December 21, 2017 / 12:01 PM / 6 months ago

U.S. tax curbs on debt deduction to sting buyout barons

* Tax bill caps interest deductible in blow for private equity

* Makes it harder for private equity firms to compete for deals

* Lobbyists succeed in keeping tax treatment on performance fees

By Joshua Franklin

Dec 21 (Reuters) - As corporate America celebrates one of the biggest-ever cuts to its tax bill, one corner of Wall Street is fretting over the impact the reforms will have on its ability to profitably invest in companies.

Private equity firms that buy companies only to sell them a few years later at a profit face restrictions on their ability to deduct the interest these companies pay on their debt from their taxes, according to legislation approved on Wednesday by U.S. lawmakers and set to be signed into law by President Donald Trump.

The changes are a blow to the industry's business model of larding companies with debt to juice returns. They could make it more difficult and less profitable for buyout firms to outbid competitors for companies, industry executives said.

"It's a deviation from what has been allowed in the last 50 years," said David Fann, chief executive of TorreyCove Capital Partners LLC, a private equity advisory firm.

"This is a radical change. In fact, the buyout business would have never evolved without the benefits of leverage."

The rules also show the limits of the industry's influence in Washington, despite efforts by executives such as Blackstone Group LP Chief Executive Stephen Schwarzman to cultivate Trump and his Republican party.

Companies that were previously unrestricted in the amount of interest they could deduct now face a cap for the next four years of 30 percent of their 12-month earnings before interest, taxes, depreciation and amortization (EBITDA).

After 2021, the cap becomes even more constrictive by switching to 30 percent of 12-month earnings before interest and tax (EBIT).

HEAVILY INDEBTED COMPANIES TO TAKE A HIT

S&P Global Ratings estimates that nearly 70 percent of companies whose debt amounts to more five times EBITDA would be negatively impacted by the interest deductibility cap. This casts a wide net, given that private equity firms, on average, saddle companies with more debt than that, according to Cambridge Associates.

Around a third of all leveraged buyouts are expected to be worse off under the new tax system, according to Moody's Investors Service Inc.

Using excessive borrowing as a yardstick, health publisher WebMD, software provider LANDESK and auto accessory seller Truck Hero are among those that could take a hit from the interest expense deductibility cap. All these companies are indebted at well above five times EBITDA, according to Thomson Reuters LPC data.

WebMD owner KKR & Co LP, and Truck Hero owner CCMP declined to comment on the impact of the cap on their companies and whether other aspects of the tax code overhaul could offset it.

A representative for LANDESK owner Clearlake Capital did not immediately respond to a request for comment.

While the tax rates of private equity-owned companies will decrease alongside all other U.S. companies, the changes could hasten the demise of those struggling with their debt piles, Moody's said last week.

This means that bankruptcies of heavily indebted private equity-owned companies, such as that of U.S. retailer Toys "R" Us in September, could come more quickly and become more difficult to escape.

"Defaults for lower-rated (credit) issuers could increase in a downturn," Moody's analysts wrote in a note.

That could discourage private equity firms from overburdening companies with debt, but also erode returns by pushing them to stump up more of their cash as equity to fund acquisitions.

Given publicly traded companies that are not as indebted will have more cash under the new tax system to make rival offers for assets, the changes could make leveraged buyouts harder to complete on attractive terms, investment bankers said.

"The valuation challenge that private equity firms are facing in considering new investments may become exacerbated in 2018," said Gary Posternack, global head of M&A at Barclays Plc .

"Companies with the same P/E ratio but with lower tax rates may see EBITDA multiples go up, making the economics more challenging for private equity firms," Posternack added.

FLEXIBILITY

To be sure, the new rules offer some flexibility. They allow companies to deduct interest payments above the 30 percent cap to the extent they did not reach that limit in the previous years.

And the benefits from a tax rate cut to 21 percent from 35 percent and full upfront capital expenditure deductibility outweigh the cost of the curbs on interest deductibility for the majority of private equity-owned companies.

Given that private equity fund managers have also largely been spared a much-feared tax hike on their performance fees, known as carried interest, the American Investment Council (AIC), the industry's lobby group, has put on a brave face.

"On balance, the tax bill represents a net positive for private equity and will enable the industry to continue to make long-term investments that will grow the economy," AIC President and CEO Mike Sommers said in a statement.

The impact of the new tax system will also vary across sectors.

Those with high leverage and significant leveraged buyout activity, such as technology, healthcare and aerospace and defence, have the highest percentage of companies worse off, according to Moody's.

"As cash flow scenarios and interest rates fluctuate, those (interest expense deductibility) caps could start to make leveraged deals harder," said Larry Grafstein, UBS's co-head of M&A in the Americas.

See graphic tmsnrt.rs/2AZlrZf

Reporting by Joshua Franklin in New York; Additional reporting by Andrew Berlin in New York; Editing by Greg Roumeliotis and Meredith Mazzilli

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