Fifth Street CEO: Deal activity to heat up

The possibility of higher taxes on capital gains, and the need for private equity firms to bolster track records for upcoming fundraisings will fuel a heated deal environment in the second half of 2010, according to Leonard Tannenbaum, chief executive officer of Fifth Street Finance Corporation.

“We’re finding everyone wants to sell their company this year, rather than next year,” Tannenbaum told PEO in an interview. “You’ll pull a lot of M&A business into this year from the first half of next year.”

Without action from the US Congress, the tax on capital gains, which stands at 15 percent, would increase to 20 percent in 2011. The tax was cut under former President George W. Bush, but the reduced rate is set to expire next year. President Barack Obama has called for various changes in taxation, including allowing the reduced rate on capital gains expire.

Leonard Tannenbaum

Also, GPs are facing an increased on carried interest. Carried interest has been taxed at the capital gains rate of 15 percent, but a proposal that has been approved by the US House of Representatives would tax 75 percent of carried interest at the same rate as ordinary income – at 35 percent. The remaining 25 percent would be treated as capital gains. The proposal still needs approval from the Senate.

At the same time, many private equity firms are planning to hit the fundraising trail next year. In order to get potential investors on board, firms need to show a track record of reaping profits on investments. LPs are being especially selective these days after taking big hits to their portfolios in the economic downturn.

According to data from the Florida State Board of Administration, one of the biggest limited partners in the industry, firms including Kohlberg Kravis Roberts, Permira, Providence Equity Partners, Coller Capital, Cinven, Montagu Private Equity and Apollo will come to market with new funds in 2011.

“In order to raise a new fund, you often have to show you’ve exited a number of investments at a profit,” Tannenbaum said.

These two factors will combine to cause many firms to look for exits on investments by the end of this year. The private equity exit environment has been active through 2010, with several firms using the public markets as a way to cash in on investments.

In the US, private equity has exited $27 billion of investments so far this year, excluding initial public offerings, compared to about $13 billion in exit activity for all of 2009. In Europe, this year’s exit total, excluding IPOs, stands at $18 billion, compared to about $4 billion for all of 2009, according to Dealogic.

Private equity firms have completed about $4.4 billion in IPOs in the US this year, compared to $467 million last year. Europe has seen about $6 billion of IPO activity this year, compared to zero last year, Dealogic said.

Fifth Street Finance lends to and invests in small to mid-sized companies in connection with private equity investments.