Private Equity and Venture Capital Firms Are Still Digesting Trump Tax Reform
June 25, 2018
The headlines leading up to passage of the new tax law were ominous.
Changes requiring private equity and venture capital funds to hold investments longer to get a lower capital gains rate on carried interest — coupled with new caps on interest deductions — would create “prompt upheaval,” The Economist declared.
Methods for valuing buyout targets would be disrupted. And a diminished appetite for financing deals with debt meant that “some of the ‘leverage’ will come out of leveraged buyouts,” The New York Times said.
Even President Donald Trump acknowledged last November that his wealthy friends are “not so happy with me, but that’s OK.” He signed tax reform into law a few weeks later, on Dec. 22, 2017.
Some industry leaders worried that the tax reform law diluted key provisions that helped fuel the private equity boom in recent decades.
The private equity industry raised a record $453 billion globally last year, according to financial data firm Preqin, and some skeptics worried that the new tax code would erode that momentum.
The largest overhaul of the tax code in three decades certainly has significant impacts on private equity, venture capital and other alternative investment firms.
New carried interest rules require holding investments for three years — instead of one — to get the lowest capital gains tax rates. That will raise about $1.1 billion over 10 years, the Joint Committee of Taxation estimated.
That will force many financial analysts at private equity firms, venture capital firms and hedge funds to adjust valuation projections and hold period assumptions within their investment models to take into account:
- Increase in value due to higher cash flow from lower corporate tax rates and capital expenditure deductions
- Increase in value for companies with large amounts of low taxed foreign earnings and cash that can be repatriated
- Whether the value of net operating loss (NOL) tax credits and other incentives are impacted
- Decrease in value for companies with significant imports, and increase in value for companies with significant exports
- Decrease in value for highly-leveraged companies on decreased cash flow from reduced interest deductions
The amount of deduction for tax purposes on interest paid on debt is now capped at 30 percent of earnings before interest, taxes depreciation and amortization (EBITDA) – the newly created term under Trump’s tax reform law is Adjusted Taxable Income (“ATI”). Previously, there was no cap.
Investors are also trying to understand what the new rules mean for the free cash flow of portfolio companies and other target companies they are considering buying.
All eyes are on transaction volume and prices to determine whether any of these new tax provisions will depress valuations.
All the fretting about Trump’s tax reform hurting private equity seems a bit overblown.
So far, there have been no fundamental changes to how private equity firms are conducting business under the new legislation, according to private equity advisory firm Hamilton Lane.
The enormous benefit of a plunging corporate tax rate and the ability to deduct capital spending upfront more than overcome the negatives from the other provisions of the new tax law, Hamilton Lane said in a January report to clients and other industry observers.
“It’s absolutely going to be a positive,” Hugh MacArthur, head of Bain’s Global Private Equity practice, told Fortune in a February interview. “The cap on debt deduction is a modest negative, and we believe it’s modest enough that it won’t impact most deals at all. The overwhelmingly positive factor that dwarfs this is the net reduction in corporate tax rates from 35 percent to 21 percent.”
Values of profitable private equity-owned companies in the U.S. should increase by 3 percent to 17 percent on average in the coming years, Hamilton Lane forecasted.
That makes private equity “very much a big winner” in tax reform, Brian Gildea, a managing director at Hamilton Lane, told The Wall Street Journal in January.
The American Investment Council, the trade and lobbying group for the private equity industry, has also said that tax reform “represents a net positive” for its members.
Another sign that private equity wasn’t fazed by the new tax law: Stephen Schwarzman, the CEO of The Blackstone Group, a New York-based private equity firm, hosted a $100,000-per-plate fundraiser lunch for Trump in December as the legislation was making its way through the Senate.
The event included a menu of grilled chicken and asparagus, plus a 20-minute group chat with Trump.
In January, weeks after Trump’s tax reform was signed into law, Schwarzman praised the message that the new tax code telegraphed to would-be investors across the globe.
“This really creates enormous energy and enthusiasm,” Schwarzman said in an interview with Maria Bartiromo on Fox Business in January. “It’s an example around the world of how you get the economy going.”
‘Do We Do This Deal?’
So far, it’s hard to ratify that sentiment with data on private equity transactions.
The value of private equity deals in the U.S. slid 33 percent to $88.8 billion in the first quarter of this year, according to data by PitchBook. Deal volume slipped 4 percent to 1,101 completed transactions.
Those figures are somewhat deceptive because 124 transactions worth a collective $94 billion have been announced but haven’t yet closed in 2018, PitchBook said.
That’s partly because bankers, analysts, lawyers, accountants and other deal making professionals are still assessing the exact impact of tax reform on deals that were in the pipeline. And they are awaiting clarification from the Treasury Department, the IRS and other authorities on how to interpret some of the language.
For example, the U.S. Chamber of Commerce sent a 15-page request to the Treasury Department seeking clarity on “a host of errors and ambiguities” in provisions of the law, Jim Tankersley of The New York Times reported in March.
Many private equity investors are re-running numbers and putting a finer point on deal assumptions, cash flow models and hold periods. The outcomes of those exercises may lead to renegotiations, said Sean Lelchuk, a corporate banker in the Asset Based Lending Group at Synovus Financial Corp. in Atlanta.
“There’s a lot more conversation going on about ‘Do we do this deal? Does this change our return?’” Lelchuk said. “If this is going to materially alter your valuation, maybe it saves you a point. Maybe you renegotiate the deal. Maybe you skinny up what you have to pay.”
In the long run, the new tax law isn’t likely to hurt the industry because savvy investors will quickly adapt, Lelchuk said.
“It’s a new normal, so this is what we have to deal with,” Lelchuk said.
What to Do
Executives at private equity and venture capital firms should thoroughly assess and update all financial models and deal assumptions that take into account projected hold period, carried interest, interest deduction and free cash flow under the new rules.
They will likely find Trump tax reform primarily impacts certain types of deals, such as investments intended to be held for just a couple years or highly leveraged investments whose main value are driven by revenue, asset value or another financial metric as opposed to EBITDA.
Only 27 percent of private equity portfolio investments in the U.S. fell under the 3-year hold period last year, according to PitchBook, and the median hold period was 5.2 years.
Investors who back those types of short-term deals simply have to hold them longer before exiting if they want the most favorable capital gains tax rates, or pay ordinary income tax rates if they sell before the 3-year window.
In a few extreme cases, private equity firms are exploring changing their corporate structure.
Ares Management said in February that it would convert from a publicly traded partnership to a C-corporation to take advantage of the new lower corporate tax rate. Converting to a C-corp would also open access to more investors such as index funds or institutional investors that have restrictions on buying the stock of partnership structures.
The news pushed Ares’ stock up as much as 12 percent, although the shares have since given back that gain.
Another private equity fund considering conversion to a C-corp is KKR, the world’s second-largest private equity fund behind The Blackstone Group.
“We’ve heard for some time that there are investors that find publicly traded partnerships difficult to own,” KKR Chief Financial Officer William Janetschek said on the New York-based firm’s fourth-quarter earnings call with analysts and media.
The Trump tax reform includes several significant changes for private equity, venture capital and other investors.
To get the lowest capital gains tax rate, investments must be held for three years or longer, compared with one year previously.
The amount of interest in an investment that can be deducted is now capped at 30 percent of earnings before interest, taxes depreciation and amortization (EBITDA), whereas there hadn’t been a cap before. The new term is Adjusted Taxable Income (“ATI”).
Private equity leaders and industry advocates say the negatives from those changes are largely offset by a new lower corporate tax rate of 21 percent, from 35 percent previously.