Finance

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

How's this for irony? KKR & Co. -- the firm whose history-making leveraged buyout of RJR Nabisco was detailed in "Barbarians at the Gate" -- has an activist shareholder on its own doorstep. 

ValueAct Capital Management President Mason Morfit on Thursday revealed that his firm has used derivatives to take a $750 million, or almost 5 percent, stake in the New York firm. Morfit slapped a price target of $37 a share on KKR, implying that it's worth more than double its closing price Wednesday -- and that projection sent the stock up as much as 7.4 percent to its highest level in roughly 18 months. It pared some of those gains in afternoon trading, but was still more than 4 percent higher. 

Back of the Pack
Even after Thursday's share price bounce, KKR trails its peers on a number of metrics, including on a blended forward P/E basis
Source: Bloomberg

KKR was already poised for a small bump, having reported better-than-expected first-quarter earnings on Thursday. On a call with analysts, management said it welcomed ValueAct's ownership, adding that the hedge fund shares its perspective on the firm's future, but it's unclear if that statement refers to ValueAct's supposed keenness for KKR to convert from a partnership to a corporation. 

Momentum behind that idea has been growing, in light of President Donald Trump's proposed tax reform, which would reduce the corporate tax rate to 15 percent. On Thursday, KKR's Chief Financial Officer Bill Janetschek said that while the firm was awaiting "more concrete information," management would keep an open mind regarding its corporate structure. His counterpart at Blackstone Group LP Michael Chae and Apollo Global Management LLC's co-founder Leon Black have echoed similar sentiments -- each firm isn't going to make a move until there's certainty from Washington. Such patience makes sense: It wouldn't be prudent to give up its effective tax rate -- sometimes as low as 1 percent -- until Trump's tax cuts are formalized and approved by Congress, which isn't guaranteed.

Who Needs a Tax Break?
Even if the corporate tax rate is cut to 15 percent, alternative asset managers like KKR may not necessarily rush to become a C-corporation
Source: Company filings

If tax reform does occur, there is a case to be made for KKR and its rivals to become corporations. Firstly, institutional investors that were previously hamstrung from owning the stocks because they're partnerships and as a result, not included in indexes or exchange traded funds, would be given free rein: 

Cast the Net Wider
If firms like KKR converted to a C-Corp structure from a partnership, a significant number of institutional investors would no longer be restricted
Source: Credit Suisse survey

Predicting the impact of a broader investor base is tough, but an early attempt shows that there would be a financial benefit, albeit slim. For example, if these firms converted to corporations and were added to various indexes, price-to-earnings multiples across the industry could increase by at least 20 percent, according to half the institutional investors surveyed by Credit Suisse Group AG. But even with tax reform, they'd be paying higher taxes than what they effectively pay now. That could dent earnings by roughly 10 percent (or more), capping share gains at anywhere between 5 percent and 10 percent. That's still better than nothing, right? 

I've written before that KKR's toughest sell is its own shares -- the stock trails those of other alternative asset managers on a price-to-earnings basis. That's in part because of its comparatively less-generous dividend policy and strategy of using its balance sheet to invest in its funds and deals, which adds both more risk and potential rewards. Shareholders should be grateful that ValueAct is on hand and seemingly willing to help narrow the gap, especially after taking a more passive approach with its stake at Morgan Stanley, the bank whose share price gains can be attributed to the Trump bump rather than anything prescribed by the activist. 

Not Convinced
Wall Street analysts believe there's upside in KKR's shares, but even the most bullish one, at $25, falls short of ValueAct's $37 estimate
Source: Bloomberg

Regarding KKR, ValueAct will need to have some other ideas up its sleeve. Even factoring in Trump's proposed tax cuts and a subsequent conversion into a corporation, it's hard to see how the stock gets to $37.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net