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.