Private equity titans, beware: The tax bill House Republicans unveiled on Thursday could have seriously negative implications for buyout firms.
The legislation includes a provision that would cap interest deductibility at 30 percent of adjusted taxable income, a dramatic shift from the 100 percent allowed now. While the shift would be a concern for any company that issues loans and bonds, it would be particularly worrisome for private equity firms that rely on large levels of debt to finance their transactions. These borrowings -- and the way they are treated for tax purposes -- are crucial in helping firms achieve their targeted annual returns of 20 percent or more.
There also doesn't seem to be any wiggle room. "Certain small businesses" would be exempt from this change, but the definition of this seems to be companies with gross receipts of not more than $5 million. That rules out pretty much all private equity-backed portfolio companies.
For what it's worth, Moody's Investors Service's Chris Padgett has warned that for some companies, the hit from a limit on interest deductibility may outweigh the benefits of a lower corporate tax rate (which is also part of the bill). The idea is that some of the most vulnerable corporations are the most indebted borrowers. Either way, it's a fact that many private-equity-backed companies carry a fair amount of debt.
If the plan had existed, say, five years ago, now-bankrupt private-equity backed companies such as Toys "R" Us Inc. would likely have met an earlier fate. For instance, in the year ended Jan. 28, the heavily-indebted toy-store chain would have had to pay substantially more taxes, because roughly $220 million of its interest expense wouldn't have been deductible. (Separately, you can read more about how private equity firms have caused retail carnage by overloading buyout targets with debt here.)
Shareholders of Blackstone Group LP, Apollo Global Management LLC and their peers are starting to get spooked. After holding their ground most of the day Thursday, the stocks took a tumble in afternoon trading.
It may be that the tax bill -- like other legislative initiatives backed by President Donald Trump -- won't be passed, or not in its current form. On the off-chance that it is though, the longtime appeal of leveraged buyouts and the firms that engineer them may be challenged.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
One counter-move from private equity firms could be to focus more on targets with heavy capital expenditure bills, because the tax plan allows immediate and full deductibility of such spending for five years (that's close to their average ownership period).
To be sure, there are also hundreds if not thousands of private equity-backed companies that don't rely heavily on debt and may be net beneficiaries of the tax bill.
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