If there is one topic dominating discussion in the US private equity market, it’s tax reform. The Tax Cuts and Jobs Act of 2017, effective 1 January is the biggest change to US tax policy in decades, and affects private equity in a number of ways.
A key question for the industry’s listed giants, most of which are structured as publicly traded partnerships, is whether it would be wise to convert to a C corporation.
Potential benefits include expanding the universe of eligible investors, more straightforward tax reporting and investors applying higher valuations to various different income streams, according to a research note from Morgan Stanley.
As this issue went to press Ares Management announced it has elected to convert to a C corporation, leading one analyst to suggest this could set off a domino effect among its peers.
On an investor call in February, Apollo co-founder Josh Harris explained if the Act had been effective at the beginning of 2017, the firm’s economic net income would have been 3 percent higher than its reported results. If the publicly traded partnership had also been a corporation at the beginning of 2017, it would have been 16 percent lower.
“Of course, we recognise that with a simplification to our current structure there might be positives to partially or wholly offset the earnings dilution we would have experienced, such as an expansion in valuation multiples,” Harris said.
Apollo’s conclusion – and those of its peers – has been to wait and see. Oaktree said it had “no current plans” to convert to a C corporation, while Blackstone also said it would take more time to evaluate the issue.
Carlyle’s co-chief executive Glenn Youngkin said on an investor call the firm’s analysis suggested converting would result in a 15 percent reduction in ENI.
“Converting to a C corp is a no-going-back kind of decision,” he said. “So, while we are comfortable with our partnership structure today, we will revisit this topic when appropriate as the certainty related to both the drawbacks and benefits of a possible conversion become more clear.”
KKR estimated its ENI would have been around 17 percent lower, and thus the firm would need to see two turns of multiple expansion for a break-even stock price.
Whether the tax bill is an overall positive or negative for existing portfolio companies comes down to how highly levered they are. Analysis from Hamilton Lane shows the drag from limited interest deductibility begins to offset some of the benefits of the tax cut once debt levels approach 5x EBITDA.
“The tax bill should be a net positive on the equity value of currently held companies, though companies with over 7.5x leverage or with a weighted average cost of debt above 11 percent could see their equity value fall,” a report by Brian Gildea, a managing director at Hamilton Lane, says.
The companies that will benefit most are US firms with 100 percent domestic revenue, high current tax rates, debt levels on the lower side and high capital spending, because companies will be able to fully expense capital expenditures until the end of 2022. Portfolio companies should be worth between 3 percent and 17 percent more, according to Hamilton Lane.
“For the majority of our portfolio companies, the benefit of a lower corporate tax rate outweighs the costs associated with potential limitations on interest expense deductibility,” Youngkin said, adding there should be “an overall positive impact on our portfolio”.
The potential uplift in valuations should provide a boost to performance. However, GPs are pricing in the impact of the reform, meaning they are willing to pay more for assets to achieve the returns they were targeting before, Gildea writes.
“The bad news for LPs is that prospective deal returns aren’t any better off than they were before, but the good news is that existing deals and portfolios should benefit from higher valuations immediately.”
The Oregon Investment Council said in its annual private equity review that the US leveraged buyout model would need to adjust for new deals.
“The reduced ability to deduct interest expense will decrease the benefit of leverage, accelerating private equity’s evolution away from financial engineering toward operational intervention,” the pension plan wrote. “Reduced corporate tax rates should allow for increased reinvestment in value creation initiatives.”
The industry consensus on the tax changes affecting carried interest – that it will be taxed higher if an investment is held less than three years – is they could have been worse. As Gildea puts it: “It’s a snoozer – it just won’t have any significant impact.”
Hamilton Lane research shows that in 2016 only 13 percent of deals exited were held for less than three years.
However, the issue becomes more complicated once add-on acquisitions – purchased during the life of the investment, and therefore often made less than three years before exit – are taken into account.
Rafael Kariyev, a tax partner at Debevoise & Plimpton, suggests in these cases a portion of the carried interest would be taxed at ordinary rates and the remainder as capital gains, although he conceded it would be challenging to determine how to split that in the case of merged corporations.
“The issue comes up primarily if you’re selling a portion [of the company], and what you’d like to do is sell the stock you’ve held for longer, but you can’t do that. When you sell, a portion of it will be long-term, and a portion will be short-term.”
Distributions from dividend recaps will either be treated as a return of capital, and therefore not taxed, or as a dividend for US tax purposes, which are entitled to the capital gains rate and are not subject to the three-year holding period.