- House approves tax bill
- Fate of Senate version uncertain
- Leveraged companies face squeeze
By David M. Toll and Sam Sutton
The House and Senate tax-reform bills would likely mean higher tax payouts for a significant number of portfolio companies, and those experiencing down years could find themselves badly squeezed, according to an analysis by Chicago investment bank Lincoln International. Large public companies, by contrast, would mainly benefit.
Under the House bill passed today, companies would be able to deduct interest payments only equal to 30 percent or less of their earnings before interest, taxes, depreciation and amortization (EBITDA). Amounts exceeding that total could only be carried forward for the next five years.
For example, if a company earns $100 and owes $40 of interest one year, it could deduct $30 in the first year. The extra $10 it paid in interest expenses can then be deducted at some point over the next five years (assuming the subsequent interest payments don’t exceed that 30 percent cap).
Senate: less-favorable basis
The Senate proposal, which faces opposition from prominent Republicans like Ron Johnson of Wisconsin and possibly Susan Collins of Maine, uses a less-favorable calculation for taxable earnings: EBIT, as opposed to EBITDA. But it allows for an indefinite carry-forward period for interest expenses in excess of 30 percent.
“Both proposals are limiting interest expense to 30 percent of ‘adjusted taxable income,’” Keith Mannor of BDO USA wrote Buyouts in an email. “The Senate proposal is slightly more ‘PE friendly’ given that they are proposing an indefinite carry-forward period for any disallowed interest expense. In comparison the House proposal would allow only a five year carry-forward period for disallowed interest expense.”
However, because the Senate calculates taxable earnings using EBIT, businesses that rely on depreciation or amortization deductions — such as oil-and-gas companies — could feel squeezed, said Rafael Kariyev of Debevoise & Plimpton.
“The fight’s going to be around whether you have add-backs around depreciation and amortization. And I’d hope the House is winning on that point, frankly,” Kariyev said.
Looking at a population of 561 U.S. sponsor-backed companies for which it provides valuation services, Lincoln International found that nearly three-quarters (74 percent) made third-quarter interest payments of 30 percent of EBITDA or more. Nearly a third (30 percent) made payments of 65 percent of EBITDA or more. The median company made interest payments that totaled 45 percent of EBITDA; under the House bill, median companies would be unable to deduct a third of their interest payments.
The companies included in the analysis generated median EBITDA of just over $24 million and have an average enterprise value in the range of $170 million to $180 million. Lincoln International left companies with negative EBITDA out of its analysis, along with specialty-finance companies and special-purpose entities.
Applying a similar analysis to companies in the S&P 500, Lincoln International found that they would not be nearly as affected by the 30 percent cap. The median S&P 500 company in Q3 made interest payments of just 11 percent of EBITDA, according to the analysis. Only 3 percent of companies in the S&P 500 made interest payments that cleared 30 percent of EBITDA.
All that said, whether portfolio companies would pay more or less in taxes overall under the House bill than they do today is a complicated question. Take a typical $10-million EBITDA company paying $4.5 million in interest per year. Assuming no amortization and depreciation costs, the company’s tax bill would go down under the House bill given the proposed drop in the corporate tax rate to 20 percent from 35 percent. By contrast, were the same company paying $6.5 million in interest per year (not unusual, according to Lincoln International’s analysis), its tax bill would go up.
Squeezing portfolio companies
Under some scenarios portfolio companies would fare even worse. Should interest rates rise, causing interest expenses to spike, many would face higher tax bills than they pay under the current system since their ability to deduct interest expense would be capped. Highly leveraged companies experiencing a downturn in earnings (and thus lowering the deduction cap in absolute dollars) would also pay higher tax bills at the time they need to preserve cash the most.
Said Larry Levine, managing director of Lincoln International: “As their financial performance falters, they get more and more squeezed.”
“One thing to think about is that each portfolio company is situated differently,” said Jason Mulvihill, general counsel for the PE industry’s lobbying organization, American Investment Council. “It’s hard to generalize. But I think the overarching concern is that you want to make sure the companies will be able to strengthen and expand, and interest deductibility has allowed that to happen.”
The Senate limits the deductibility of interest as well, of course, putting a giant question mark next to the future of— one of private equity’s most important tools.
“The best possible result would be to negotiate the greatest possible deduction of debt, moving forward,” Mulvihill added. “There are certainly a lot of risks with starting to limit it in any way.”
Action Item: Read the full text of the House bill at https://goo.gl/rU9unC
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