely priced in. These Brokers & Asset Managers firms have more sticky management fee-related earnings @ North america industry View vs. BX/CG/KKR that may see less benefit. We believe ARES could be the first Alt stock to convert; we would view that as a positive catalyst for the group that, if suc- cessful, could lead others to follow. ARES reports 4Q earnings on February 15, and we expect a potential announcement or indications of mgmt@ intentions and/or timing. C-corp conversion has domi- nated our conversations with investors of late with increased inbound questions including interest from some new to the Alts. As a result, in this report we expand on prior work here, and here, cre- ating a C-corp conversion scorecard with qualitative pros/cons for each company. We also evaluate the potential valuation impact if Alts convert, and we take a deep dive into how the market might value two earnings components ina C-corp structure: )) sticky, recur- ring management fee-related earnings and 2) performance fees. We see an opportunity for Alts to unlock value by shedding the partnership structure and converting to C-corps. Changing from a partnership structure could help alleviate the complexities of cur- rent K-1 tax reporting and expand the universe of eligible investors in the Alts. Some investors today are restricted from investing in lim- ited partnerships, while others don®want the operational and tax complexities of investing in a partnership structure. Management fee-related earnings could re-rate higher toward 22.5xin our upside case, as we look at three different approaches for valuing this sticky earnings stream: 1) traditional asset man- ager comps vs. organic growth, 2) publicly traded C-corp Alts comps, and 3) an approach looking at FRE as bond yield proxy with a credit spread, to determinate an appropriate cap rate. In-Line Performance fees appear cheap (at 6.1x) if management fees re-rate to 22.5x in the context of Alts converting to C-corps anda 24% overall tax rate. This suggests the market is misvaluing perform- ance fees, and we could also see Alts performance fee earnings re-rate higher if C-corp conversion expanded the investor base. We see companies that have a greater skew to management fees as best positioned for conversion, as we see the greatest potential for multiple expansion on for this portion of the earnings. For stocks under coverage, we see APO as potentially being able to unlock the most value, with near-term upside to current prices of 26%, if the shares re-rate. We see ARES as another winner from conver- sion but the we belive this is priced with shares up 23.5% YTD. Our analysis suggests a less favorable upside/downside scenario for con- version for companies under coverage with lower taxes and/or greater exposure to performance fees (KKR, CG, BX). Exhibit 1: Upside/Downside Scenario Impact to Alts' Share Price if They Convert to C-Corps from Current Partnership Structure Estimated Change to Curent Share Price 30% 20% 10% 11% 9, -10% -14% -15% 26% Downside ™ Upside -18% 5 -21% ~20% -20% 27% -30% -40% APO OAK KKR- BX ARES CG Avg. Source: Company Data, Morgan Stanley Research estimates Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to th®isclosure Section, located at the end of this report. HOUSE_OVERSIGHT_025554