After roughly a year of legislative gridlock during President Donald Trump’s first 12 months in office, respite came as The United States’ Congress passed the Tax Cuts and Jobs Act of 2017 into law in late December. The new law received positive feedbacks and receptions as it was hailed as business friendly, this mainly would be because it reduces drastically, the corporate tax rate from 35% to 21%, amongst several other benefits. Moving on to private equity industries, things weren’t as smooth; the reaction was more mixed.
In mid-January of 2018, the discord that existed over the passage of the tax cuts and jobs act was brought into the public glare when The New York Times published “Why Private Equity Isn’t Cheering the Tax Overhaul,” which argued that the reform would change how targets are valued and reduce how quickly Private Equity firms could cash out. As if the drama that went on throughout that period was not enough, less than a week later, The Wall Street Journal countered with “Private Equity Expected to Benefit from Tax Overhaul,” which cited a Hamilton Lane study saying Private Equity-owned companies would grow between 3% and 17% in value thanks to the corporate shrink, easily outweighing potential negatives.
It is shockingly the most significant alteration to the tax code since the 80s, specifically the tax reform act of 1986. It is surprising that the law penalizes private equity at all, given that Trump’s Cabinet includes numerous Private Equity veterans and Blackstone co-founder and CEO Stephen Schwarzman served as the head of the commander-in-chief’s since-disbanded Strategic and Policy Forum. Yet tax reform could affect private equity deal structure, Private Equity-backed portfolio companies, and overall deal-making, among other things. Highlighted below are three perceptions from the presentation hosted by accounting giants PricewaterhouseCoopers, on the potential implications of the tax bill for Private Equity.
Carried Interest ‘Reform’ Will Affect Approximately 1/4 of Investments
The carried interest loophole has been a topic of long and unending debates in private equity spanning years back, with investors arguing there’s nothing unfair about profits being taxed at the lower capital gains rate, which tops out at about 20%. After Trump expressed a desire to nix the provision on the campaign trail, he backed down. Instead, the rule will change only slightly under the new tax law, as portfolio companies held for less than three years will now be taxed as short-term capital gains, which are taxed at the normal rate, which tops out at 37%.
How much of a difference will that make? The median investment hold time for US Private Equity firms was roughly 5.2 years in 2017. And just 27% of those portfolio companies were held less than three years. In fact, the Private Equity hold times of less than three years haven’t made up the majority of Private Equity investments since 2009.
The Fundamental Structure of LBO’s (Leveraged Buy-Outs) Could Change
Under the new tax law, interest expense deductibility has decreased to 30% of a company’s adjusted taxable income until 2021. Under the previous tax law, there was no limit.
In other words, Private Equity firms will no longer have unlimited leverage parameters when conducting a buyout. That could have a variety of impacts:
A firm may have to put down more capital up front to complete a deal, find an international lender that can provide more favorable terms or shift a portfolio company’s existing debt-to-equity ratio. In any scenario, the post-cash cost of debt will effectively increase, because firms no longer get the benefit of what can be a massive tax write-off when buyouts are in the billions.
Deal Valuations Will Remain Frothy, Partly Due to the Tax Reform
With dry powder approaching record levels and Private Equity deal activity in the US down slightly, don’t expect the competitive deal-making environment to dissipate anytime soon. As a result of the corporate tax decrease, strategic acquirers (hello, Amazon) will have increased capital available for investments. That could make them more formidable rivals for PE firms looking to strike deals and also drive up valuations, according to BDO’s latest report.
Spectrum Venture Capital and its affiliates do not provide tax, legal, regulatory or accounting advice. Nothing contained herein is intended to provide, and should not be relied on for, tax, legal, regulatory or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in or refraining from any transaction, as this site should not be used as a substitute for competent professional advice from a qualified practitioner in your jurisdiction.