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The new Tax Cuts and Jobs Act should be a shot in the arm for private equity funds and could boost the valuation of deals as companies use their rising cash flow to expand operations.
The reduction in the overall corporate tax rate to 21 percent from 35 percent will benefit companies organized as C corporations. Firms that are organized as pass-through entities — LLCs, partnerships and S Corporations — will also see marginal income taxes decline from about 40 percent to as low as 29.6 percent.
There was only a minimal change to the controversial carried-interest provision: Carried-interest gains from the sale of portfolio companies are now classified as long-term capital gains only if the underlying investment has been held for at least three years. Previously, the holding period requirement for long-term capital gains was one year. That change may impact the decision to buy companies for an extremely short-term turnaround, but since the typical PE fund holds portfolio companies for five to seven years, the change may have limited impact.
Property and Depreciation
New rules for expensing the purchase of property — previously depreciated over a five- or seven-year period — is a huge boon for growing companies. Businesses can immediately deduct 100 percent of the cost of expenditures of qualifying personal property acquired and placed in service between September 27, 2017, and the end of 2022. (The benefit starts to phase out after 2022.)
The change effectively lowers the price of purchasing equipment and applies to both new and used personal property. That’s a huge benefit for capital-intensive industries and could spur investment for growth.
Interest deductibility may be limited under the new law. That will mean that larger companies that are already leveraged will not be able to take advantage of new depreciation rules as much as smaller companies and firms that have less debt.
The new law limits the interest deduction to 30 percent of the business’s adjusted taxable income (effectively, EBITDA) for companies with more than $25 million in average gross receipts. Disallowed interest deductions carry forward indefinitely and can offset future income in years where the company doesn’t hit the 30 percent ceiling.
Private Equity Deals and Leveraged Buyouts
Some fear the interest deduction cap could crimp PE deals. Reuters reports that S&P Global Ratings calculates that nearly 70 percent of firms
with debt of more than five times EBITDA will be hurt by the interest deduction cap. And Moody’s Investors Service estimates one third of all leveraged buyouts will be worse off under the new tax system.
However, there are ways that highly leveraged companies can get around the interest deduction cap, blunting the impact of the change. Instead of funding purchases through debt, firms can structure the ownership of equipment through leases.
There are clawbacks elsewhere in the code. For example, under the new law, manufacturers lose the Domestic Production Activities Deduction under Section 199 of the tax code. That had allowed manufacturers to deduct 9 percent of their income, to encourage production of personal property in the United States.
On balance, the new tax law should favor private equity investment in the coming years. Even before the tax changes, the outlook for 2018 was bright. Now, the new law will favor PE purchases of capital-intensive businesses — from manufacturers, to freight and logistics companies, to health care firms.
Overall, the biggest gains for PE investors from the tax code changes will come from the fact that portfolio companies should now have more cash available to grow earnings and boost valuations, ultimately driving fund valuations higher.
This article was originally published in American City Business Journals
on March 2, 2018.
The EKS&H Transaction Advisory Services team offers more than 25 dedicated professionals with extensive business, industry, tax, and technical expertise. Our CPAs, CFA Charterholders, ASAs, and ABVs have assisted with more than 400 transactions and skillfully utilize technology, tools, and experience to provide greater understanding to all concerned parties. To learn more about out how our tax services can help ensure your next transaction is a success, please contact Brent Hendricks at firstname.lastname@example.org or call us today at 303-740-9400.