Tax Reform Prompts KKR to Consider Incorporating

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For years, private equity companies have structured themselves as partnerships in order to obtain valuable tax benefits and avoid the high rates that corporations pay. Yet now that tax reform is a reality, and corporate tax rates have come down enough to offset some of the negatives of corporate status, KKR (NYSE: KKR) believes that it might be time to incorporate.

Coming into Thursday's fourth-quarter financial report, KKR investors expected to see substantial gains in key fundamentals. KKR's results were solid, and the company says that it's embracing diversification to take advantage of the hunger for smart investments among its clients.

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How KKR fared

KKR's fourth-quarter results were once again mixed in many shareholders' eyes. Total reportable segment revenue soared 52% to $1.01 billion, which was a much faster growth rate than most investors had expected. The company's favored after-tax economic net income measure was higher by 22% to $414.9 million, and that translated to $0.48 per adjusted unit, up 20% from year-earlier figures.

KKR's fundamental business finished the year strong. Assets under management soared 30% to $168 billion, rising by $15 billion in just the past three months. Book value hit $11.7 billion, which worked out to $14.20 per unit, up $0.40 since September and $2.05 over the past year. Fee-paying assets under management were up roughly 16%, and uncalled capital commitments soared by roughly half from year-ago levels.

The strategies that KKR has followed have worked well. In its goal to produce strong investment performance, KKR's flagship fund strategies were generally up 9% to 34% during 2017. Capital raising has been successful, and KKR put $18 billion to work globally in pursuing attractive investment opportunities. Returns on equity were favorable, and solid distributable earnings to unitholders helped validate the model that KKR has followed.

Yet not everything went right for KKR. Total investment income was down 19%, as higher dividend income in the portfolio failed to offset reduced gains. Expenses were also higher, by more than 40%, mostly because of higher compensation related to solid investment performance for fund personnel.

What's next for KKR?

KKR is happy with the way things are going. "Through our integrated model -- the combination of our investment funds, balance sheet, and capital markets capabilities," said co-CEOs Henry Kravis and George Roberts, "we were able to create more investment opportunities for our fund investors and generate record results in our capital markets business." The co-CEOs also mentioned the rise in book value and assets under management as noteworthy.

Yet one of the most interesting things in KKR's report was a simple sentence: "KKR's Senior Management and Board of Directors are evaluating whether to convert from a partnership to a corporation." The move stems from the changes that tax reform measures have brought about, especially the reduction in the corporate tax rate from 35% to 21%. The penalty for having carried interest taxed at the entity level was larger under previous law than it would be after reform, since carried interest qualified for capital gains treatment when passed through the partnership structure. It'll take time for the private equity company to evaluate fully the pros and cons of making a switch, but for investors who don't like dealing with the additional paperwork that comes with investing in a partnership, a change to corporate status could make KKR look more attractive.

KKR shareholders didn't seem particularly excited about the news, and prices of KKR units were down just a fraction of a percent in early-morning trading following the announcement. The bigger question for the company is whether it can successfully navigate the new turbulence in the market. If it can profit from it, then investors might well appreciate the new environment, regardless of whether KKR remains a partnership or chooses to incorporate.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool recommends KKR. The Motley Fool has a disclosure policy.

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