Private Equity PErspectives Podcast - Episode 3

February 2018


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Episode 3: Tax Reform Accelerates Private Equity’s Transformation

Todd Kinney: Good morning. This is Todd Kinney. I’m a director in BDO’s national Private Equity Practice. I’m based here in New York City, and I welcome you to this month’s edition of BDO’s Private Equity PErspectives podcast. With me today is Joe Pacello, who is a tax partner at BDO. Joe, thanks for joining us this morning.

Joe Pacello: Thanks, Todd. Good to be here with you today.

Assessing Tax Reform’s Overall Impact [0:45 – 2:13]

Kinney: Yes, good to have you. Let’s jump right into it. BDO’s recently published Private Equity PErspective Survey revealed that 57 percent of fund managers who responded to the survey said that tax reform is the policy issue really having the greatest impact on their strategy.

So, Joe, the question for you is which tax reform provisions do you think will have the most impact on private equity?

Pacello: I want to start by highlighting the provisions that are making the most headlines in the private equity world. So, we’re talking about the corporate tax rate cut. That was definitely a positive, the rate going from 35 percent to 21 percent. On the other hand, you have the limitation of interest expense deductions, which is definitely going to be a negative for the PE industry.

And then you have the change to carried interest treatment, which is slightly negative for private equity and venture capital funds, but it’s not the end of the world. I mean, it imposes higher taxes on gains with respect to investments that are held for less than three years, and as we know private equity funds and venture capital tend to have a longer time horizon than three years. So, we don’t expect that to have a significant impact. I think it’s fair to say the private equity industry dodged a bullet so to speak, especially when you compare the final law with respect to carried interest versus prior proposals over the past 10 years, and private equity certainly fared better than hedge funds in that regard.

How Limits to Interest Rate Deductibility Will Affect Leverage [2:14 – 3:24]

Kinney: Right. Right. Well, I hate to start with the negative, but maybe why don’t we do that since you did highlight the limitation of the interest rate deductibility. Many in the industry are saying that this will force PE firms to really lower the amount of leverage that they’re able to use on deals, which certainly will affect their ROI, which is the real driver. Do you tend to agree with this?

Pacello: Oh, sure. Yeah. Private equity funds tend to use leverage to boost their returns. So, this change will definitely impact the after-tax returns for sure. Deals have been structured historically to address some of the old limitation rules, so-called interest stripping rules, that addressed related party debt. But these new rules are much broader in scope than the interest stripping rules, and now you have limits based on an EBITDA calculation, and then in a few years it goes to EBIT, which is even worse for the industry, and will have a tremendous impact on portfolio companies that are highly leveraged and capital intensive.

The Corporate Tax Cut & Portfolio Companies [3:25 – 4:30]       

Kinney: Okay. Well, maybe let’s highlight one of the more positive topics there, the corporate tax rate cut. Many corporations publicly have obviously celebrated this. We’ve seen raises and bonuses announced in the news, but on the PE side specifically, do you think that this cut will offset the increased expense that’s going to come from the previously discussed limitation on the interest rate deductibility?

Pacello: Well, in general, the interest expense limitations that have been created were intended as a way to pay for, or at least contain, the cost of the corporate tax rate cut, which is a big-ticket item from a budget standpoint. As it relates to PE, it really depends on how highly leveraged the fund is or the portfolio companies underlying the fund. But, in theory at least, I would expect a lower corporate tax rate to enhance the ability of the underlying portfolio companies to pay dividends and otherwise enhance shareholder value.

Offsetting the Limits to Interest Deductibility [4:31– 5:34]

Kinney: Interesting. Are there other tax reform provisions that you think could help offset the impact of this limiting deductibility?

Pacello: Yes. For example, there is more ability now to fully write off capex through accelerated depreciation deductions for property acquisitions. This will be especially helpful for companies that are capital intensive. There’s also an important provision for portfolio companies that are holding a lot of cash overseas through foreign subsidiaries for example. The new tax law allows for the repatriation of that cash and that capital at a much lower tax rate than would otherwise apply, and that could definitely provide some relief. In the short term, there’s going to be a bit of a tax bite as they pay the tax on that repatriated cash. But once again, I would expect that it would free up capital and free up cash for dividends and other business opportunities.

