All in the same boat

US managers navigating changes to interest deductibility rules can turn to their British and German counterparts for advice and, if they’re lucky, hope.

It is “concerning”. It has prompted at least one firm that sister title pfm spoke with to bring forward plans to take out loans. It could fundamentally change the nature of private equity investment. Can you guess what it is yet?

That’s right – restrictions on interest deductibility. The move, introduced under US tax reform proposals, will make borrowing more expensive for most businesses that rely on credit to fund new investments or meet operating costs.

It can also make the leveraged buyout model, so popular among private equity managers, less attractive. It’s not hard to see why US market participants anticipate an industry lobby against the proposal’s inclusion in the final tax reform document.

But it’s not only US fund managers that are facing restrictions on interest deductibility, and firms that are not subject to similar rules soon will be. Article 4 of the OECD’s Base Erosion and Profit Shifting initiative – which aims to standardize global tax rules – outlines a similar limit and more than 100 countries globally have agreed to implement rules to reflect this restriction.

Managers in the UK were forced to lead the pack on implementation in April, and may soon be able to advise their US peers. It’s too early to assess the impact of the restriction on interest deductibility yet, but a clearer picture should emerge over the next 18 months as more transactions happen, a London-based tax lawyer says.

“Some conservative houses have modeled without any deduction being allowed for. This is not likely to become widespread, but it is very likely the measures will impact acquisitions,” Daniel Lewin, tax partner at MJ Hudson, says.

He outlines some of the options firms are considering to deal with the removal of the restriction, including replacing some debt with preferential shares, which are not subject to the same limitation; reconsidering their internal performance calculations; and assessing whether they are willing to pay such high prices for assets.

If the UK was early to the interest deductibility party, Germany was the one sending out the invites. It introduced a 30 percent limit on interest deduction in 2008 to plug the shortfall created by lowering its corporate tax rate by 10 percentage points to 15 percent.

Perhaps because of the limitations, far fewer German private equity deals (8 percent compared with 22 percent globally) are majority financed by debt, while half of the country’s managers are content with a debt ratio of below 40 percent, versus one-sixth for the same figure internationally, according to PwC data.

It does not appear to have hurt the industry. “The short story is that it has had no significant impact,” Jeremy Golding, managing partner of Munich-based Golding Capital, tells pfm.

Data from InvestEurope show the DACH region as a whole saw more buyout activity by value invested than either the Nordics or the UK and Ireland in 2016. Deal professionals based in the country became the highest paid across Europe, executive search firm Heidrick & Struggles found.

There’s no doubt changes to interest deductibility rules will have an impact on private equity operations, and it may take a while for managers to navigate the change. But the industry has always proved itself to be adaptable – who would have thought Securities and Exchange Commission registration and compliance with the Alternative Investment Fund Managers’ Directive would turn out to be no bad thing? There’s no reason why, much like their German peers, US managers can’t knock this latest curveball out of the park.