Tax reform has scrambled the deal calculus for corporate buyouts, potentially adding risk to some deals and higher returns to others at a time when private-equity firms are sitting on a record amount of cash they are under pressure to deploy.
The tax bill that passed the House of Representatives and will be taken up by the Senate this week would change the game for buyouts in two important ways. On the negative side, the bills penalize companies that take on lots of debt by reducing their ability to deduct interest payments. That is offset by lower overall corporate tax rates.
If the bills pass with the proposed corporate tax cut—to 20% from 35% in the House bill—intact, the returns on buyouts would likely go up, even after scaling back the interest deduction. Analysts at Goldman Sachs and Morgan Stanley both calculate that the tax overhaul package would have a net positive impact on internal rates of return—the key measure of profitability for private-equity investments—of more than 1 percentage point a year.
But the calculus will be different for each deal. The House bill would cap the amount of interest expenses that companies can deduct from their taxes at 30% of earnings before interest, tax, depreciation and amortization. This presents a challenge to the private-equity playbook of levering up acquired companies to boost returns.
Assuming a 6% cost of debt, a company could lever up to five times Ebitda and still stay under the deduction limit, notes Goldman Sachs analyst Alexander Blostein. Recent leveraged buyouts have typically featured interest rates of around 5% to 7%, and leverage of four to six times Ebitda, says Adam Benson, managing director of the tax practice at consulting firm Alvarez & Marsal.
If rates move higher, more deals would breach the 30% threshold. More important, companies could be caught in a tax vise if Ebitda declined since interest expenses would stay the same, generating a higher tax bill, notes Mr. Benson.
To stay out of the vise, private-equity companies may steer clear highly cyclical companies. Some may focus on small, domestic companies that currently face high tax rates and would benefit most from the overall cuts.
There still could be changes to the tax reform package. The current Senate proposal is less generous, capping the interest deduction at 30% of earnings before interest and tax, but not depreciation and amortization. This would make capital intensive businesses much less attractive to private-equity buyers. With fewer potential targets, the remaining buyout candidates could become more expensive, potentially lowering future returns.
There is some urgency for the firms to figure this out. Private-equity firms in North America were sitting on more than $ 500 billion in dry powder at the end of March, according to research firm Preqin. Meanwhile, there has been just $ 8.3 billion of private-equity-related deals in the U.S. in November, compared with a monthly average of nearly $ 27 billion for the rest of the year, according to Dealogic. Shares of the big listed private-equity firms are down around 4% this month compared with a roughly 1% gain for the S&P 500.
Tax reform may ultimately benefit buyout firms, but they need to adapt quickly.
Write to Aaron Back at firstname.lastname@example.org