Obama Takes on the Private Equity Industry
As we all know, corporations are allowed to deduct the interest they pay on loans from their taxable income. This often makes borrowing a more attractive way of raising money than an equity offering. Barack Obama would like to put debt and equity on a more even footing, so he's proposing to reduce the deductibility of interest expenses. Dan Primack digs in:
Obama's basic framework is to lower the corporate rate from 35% to 28%....Private equity firms would uniformly support the lower rate, since it would benefit every one of their portfolio companies. But Obama also wants a reduction in the deductibility of interest payments on corporate debt....And for PE-backed companies with major leverage loads, this is not an even trade-off.
For example, take a look at hospital chain HCA Holdings (HCA), whose private equity sponsors include Bain Capital and Kohlberg Kravis Roberts & Co. (KKR). For 2010, it reported $2.23 billion in income before income taxes, and nearly $2.1 billion in interest expenses. Let's imagine everything else is equal, except that the corporate rate is now 28% and there is no deductibility for interest payments. HCA's tax bill would climb by $587 million ($156m in savings plus $734m in new taxes).
....Obama argues that reducing the deductibility of corporate debt interest "will reduce incentives to overleverage and produce more stable business finances, especially in times of economic stress."....On the other hand, I happen to still believe that private equity is a net positive for the economy — more good than evil — and much of the model is based on this particular tax quirk.
The question, therefore, becomes how big of a reduction to the deductibility is Obama looking for? If he's just looking to reduce the deduction from 100% to 80%, then HCA would actually save money under Obama's plan (again, based only on these two variables — excluding other "lost" deductions). But it would lose money at a 70% deductibility threshold. Wish I could give you an answer on his thinking here, but all I have is a source at Treasury telling me that they haven't yet gotten into that level of detail.
For me, my initial bias would be to go to around 65% or so — thus achieving the goal of reducing leverage while not making the tax hike so onerous as to destroy the profit potential of debt-heavy LBOs. And probably add in an exemption for companies with revenue below a certain level ($20m?), so as not to discourage the creation of capital-intensive small businesses in markets like manufacturing.
I don't have a settled opinion on the goodness vs. evilness of private equity financing. But I do have a bias against the tax code heavily favoring one type of financing over another — not a huge bias, mind you, but still a sizeable one. So if leveraged buyouts make sense only because of quirks of the tax code, they'd have to be enormously beneficial to make it worth supporting those tax quirks. And the evidence suggests to me that it's a close call. Private equity might be a net benefit to society, but not by a whole lot compared to other ways of financing corporate growth and acquisition.
So I'd probably go further than Primack. If a deal makes no financial sense unless Uncle Sam gives you a big writeoff, then maybe it just doesn't make sense. Lowering the writeoff to 50% would still keep moderately leveraged buyouts profitable, but it would probably kill off the most heavily leveraged ones, which are also generally the most destructive. I think I could live with that.