PE Dodges the Carried Interest Bullet [5:35 – 7:06]

Kinney: It’s tough to think of private equity without the topic of carried interest coming up. For decades people have been talking about carried interest and potential tax impacts. I think as you said in your opening remarks, overall private equity is pretty much coming out unscathed and certainly on this topic of carried interest. What are you thinking?

Pacello: Yes. So, under the new law gains from investments that are held for less than three years will be taxed at the ordinary rates, which are higher, generally 37 percent, as opposed to the long-term capital gains rate. But, as we mentioned earlier, private equity firms tend to have a longer time horizon and hold onto investments for more than three years. The average holding period for private equity investments is probably anywhere from four to six years. So, there are no real major concerns here.

It could have been a lot worse like I said. Over the past 10 years there have been a number of provisions that would have been a lot more onerous for private equity funds. One other thing to point out on the positive side is that there’s no impact—based on a plain reading of the new law—on qualified dividends, which are generally eligible for long-term capital gains rate. Also, the new carried interest law does not accelerate income. So, if you have unrealized gains it doesn’t affect the timing of that. It’s just on its actual exit and sale of the position.

How Private Equity Can Adapt to Tax Reform [7:07 – 9:53]

Kinney: Right. That’s a lot to take into account and comprehend, but I’m sure we’ll all get there over time. Not really looking into your crystal ball, Joe, but what advice would you have to PE firms as they really try and adapt to the new tax regime? What are you thinking?

Well, it’s critical to review structures and deals with the tax professionals. It’s important to review things like choice of entity for portfolio companies, for funds, for the management companies as well in light of all these changes that we just highlighted, as well as some new provisions related to deductions for pass-through entities. That will have a big impact on choice of entity—corporation versus pass-through entity.

Also, another item that’s sort of looming large is potential state tax implications. We’re not sure how the states are going to react to all this and there’s a lot of implications there. So, I would say you need to model out transactions and different scenarios, and the good news is that for our clients, BDO has developed a tool in conjunction with our national office to assist clients in that exercise.

Kinney: That’s very interesting. Maybe you could go into that tool a little bit and how at BDO we’re trying to kind of differentiate ourselves there.

Pacello: So, the tool takes into account all the changes and helps clients go through sort of a decision tree on how an entity should be formed. So, the question is: Should it be a pass-through entity? Should it be a partnership? Should it be a C corporation? Should it be an S corporation? And, there are a number of variables depending on the business, the nature of the business, depending on the intention of management. Do they intend to distribute earnings currently or are they in a position to reinvest in the business? In that case, a corporate structure could be more compelling.

But there are also other considerations even if you intend to retain the earnings and not distribute it currently in a C corporation form. In addition to all these new rules that we just highlighted, there are some dusty old rules that really haven’t come up. For example, the accumulated earnings tax and the personal holding company tax. The IRS will probably dust those off and attempt to impose those in situations where they feel that the retained earnings is some sort of abuse to try to get around the double tax. So, it’s just one more consideration amongst many at the federal and state level.

Preparing for the Unknown [9:54 – 11:47]

Kinney: So, looking forward, it seems like there’s still a lot unknown, uncertain, and to be determined. What should we be thinking about with respect to timing and when things will certainly start to firm up a little bit more? Do you have a sense for that?

Pacello: Yeah. Well, the industry is still just getting their arms around the law as it’s written. But we do expect, given the timeline of how quickly and how momentous this law is, that there’s going to need to be some sort of technical corrections, or at a minimum a lot of IRS regulations to kind of fill in the blanks and address some of the unanswered questions. The one thing to keep in mind for technical corrections is the reason that this was able to get enacted so quickly is because they used a budget reconciliation process which allowed the Senate to pass it with only 51 votes. Now, the technical corrections, from what I understand as far as the legislative process, will need a super majority, which means 60. And that’s going to be very difficult to accomplish because I don’t think the Democrats are going to be very cooperative in that regard.

Kinney: Yeah. That doesn’t seem like people are playing nice-nice in the sandbox these days. But hopefully we’ll get our act together. Well, listen that’s a lot of great information. Certainly, won’t be the last time you and I or others are talking about tax reform and the impacts to our clients and contacts, but can’t thank you enough, Joe, for joining us today.

Pacello: Thanks for having me.

Kinney: Yeah, of course. And just in closing, I’d like to invite our listeners to read BDO’s 9th Annual Private Equity PErspective Survey to get a glimpse of PE funds managers’ overall outlook for the asset class. You can find that survey on Thanks, and have a great day.

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