Three ways tax reform drives strong PE activity

By Torsdon Poon, Petter Wendel, Gerald Whelan | EY

In the first quarter of 2018, private equity deal activity was up 60% over the same period in 2017, making it the most active first quarter for PE in more than a decade. That activity level is an indirect result of the Tax Cuts and Jobs Act, says Torsdon Poon, EY Americas Transaction Tax Leader.

“The fact that corporate tax rate reductions are helping to create more stability in the market is beneficial,” says Poon. “M&A is driven by certainty and returns. Those are the fundamental elements driving deals. The fact that there is more certainty and stability in the US market will attract investors, whether deals are domestic or whether they are inbound.”

1. PE limitations offset by free cash flow
The lower corporate tax rate has more than offset some lost tax preferences for private equity deals. This includes the need to lower the potential value of net operating losses or adjust to a cap on interest deductions — now limited to 30% of adjusted taxable income. For these reasons, some firms may need to reevaluate their approach to financing leveraged buyouts.

“When you look at the interplay between the rate reduction and the loss or deferral of an interest deduction, usually what you see is that the corporate rate reduction is counteracting the negatives for PE . It oftentimes makes up for the fact that you’re not getting the interest deduction,” says Petter Wendel, Partner, Ernst & Young LLP, and EY Americas PE Tax Leader.

Reducing the top corporate tax rate from 35% to 21% means that nearly any investment will yield additional free cash flow, creating further incentive for deals. The effective new rate for pass-through businesses is 29.6%, which reduces the rate disparity between corporate and flow-through structures and makes choosing a legal entity (LLC, C-corp, etc.) at the portfolio company level a bit more complicated.

“There was so much cash that was already in the market because of low interest rates. And now you have the stimulus effect, late in the business cycle, of lower corporate rates,” says Gerald Whelan, Tax Principal, Ernst & Young LLP. “That is going to be the biggest driver across the board of M&A, for corporate and private equity. Maybe you do more add-on acquisitions; maybe you do consolidation deals in the private equity space, where you set up or buy a platform in a fractured industry and then you do a bunch of roll-up transactions. Now it’s easier to do that because of free cash flow.”

2. Capital expense write-downs
Another area of the tax law that could drive PE spending — and economic growth — is capital expense depreciation. Under the new law, qualified tangible property acquired and put in use between September 2017 and January 2023 is fully deductible. That deductibility then phases out through 2026.

Industries like manufacturing or trucking, which are rich in tangible assets, are now offered an immediate tax incentive for spending in the short term, making them more attractive to PE backers.

“For example, our PE clients with manufacturing companies, their machinery and equipment generally would be depreciated or amortized over a seven- to 10-year recovery period. Now, with this post-tax reform, those portfolio companies can expense all of this,” Whelan says. “So, essentially, this is like bonus depreciation magnified.”

3. Onshore of cross-border deals
Regardless of industry, the 21% corporate tax rate makes the United States far more appealing to foreign investors. The country now has a lower corporate income tax rate than the G20 average for the first time in more than 20 years. That will likely increase inbound investment in US companies, Poon says. “The US is more attractive now,” he says. “You’ve taken off the table uncertainty and ambiguity around tax reform within the United States. Regulatory reform is still ambiguous at this point, but at least tax reform is off the table and people have certainty in the rates, and they’re lower rates.”

The competitiveness of the US rate is also changing the way that PE firms consider and structure cross-border deals. While in the past the goal was to keep the parent company based outside the United States or move assets offshore, having an American company at the top is now a viable option.

“Now, we don’t have a worldwide system; we have this quasi-territorial system with a much more competitive rate,” Whelan says. “So going forward, I think the base case for every deal is: ‘Tell me why it doesn’t make sense to do everything onshore, and have a US top company.’”

How EY can help
With the recent changes to corporate taxation and pass-through entities, private equity must consider which investment form and capital structure provides the best tax and operational efficiency for target companies.

EY teams work with private equity funds to understand the changes resulting from tax reform and its impact to existing and prospective portfolio investments. This includes transaction leverage and the interplay of new tax laws to evaluate leverage buyouts, bespoke models, assumptions around key inputs or specific fact patterns.

Our global network of tax advisers can help clients mitigate transaction risk, enhance opportunity and provide crucial negotiation insights.

Compliments of EY, a member of the EACCNY