Private Equity Profit on Line as Obama Urges Tax Break Study
The fight over how private equity managers’ compensation should be taxed obscures other breaks that are central to the buyout industry’s business model.
President Barack Obama and other Democrats have spent several years arguing for higher taxes on the carried interest earnings of private equity executives. What makes private equity deals so profitable, though, is the tax deductibility of interest.
“Part of the so-called value that’s created in private equity buyouts is really just reshuffling the balance sheet” to take advantage of the interest deduction and other tax breaks, said Victor Fleischer, a law professor at the University of Colorado who tracks the private equity industry.
The Obama administration and lawmakers in both parties are examining the tax code’s debt bias as they seek to lower the corporate tax rate without expanding the federal budget deficit. Any changes to the tax treatment of debt would make it tougher for private equity firms and other companies that rely on deductible debt to structure profitable transactions.
“A tax system that is more neutral towards debt and equity will reduce incentives to over-leverage and produce more stable business finances,” the Obama administration wrote in its corporate tax framework released Feb. 22, which called for lowering the top tax rate to 28 percent from 35 percent.
Subtracting Borrowing Costs
The interest deduction, which lets companies subtract borrowing costs from taxable income, is important for private equity firms because debt is at the core of their business model.
The firms, including Blackstone Group LP (BX) and the Carlyle Group LP, identify companies they want to take over. They revamp the companies’ operations and then sell to the public or other private owners. In a typical deal, investment firms have the target company take on debt during the restructuring process, amplifying profits and creating tax deductions that improve the bottom line.
U.S. private equity investment totaled $147 billion in 2011, according to PitchBook Data Inc., a Seattle-based provider of information about the private equity industry. Deals valued at more than $1 billion used debt for about 61 percent of their financing, while smaller deals averaged 46 percent.
Oil Unit Acquisition
One example is Apollo Global Management LLC’s acquisition of El Paso Corp. (EP)’s oil-and-gas exploration unit, which was announced Feb. 24. That $7.15 billion deal included $5.5 billion of debt financing, with $1 billion of that funded at closing, four people with knowledge of the transaction told Bloomberg News last month. They asked not to be identified because the information is private.
Interest payments on that debt will be tax deductible.
Other breaks, such as accelerated depreciation, can magnify the tax benefits of using debt in transactions. According to the Obama administration’s report, the effective tax rate on new equipment financed with equity is 37 percent, while the comparable rate for a debt-financed purchase is an effective tax subsidy of 60 percent.
“The ability to deduct interest clearly creates a bias for using debt,” said Robert Willens, a New York corporate tax consultant. “The only thing that limits you is what the market will permit in terms of a prudent deal.”
In a regulatory filing today, Carlyle said the administration’s framework “reflects a commitment” by Obama to make tax changes that would negatively affect the company.
Cost of Financing
“A reduction in interest deductions could increase our tax rate and thereby reduce cash available for distribution to investors or for other uses by us,” wrote Washington-based Carlyle, which is preparing for an initial public offering. “Such a reduction could also increase the effective cost of financing by companies in which we invest, which could reduce the value of our carried interest in respect of such companies.”
Interest deductibility is less important today than it was in the 1980s when deals often were composed of 90 percent debt, said Steven Kaplan, a professor at the University of Chicago’s Booth School of Business who studies the private equity industry.
Still, he said, if interest weren’t deductible, debt would be more expensive and private equity firms couldn’t pay as much for takeover targets to achieve the same after-tax returns.
Limits on interest deductibility, if paired with cuts in the U.S. corporate tax rate, wouldn’t stop the private equity business model from being feasible, Kaplan said.
“If you give it back in terms of some lower tax rate somewhere else,” he said, “it would be a slight negative for certain deals, but it wouldn’t kill the business.”
It would be difficult for Congress to start curbing the deductibility of interest, said Jonathan Talisman, a tax lobbyist in Washington whose clients include the industry trade group, the Private Equity Growth Capital Council.
“Borrowing costs are a fundamental cost of doing business and so to the extent there’s borrowing in the mix, you would think they would get an interest deduction for it,” Talisman said.
Lawmakers haven’t settled on an approach for limiting the interest deduction.
The two tax-writing committees in Congress held a joint hearing last year on economic distortions caused by the interest deduction. Senators Ron Wyden, an Oregon Democrat, and Dan Coats, an Indiana Republican, included limits on debt in their tax overhaul proposal.
“At least let’s take away the automatic escalator for debt,” said Wyden, whose proposal would prevent companies from receiving a deduction for the portion of interest expense that reflects inflation. “I think it strikes a good balance.”
Once private equity managers have control of a company, they often try to minimize tax bills in other ways.
“It sometimes takes time for it to happen, but eventually they get to be really good at tax avoidance,” said Sonja Rego, an accounting professor at Indiana University and co-author of a working paper on the tax rates of companies owned by private equity firms.
Lower Tax Rates
Even excluding the effects of debt, Rego and her co-authors found that U.S.-based companies owned by private equity firms tended to have lower tax rates and use subsidiaries in low-tax countries more than similar private companies do. The cash tax rate is typically 5 to 10 percentage points lower for a company backed by private equity, said Brad Badertscher, an accounting professor at the University of Notre Dame in Indiana.
Rego said she wasn’t sure exactly what private equity managers were doing to reduce tax rates other than viewing taxes as another place to look for efficiencies.
As highlighted in Republican presidential candidate Mitt Romney’s tax returns, private equity firms often set up so- called blocker corporations in low-tax countries such as the Cayman Islands and Bermuda.
The blockers often don’t directly benefit the private equity firms, the managers or the companies they operate. Instead, they help expand the pool of potential investors.
Blocker corporations allow U.S. tax-exempt investors, such as pension funds and university endowments, to invest in debt- financed vehicles without incurring a tax intended to discourage such investments.
They also give overseas investors access to U.S. private equity funds without triggering U.S. tax-filing requirements.
“It’s a very tried and true way of sanitizing or cleansing income,” Willens said.
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