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Feb 23

What is Private Equity, Part 3

 

Delving into the Private Equity minutia, here’s a little analysis of President Barack Obama’s recent tax proposal. The proposed cut of corporate taxes from 35% to 28% has drawn all the headlines, but more important are the details in the fine print.

A great example is the proposed change to interest deductions. Currently, companies can deduct their interest expense from earnings before calculating owed taxes. It’s similar to how homeowners can deduct mortgage expense before calculating what we owe to Uncle Sam.┬áPresident Obama would like to do away with the corporate version of the deduction.

The problem is, for any company with a substantial amount of debt, this change might increase the tax bill. This change would strike particularly hard at companies who have been acquired (LBOs) or invested in (financed) by private equity (PE) firms. Using leverage, as I explained in a previous post, helps private equity firms to make a higher return, and thereby allows the PE industry to exist.

Why is that important, you might ask? Well, I discussed some of the reasons here. Briefly stated, PE is a fundamental facet of capitalism that provides financing sources┬áto established, mature┬ácompanies who do not have, or do not wish to have, access to public markets. The vast majority of the PE industry is absolutely, positively not about “vulture capitalism” — no matter what you might hear or read in the news. “Turnarounds” and “chop shops” are niches within the broader PE industry. They are not the norm. Rather, most successful PE is predicated upon investing in and supporting good, solid companies.

However, because PE investments are illiquid — in other words, a PE company can’t just sell its ownership in a company in one day — PE investments are considered higher risk. Why? If a manufacturing company runs into supplier trouble, then a PE firm is stuck with its ownership in the company and must weather the storm — if it were a public company, the PE firm could simply sell its shares immediately. In order to offset this higher risk, PE needs to exhibit higher rewards, or in investment parlance, higher investment returns. This is the classic risk-reward theory.

As I explained, using a prudent amount of debt that a company can support, a PE firm can increase its return on its equity investment. But if interest cannot be expensed before tax calculations, then suddenly the company is paying more taxes and is generating less cash to service the debt. Therefore, debt levels by necessity will have to decrease. Private equity returns will decrease. Private equity may no longer provide its investors with a reward (return) commensurate with its level of risk.

The President wants to simplify the tax code and reduce deductions that corporations can take. In exchange, he will lower the global tax rate to offset some of the higher tax bill that the detailed changes will incur. He has admitted as much.

I approve of the concept of simplifying tax code. But the President needs to be careful about making sweeping changes without understanding all of the resulting effects that such changes will procreate. Not that any of this matters, I guess, as there is no way this iteration of the bill goes anywhere, especially not in an election year…
Note: All opinions contained herein are my own, and not necessarily representative of my employer(s).

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