On December 19th, a Republican-controlled Congress narrowly passed a tax reform bill. This bill represents the most significant tax overhaul since 1986 and has profound implications for the private equity industry. Although this administration is often chastised for being overly friendly to private equity barons, the reality of this bill is far more complicated.
The new bill caps the tax-deductible portion of interest payments at 30% of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). This represents a marked departure from previous policy, which allowed full deductibility of interest. In 2022, restrictions on interest deductions will become even more onerous as the 30% cap is shifted to a percentage of Earnings Before Interest and Taxes (EBIT) rather than EBITDA. For many highly levered firms, this cap on interest deductibility may force a change in capital structure. In fact, S&P Global finds that over 70% of companies with debt levels of 5x EBITDA would be negatively impacted. Nevertheless, private equity did achieve some victories in this tax reform bill. Traditionally, private equity firms receive a large part of their revenue through “Carried Interest” provisions. Carried interest is the right of a firm to share in the profits resulting from the investments they undertake on others’ behalf. In private equity, the standard is for the general partner (the private equity firm managing the investment) to share in 20% of the gains above a certain baseline rate of return. This carried interest gains revenue is taxed at the capital gains rate rather than the standard income tax rate. Many contend that this preferential tax treatment is an unfair market distortion, and there was much talk of eliminating it in the tax reform bill. The Republicans eventually decided to preserve the preferential tax treatment of carried interest, but they amended the law to mandate that only investments that were held for at least three years would qualify for this preferential tax treatment.
Private equity firms will see most of the benefits of tax reform in the performance of their portfolio companies. Companies are now allowed to expense many assets immediately. These accelerated depreciation timelines result in tax shields that can be used sooner which should drive higher returns in the long run. The corporate tax rate has also been lowered from 35% to 21%, which means that cash flows should be nearly universally higher. Many portfolio companies will be able to repatriate cash more easily, which will allow private equity firms to receive dividends at lower tax rates or engage in more investments within their portfolio companies.
For many firms, the positive impact on cash flows of corporate tax rate cuts will outweigh the negative consequences of capped interest deductions. Even if private equity firms can generate higher net returns through the tax plan, they will face the problem of becoming relatively less attractive compared to other high-yield investments. Nearly every investment vehicle will benefit from the higher corporate cash flows and resulting higher returns created by the Republican tax plan. Comparatively, private equity is much more heavily dependent on interest deductibility to drive returns. Other investment types use other strategies (arbitrage, understanding complex problems, litigation or activism, etc.) to generate outsize returns. These strategies are proportionately less impacted by tax reform, which means that investors who use them gain a comparative advantage over private equity firms. This will impact PE firms that rely heavily on financial engineering to drive returns more than it will harm firms that rely on operational improvements. Over the long term, this tax reform will likely incentivize a shift to PE firms focusing more on operational improvements and creating scale to drive returns rather than targeting companies that they can lever up as much as possible.
Ultimately, the direct impact of the Republican’s tax plan on private equity firms will be heavily dependent on the specifics of their investing strategy. Firms that rely heavily on leverage to drive returns may come out worse, but firms that center their strategy around driving value creation in their portfolio companies may come out ahead. The cap on deductibility of interest will lower the price that sponsors are willing to pay to acquire companies and give strategic buyers a stronger position in the M&A landscape. Regardless, private equity firms must adapt to this new tax landscape or be swept away under a tide of changing norms.