When the framework for US tax reform came out at the end of September, it had a few surprises for the private equity world: there was no mention of the carried interest tax, but it did suggest limiting the deductibility of interest expense.
The language in the proposal was vague, and gave no details of what a limitation would entail. It stated that “the deduction for net interest expense incurred by C corporations will be partially limited”, and that “the committees will consider the appropriate treatment of interest paid by non-corporate taxpayers”.
In a worst-case scenario, a large cut could disrupt the private equity model.
“Of all the components of the tax proposal, that is the one that could have the most potential impact on portfolio companies and the private equity model going forward,” said Jeremy Swan, managing principal and national director of financial sponsors and financial services industry at professional services firm CohnReznick.
“If you eliminate the interest expense deduction, [GPs] are going to have to rethink how they invest,” Jerry Schwartzman, head of M&A tax at Houlihan Lokey, said of GPs.
For all the increased focus on operational improvement, buyout specialists are currently taking full advantage of cheap debt and interest expense deductibility to bolster returns. A limit on the deductibility would hit one of the buyout model’s drivers of value creation and ultimately returns.
As the industry awaits additional details on the reform, tax experts offer some clues as to what the limitation could look like:
- It is not to be a full exclusion or elimination, but how much remains deductible is unknown.
- The limitation could be a simple haircut on corporations’ ability to use interest deductibility, perhaps determining the cap based on a factor of EBITDA.
- The limitation is likely not to apply to non-corporate entities, leaving the door open to GPs to put debt at a non-corporate entity level such as a fund or a management company.
- It is unclear whether existing debt obligations would be grandfathered in.
If the reform passes, deal teams will be forced to adjust their assumptions. Some firms have started testing new cashflow models based on the different possibilities.
For now, with uncertainty surrounding the details of the reform and its passage in Washington, PE firms are far from panicking about the prospects of a limit on interest expense deductibility.
“The whole capital market world, including alternative investors, could be upside down,” added Schwartzman. “But the funny thing is: people are not addressing what would happen. My impression is that people in the industry are not addressing this at all because they don’t think the likelihood for them is high enough to spend the time.”
But if the rest of the world is anything to go by – a number of European jurisdictions have already capped interest deductibility – then US GPs should take the threat seriously.