Why this is a fight that should be picked

As US Congress gets ready to reform the tax code, private credit and private equity firms will square off with elected leaders over a tax deduction that is crucial to both asset classes.

Andrew Hedlund, Americas editor, Private Debt Investor

There was bad news and good news last week for private credit firms when the US House Republicans’ tax plan came out. The bad news was the draft of the bill contained a cap on business interest deductibility at 30 percent of a firm’s taxable income. The good news of the proposal was that it was just that – a proposal.

Currently, interest expenses are fully deductible through the US tax code. The suggested limit could change how private equity firms finance their deals, which, of course, often use debt as a majority of the financing, many times from alternative lenders.

The fate of private credit and private equity are, to a degree, inseparable. While some credit shops do deals both with and without a financial sponsor, there are a good number that focus heavily or exclusively on transactions involving private equity-backed companies.

“It amounts to both the introduction of a new business tax and an increase in the cost of capital,” American Investment Council chief executive officer Mike Sommers wrote in our sister publication Private Equity International. “For private equity, it would constrict portfolio companies in a downturn; the time in which the deduction is needed the most.”

In a worst-case scenario, it could slow the number of entrants to the asset class, as private equity firms have been some of the most enthusiastic proponents of private credit’s prospects and many have launched new business units in the field.

Our conversations with private equity managers doing this often come back to the argument that they can potentially siphon off some deal flow for private debt from their private equity pipeline. If the deal structure changes drastically, in a way involving fewer loans, all of a sudden the number of transactions could drop, or at least the amount of capital in each deal.

This is all assuming an interest deductibility cap will make it into the final bill. While the private capital industry’s pleading may not fall upon deaf ears, there is a populist sentiment afoot in which private fund managers are often vilified. But don’t expect the industry to go quietly into the night.

In the era of its last big legislative battles, the Dodd-Frank Act and other legislation stemming from the global financial crisis, private equity and other private investment firms poured $64 million into lobbying between 2007 and 2010, with a high-water mark in 2009 of $16.57 million, according to the Center for Responsive Politics, which tracks money in politics. This year, private fund managers have spent $6.14 million on lobbying so far.

The tax reform proposal has yet to reach the Senate, and of course both legislative chambers must pass a bill and iron out any differences between them. So it’s a long way to the finish line for Republicans and, given their track record of legislative success, passage is by no means imminent. But that a cap on interest deductibility made it into an initial draft should give private credit firms pause.

The author of this piece may be contacted at andrew.h@peimedia.com.