The Trump White House has had an eventful first year in office. Despite the government’s business friendly rhetoric, corporate tax reform has left private equity in a bind, introducing restrictions around deducting interest on debt from tax, something which will adversely affect the industry and their efforts to partake in leveraged transactions.
Anyone perusing through some of the more salacious details contained within “Fire and Fury”, a spicy account chronicling the workings (or not) of the Trump White House, would be forgiven for forgetting or not noticing that one of the most monumental overhauls in US tax policy in more than three decades was enacted at the tail-end of 2017. The Tax Cuts and Jobs Act (TCJA) impacts nearly every taxpayer across income brackets and corporates of all persuasions, and private equity is no exception. Put bluntly, private equity is nonplussed with TCJA, and while the rules are not cataclysmic for the industry, they are quite disruptive all the same.
The TCJA and its impact on leveraged transactions
Historically, interest expenses on debt could be deducted from pre-tax income at private equity, which has been a major catalyst behind the growth of leveraged buyouts. As tax laws gave preference to using debt over equity, firms sought to maximise their leverage but this will no longer be the case under TCJA. Whereas traditionally there were no constraints on the amount of interest managers could offset against taxes, TCJA imposes prescriptive restrictions. Moving forward, a company will now only be allowed to deduct interest equivalent to 30% of EBITDA (Earnings before interest, tax, depreciation and amortisation). In 2022, that threshold will be limited even further by curbing the amount firms can deduct to 30% of EBIT. Real estate – amusingly – is exempted from these tax changes for reasons unknown.
The most obvious consequence of the rules will be that private equity firms may be less willing to jump into leveraged transactions. Despite the reductions in the corporate tax rate to 21%, many private equity managers using heavily geared strategies are unlikely to reap any benefits. In short, the rules are likely to make it harder for private equity managers to laden companies with debt, something which could make the industry less competitive during the bidding process, and ultimately less profitable.
Ahead of the reforms, private equity industry associations urged caution on changes to interest deductibility. “The American Investment Council (AIC) supports the process to reform our outdated and overly complex tax code. The United States is in desperate need of pro-growth tax reform and this framework includes many smart solutions for a simpler and fairer tax system. Of concern, however, is the proposed limit to interest deductibility – a century-old provision that helps companies grow over the long term,” said Mike Summers, president and CEO at the AIC, speaking in September 2017.
The provisions are also likely to accelerate the demise of private equity-owned companies struggling to pay off their debts.
He continued: “Interest deductibility is an essential component of businesses which rely on debt financing – companies of all sizes and across all sectors. Our industry is committed to sustainable economic growth by advancing access to capital, job creation, and retirement security through responsible long-term investment, and we believe tax reform requires similar long-term growth solutions.”
S&P Global Ratings reckons that approximately 70% of companies saddled with debt equalling more than five times EBTITDA will be adversely affected by the rules, while Moody’s estimates a third of leveraged buyouts (LBOs) will be worse off. The provisions are also likely to accelerate the demise of private equity-owned companies struggling to pay off their debts. A Reuters article cited Toys R Us as a prime example.
What next for carried interest?
Carried interest is also impacted by the rules. TCJA states that long-term capital gains rates on carried interest will only apply if a company has been held by a private equity firm for more than three years, an increase from the current one-year. If an asset is held for less than three years, carried interest will be treated as a short-term capital gain and subject to standard tax rates.
There are some winners from the rules, namely companies with an existing high tax rate and whose revenues are mainly US based, such as oil refineries and airlines.
While the rules are likely to adversely impact hedge funds which tend to adopt a shorter-term investment horizon, private equity will probably be spared as most firms are long-term in their investment approach with holdings typically lasting around seven or more years. Again, this is welcome news for the private equity industry, and has certainly softened the blow against some of the tougher provisions around interest deductions.
Private equity are not the only losers from the reforms. “Under previous tax laws some of the biggest names in corporate America have been able to cut their tax bills significantly by using past losses to offset future profits. However, the Republican-led legislation to cut the corporate tax rate has forced the institutions to reassess the accounting value of their deferred tax assets,” reads the FT. Banks which took an absolute pounding during the financial crisis will therefore be forced to undertake write-downs. There are some winners from the rules, namely companies with an existing high tax rate and whose revenues are mainly US based, such as oil refineries and airlines.
The Future of private equity under Trump
Despite perceptions of a heavy private equity influence on the current administration, it appears the industry has not reaped a large number of benefits, especially in terms of taxation. Private funds continue to be heavily scrutinised by the Securities and Exchange Commission (SEC), with a focus on fees and conflicts of interest still high on the agenda. Speculation that the Volcker Rule could be eased to allow banks to have ownership stakes in covered funds are unlikely to apply to private equity either.
With US clampdowns on deducting interest on debt from tax, the industry is less likely to pursue highly leveraged buy-outs, while private equity owned corporates saddled with debt are likely to fare badly. Fortunately, private equity has not seen significant restrictions imposed on carried interest, which many see as a victory. Nonetheless, the next year or so could be a tricky year for the asset class.
