The Impact of Tax Reform on Private Equity

Over the last five decades, institutional investors have increasingly relied on private equity (PE) funds to diversify their portfolios. As a result, the success of PE firms, which buy and sell companies to generate financial returns, is now inextricably linked to retirement savings for working professionals, an insurance company’s ability to pay out claims, and a university’s capacity to engage in cutting-edge research. However, a PE firm’s ability to generate financial returns may change in light of the recently enacted Tax Cuts and Jobs Act, which will reduce the profit they can generate through leverage, otherwise known as the use of borrowed funds, and increase competition with strategic buyers.

While the U.S. tax code previously allowed businesses to completely deduct interest expense “in the taxable year in which it [was] paid or accrued,” the Tax Cuts and Jobs Act only allows businesses with average gross receipts of greater than $25 million to deduct interest expense up to 30% of their adjusted taxable income. PE firms have historically used large amounts of debt to acquire target firms, because debt payments are tax deductible but dividends are not, rendering debt the cheaper source of funding. So, by limiting the allowable percentage of interest expense, the U.S. government has now increased the relative cost of debt for PE firms, effectively limiting access to inexpensive funding that can be used to invest in target firms.

In the market for firms, acquirers tend to fall in one of two categories: strategic or financial buyers. Strategic buyers tend to buy firms that will allow them to extend their current business, diversify into related product markets, or expand into new geographies, while financial buyers seek to create value primarily through financial tools such as the use of leverage. PE firms are financial buyers that are incentivized to maximize profits. So, as a PE firm's expected returns decrease, the price it is willing to pay for a target firm will decrease accordingly. Since the new tax code limits the returns that PE firms can realize through acquisitions, they will bid less for target firms, thereby increasing the the likelihood that they are outbid by strategic buyers.

Furthermore, given that the Tax Cuts and Jobs Act reduces the corporate tax rate from 35% to 21%, strategic buyers are likely to be even more formidable opponents in the market for firms, as a result of a larger war chest from which they can initiate acquisitions. If PE firms systematically lose out on deals to strategic buyers, they will face increased pressure from their limited partners to complete deals and deliver attractive returns. This spells trouble, since this pressure may lead PE firms to overpay for potential targets or purchase firms that they do not have the expertise to manage.

Research from INSEAD, a world-renowned French business school, indicates that 51% of the value created by PE firms in the 1980s was derived through leverage, as opposed to just 18% coming from improvements in operating performance derived through revenue enhancements or cost reduction. Today, they estimate that upwards of 50% of value created by PE firms is generated from improvements in operating performance alone, with less than 20% attributed to the use of leverage. The Tax Cuts and Jobs Act will only serve to accelerate this trend, because the U.S. government has now imposed a limit on the profit PE firms can derive through purchasing target firms with significant amounts of debt.

PE firms can no longer afford to focus exclusively profit generated through the use of leverage. Instead, they will have to focus on creating value by improving the operating performance of portfolio companies. This strategic shift will require PE firms to develop and maintain “in-house teams of operations specialists” by acquiring talent from “industry or from strategic and operations-focused consulting firms.”

Though this shift may be disruptive, it will allow these professionals to forge positive relationships with target company managers, because of their shared background in strategic decision-making processes. These relationships will allow PE firms to develop new strategic plans with buy-in from employees at all levels of portfolio companies, implement specific rules of engagement, and introduce the significant policy changes necessary to increase the value of portfolio firms, ultimately helping to provide institutional investors of all types with an acceptable return on investment.

The recent tax reform will not be good for PE. But looking forward, it is clear that strengthening operations teams and establishing core competencies in process engineering, identifying talented managers, and aligning the interests of owners and managers will serve as the basis for a sustainable competitive advantage in the rapidly changing PE industry.