In a move that surprised many on Wall Street, the Republican tax plan will undermine the leveraged buyout model so popular with private equity firms. In a leveraged buyout, a private equity fund contributes a small amount of cash to acquire a target company and borrows the rest. Beginning in 2018, deductions for business interest payments that exceed 30 percent of adjusted taxable income will no longer be allowed. This change to the tax code will take a bite out of the bottom line of heavily leveraged Main Street companies owned by private equity firms and will reduce the incentives of these firms to overload the companies in their portfolios with debt. This is a curious development considering the lobbying effort to defeat this provision and the large number of PE big shots in positions of influence in the Trump administration. However, private equity need not fret too much, the corporate income tax rate has been reduced from 35 percent to 21 percent.
Using excessive amounts of debt to acquire companies for their portfolios has been a key feature of private equity’s leveraged buyout model since its emergence in 1979. When PE takes over a company, it replaces the company’s equity with debt, immediately raising the company’s value simply because the tax deduction for interest payments increases its after-tax earnings; no operational improvement or enhanced performance is necessary. The effect this has on an acquired company’s taxes can be dramatic. In a $25 billion deal, made famous in the book Barbarians at the Gate, KKR took publicly traded RJR Nabisco private in 1988. The high leverage used in this buyout reduced Nabisco’s tax bill by an estimated $1 billion a year, and increased its after-tax income by a similar amount.
The benefits of loading the company with debt enrich the PE firm. The burden of repaying the debt, however, falls squarely on the company, as do the increased risks of financial distress. With the benefits going to the PE firm and any losses shouldered by the acquired company, the tax code provides private equity firms with a strong incentive to overload these companies with debt.
Debt boosts the winnings of the company’s PE owners. But it may be a different story for the company and its workers. A large debt burden limits a company’s ability to respond to a change in business conditions and increases its risk of default, bankruptcy, or even liquidation. In the 2008–09 financial crisis a large number of highly leveraged companies was unable to make debt payments; many defaulted on their loans. Some, like Sun Capital Partner’s Friendly’s family restaurant and ice cream chain, became bankrupt. Cerberus Capital Management’s NewPage Corporation, a major glossy magazine paper manufacturer, was the largest bankruptcy of 2011. Others, like Mervyn’s Department Stores and Linens ‘n Things, closed their stores for good.
Today, private equity ownership is a common feature of the rash of retail bankruptcies. The ability of brick and mortar chains to respond to the challenges of e-commerce is severely impaired by the high debt loads burdening PE-owned retailers. Nearly three-quarters of major retailers that declared bankruptcy by mid-2017 were carrying high levels of debt, mostly as a result of an earlier PE buyout. Sports Authority, Radio Shack, and clothing retailers like The Limited, Wet Seal and Gymboree have closed their doors for good, shuttering stores and laying off workers. Others, like Payless Shoe Source, Toys ‘R Us, Aeropostale, Staples, and Eastern Mountain Sports have declared bankruptcy, downsizing stores and workers but continuing to operate. Still others, like Claire’s, Nine West and J. Crew, are struggling to restructure their debts. Tens of thousands of workers have lost their jobs. Malls have lost their anchor stores.
Changes in the new tax plan reduce the tax benefits of debt in two ways. First, companies that previously could deduct 100 percent of interest payments will, in the future, not be allowed to deduct interest payments in excess of 30 percent of adjusted income. Second, with the corporate income tax rate at 35 percent, an interest payment of $1,000 would have resulted in a tax saving of $350. With the tax rate at 21 percent in the proposed tax code, the same $1,000 interest payment will reduce a company’s taxes by $200.
It is still unclear how the combination of tax changes in the Republicans’ plan will affect the after-tax earnings of portfolio companies and the returns received by their PE–owners. What is clear, however, is that the tax code changes will reduce the incentives of PE–owners to overload the companies they own with debt. This is a significant step; excessive debt increases the risk of financial distress during challenging times. Highly leveraged companies may have to shut down some operations and lay off workers in order to generate liquidity to service their debts, or even file for bankruptcy. Limiting leverage reduces this risk and improves economic stability to the advantage of Main Street companies, the communities they serve, and employees.