In the political cacophony surrounding America’s new tax law, the voice of the private-equity industry has been muted. This is perhaps unsurprising. The industry has managed in large measure to retain its favourable tax treatment, despite a threat from President Donald Trump to close the “carried interest” loophole on which it had grown fat.
Tax has always been central to private-equity business models. The industry uses large amounts of debt, interest on which is tax-deductible, to acquire companies. So it has long been adept at minimising tax, both by making full use of deductions, and through the careful choice of corporate structure. Historically, private-equity firms have been partnerships, also known as “pass-throughs”, because profits pass through them untaxed (to beneficiaries who then pay income tax). Indeed, carried interest, whereby private-equity firms’ profits are taxed at the rate imposed on capital gains, rather than that on income, only applies to partnerships. But the firms that private equity acquires (“portfolio companies”) have been a mix of partnerships and C corporations.
The new law upsets some of these arrangements. The reform restricts carried-interest rules to assets held for more than three years. It limits deductions for losses. And it caps interest deductibility at 30% of gross earnings, making debt less attractive.
But the windfalls are bigger. The law, for instance, allows generous deductions for capital expenditure and foreign dividends. And, most important, the headline corporate-tax rate is lowered from 35% to 21%. This alone should raise the value of American portfolio companies by 3-17%, reckons Hamilton Lane, an investment firm.
Becoming a corporation therefore suddenly looks more attractive. For the largest, publicly listed private-equity firms, the main motive is valuation. Shares of partnerships are excluded from financial-market indices; holders of such shares also face onerous tax-reporting requirements. That reduces investor demand, so their shares trade at a stiff discount to those of similar firms that are C corporations. Analysts at Credit Suisse reckon conversion could raise valuations by up to 60%, more than compensating for those firms’ new corporate tax bill. The move would make particular sense for firms such as Ares and KKR, which already earn a large proportion of revenue in management fees rather than in carried interest. Other large firms, such as Blackstone and Carlyle, have played down the prospect of converting.
The vast majority of private-equity firms, however, are privately held partnerships. For them conversion may make sense only where state and local income taxes are high, says Robert Phillpott of Baker Botts, a law firm. New deductions, however, make the conversion of the funds those firms run more attractive, especially ones meant mainly for (tax-exempt) institutional or foreign investors.
But the case for conversion is most compelling for some of the portfolio companies in those funds. That does not apply to those that qualify for a new 20% deduction for pass-throughs, which excludes professional-services firms and favours job-rich, capital-intensive industries over capital-light and job-poor ones. For those that do not, however, an end-investor in private equity would already face a slightly lower effective tax rate if portfolio companies were structured as corporations rather than partnerships. In industries where it makes sense to reinvest retained earnings, the gap is much greater still. A corporation can reinvest after paying 21% on its profits, whereas the beneficiaries of a partnership would have to pay the full effective income-tax rate of around 40% before putting any of that money back in.
Of course, conversion does entail some risks. As Keith Mannor of BDO, an accounting firm, points out, the new corporate-tax rate is “only as ‘permanent’ as Congress and the presidency”. Converting a partnership into a corporation is easy and basically free; converting back requires paying one-off corporate tax on the entire value of the enterprise, at whatever tax rate is in place at the time. Even so, many private-equity firms are sure to change their tune and opt for some form of variation in C.
(The Economist)
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