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Credit strategies in crosshairs of tax reform effort

Leveraged deals could fall by the wayside; investments favoring equity likely to rule

Gregory Stento thinks investors won’t be hurt if interest rates remain relatively low.

One of the unintended consequences of the tax bills being shaped into law by Congress could make some credit strategies passe and turn the spotlight on others.

Both the Senate and House bills have provisions regarding the interest expense deductibility for corporations that could make leveraged transactions — including leveraged buyouts — less attractive, industry insiders say. While the proposals differ somewhat, both would limit the deductibility of interest paid on debt. Currently, businesses can deduct all interest paid on debt, whether it comes from issuing corporate bonds or taking out loans.

These potential tax law changes come at a time when general partners are sitting on $205 billion in dry powder, according to statistics from London-based alternative investment research firm Preqin.

"The winners under this tax proposal are those private equity investment strategies that are biased toward using preferred and common equity," said David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC. "The proposed tax bills create negative consequences for credit strategies such as high-yield bonds, second-lien loans, mezzanine and subordinated debt — since the greatest degree of interest expense deductibility is associated with those approaches."

Because the interest expense associated with these sectors won't be tax deductible, the strategies would be less attractive for potential portfolio companies and investors, Mr. Fann explained.

What's more, corporations are likely to favor fixed-rate vs. floating-rate debt to insulate ​ against interest rate hikes; the strategies offered by credit managers are mainly floating rate, other industry executives said.

While many limited partners are tax-exempt, the final tax package could have an impact for general partners, said Gregory Stento, Boston-based managing director at alternative investment firm HarbourVest Partners LLC.

This impact could be worse for the losing strategies should interest rates rise. However, for many investors, interest rate increases are not a big concern.

"Right now, the cost of interest is so low, things (interest rates) would have to change very meaningfully to have an impact," Mr. Stento said. "If interest rates get back up to where they were in the 1980s, it would be a different scenario."

The private equity and private credit industry has been lobbying against the changes. The American Investment Council, a Washington-based private equity trade group, has been advocating for no change to the current practice of full interest deductibility, said Laura Christof, AIC spokeswoman.

"Interest deductibility is definitely a priority for our entire industry," Ms. Christof said. The AIC does not yet have data on how the industry will be affected, she added.

Different proposals

The House and Senate bills have different proposals for limiting deductibility. The House version limits expensing the interest to 30% of earnings before interest taxes, depreciation and amortization. The Senate version limits the expense to 30% of earnings before interest and taxes.

"We think the House version (with the 30% EBITDA limitation) is a better compromise than the Senate version," Ms. Christof said. "The Senate version would put the U.S. at a competitive disadvantage vis--vis competitor jurisdictions around the world (like Germany) that have a 30% EBITDA limitation on deductibility. EBITDA is a globally accepted way to calculate taxable income, as it accounts for the non-cash expenses of depreciation and amortization."

Tod Trabocco, managing director and head of private credit at Cambridge Associates LLC, Boston, said there are trade-offs in the proposed tax deals. He pointed to the lower corporate tax rate and a possible immediate write-off for the entire value of a depreciating asset as potentially offsetting the higher cost of capital stemming from a limit on interest deductibility.

Direct lending strategies that mainly provide loans for private equity-backed LBOs make up the majority of credit strategies, he explained. Because of the amount of dry powder, among other reasons, lenders likely would be willing to accommodate their clients by structuring deals to limit the cash portion to less than 30%, while taking the rest of the loans as payment in kind. That kind of structure could limit or eliminate the adverse tax consequences of the limited interest deductibility, Mr. Trabocco said.

While managers are fighting the deductibility issue, the Institutional Limited Partners Association, Washington, which represents private equity investors, has been focusing on other issues.

"Of the many different provisions in the House and Senate versions of the tax legislation, (the) ILPA is currently focused on the threat of subjecting public pension funds to the unrelated business income tax," said Chris Hayes, director, industry affairs. "This specific area is one where we have been asked by our members to share our collective concerns."

The Senate version does not include the UBIT provision "and we will continue to urge Congress to keep it out of any final legislation," he noted.

The American Investment Council is not alone in encouraging Congress to keep the interest deductibility provisions in the current tax code. AIC is part of a broader coalition of businesses and trade organizations that oppose limiting business interest deductions with Businesses United for Interest and Loan Deductibility, or BUILD Coalition. Members include the National Association of Real Estate Investment Trusts, S&P Global and the Association for Corporate Growth.

"The loss of interest deductibility would make borrowing more expensive for the majority of businesses, both large and small, that rely on credit to fund new investments or meet operating costs," BUILD Coalition states on its website. The group maintains the loss of interest deductibility would raise companies' cost of capital to open a new plant or store, invest in new technologies and manage day-to-day finances.

"Even if revenue from this new tax is used to finance lower tax rates, the end result is higher net costs to businesses," the group asserts.

Preferred stock appeal

One beneficiary of proposed tax changes will be preferred stock investors because the asset will be more appealing than debt, TorreyCove's Mr. Fann said. "Preferred stock and common financings will no longer be viewed as more expensive than risky credit strategies such as high yield or subdebt financings on an after-tax basis."

Private credit and private equity are not the only alternative investment asset classes potentially affected by the tax bills. The proposals have left murky areas that could hurt certain corners of the real estate industry, even though the bills exempt real estate companies from the interest deductibility limits, said Lev Shoykhet, New York-based managing director and head of tax services at Citco Fund Services, a fund administration business.

"Legislators understand the importance of debt financing in real estate markets; therefore, there is a specific exception for real estate," Mr. Shoykhet said in an email.

However, there is uncertainty on mixed business like hotels, he said. If a business engages in both real estate and other businesses, there are questions on how the business would be required to allocate or apportion the interest expense, he said.

"We can see that industry participants will be looking at further guidance from the (IRS) and will consider restructuring certain entities where real estate activity will be tainted," he said.