Biden’s Tax Blitz: Private Equity’s Downward Trend

Private equity (PE) activity over the past few years has exploded as the size and frequency of deals have grown. It is an alternative asset class that invests directly into private firms and public company buyouts, benefiting from two key ingredients to generate high returns: more debt and lower taxes. Due to lower interest rates, cheaper debt helps acquire larger and more established firms, whereas lower taxes help PE funds retain free cash flow (FCF) to pay down the debt and thus generate returns. That being said, following the Senate's finalization, it seems likely that the industry will be left reminiscing about the significantly lowered tax environment brought on by the Trump administration. Recently, Georgia's movement to win both of the U.S. Senate runoff elections has paid off, resulting in a 50-50 split. Since Vice President Kamala Harris holds the final tie-breaking vote, Democrats now have control of the chambers and are able to hike all forms of taxes. This is primarily negative news for the PE industry, as President Joe Biden looks to reverse the benefits provided by former President Donald Trump. 

In private equity, tax is segmented into the corporate and capital gains rates. The corporate rate cuts into the FCFs of the target company, whereas capital gains are a tax on the sale of an asset such as stock. In 2017, Trump signed the Tax Cuts and Jobs Act, which immensely cut corporate taxes from 35% to 21%. This act allowed PE players to relish higher FCF, more debt, and many additional loopholes. A second-term win for Trump would have most likely led to a cut in the capital gains tax from the 20% maximum to 15% for high-income individuals. Instead, President Biden aims to draw back these cuts and provide government funding through a hike in corporate taxes to 28%. Furthermore, he looks to increase the capital gains rate to the newly bumped income rates; this implies that individuals earning above $400,000 a year will have both their capital gains and income now taxed at a whopping 39.6% compared to the original 20% and 37%, respectively. 

A rise in the capital gains tax rate will significantly impact profits for PE managers, as they tend to collect large rewards in the form of carried interest. Carried interest is essentially a share of the fund's profits that managers receive, taxed at the capital gains rate. However, since Biden plans to amalgamate the capital gains rate with the newly hiked income rate, most high-income fund managers will have both their carried interest rewards and income taxed at 39.6%. Buyout firm managers will take the largest hit, as they usually receive the most carried interest from leveraged buyout returns. 

Not only will returns suffer, but the tax changes will also reduce the ability to exit investment by selling or going public.This is primarily because many large shareholders and executives of companies are paid in stock. Accordingly, increased capital gains would make those shareholders and management cores less willing to sell. As exit multiples become inflated to compensate for higher taxes, clients will be less willing to purchase those companies, significantly affecting the primary revenue driver in buyout private equity. Consequently, this will not only further worsen fund manager profits through less carried interest, but all U.S. PE firms' returns and their respective portfolio companies' FCFs as a whole. 

Presently, the U.S. private equity industry continues to face a steep downturn with exits hitting a 10-year low at the end of 2020. According to Bain & Company, this decline is mainly due to higher private equity returns than public equity returns, leading to increasing company purchase price multiples. If President Biden's plans come to fruition, the increased corporate rate would further diminish growth throughout the new year, leading to a decrease in free cash flow and further exacerbating the capacity to exit. When former President Obama proposed to abolish the carried interest loophole for 2011, the PE industry rushed to use their loopholes one last time, causing deal activity to rise 34% in Q4 of 2010. Similarly, many firms executed last-minute deals before the start of 2021 – leading to a 17% rise in deal volume and 33% rise in deal value in the last three months – and will most likely continue until legislation come into effect by the end of 2021. For instance, Stonepeak Infrastructure Partners acquired Astound Broadband, the sixth-largest U.S. cable operator, for $8.1 billion from TPG Capital in a mega PE deal. Fund managers have recognized the Biden administration’s vision to retroactively raise corporate and capital gains taxes for all of 2021 and have seized the opportunity for one last deal with lower taxes before the new year begins. 

However, despite the harsh tax implications, a unified government can provide some upside for the industry. According to eFront, a financial research company owned by Blackrock, a blue senate alone may scar PE players. However, when combined with a blue administration, a blue senate has historically resulted in a 4.9% average quarterly internal rate of return. On the other hand, divided government has historically provided a 3.2% average quarterly return. The study, which inspects the effect of political situations on U.S. private equity returns, also reports that a healthier and more unified political climate spurs greater optimism for investments and capital raises. This logic stems from investors strongly valuing higher economic certainty, which ultimately results in less risk and higher company valuations. As taxes look to cripple the PE space, a more unified America may be the panacea to this internal crisis.

The pandemic continues to scathe sectors across the board on a large scale, filling private equity with uncertainty. With the continued rise in cases of Covid-19 and the appearance of new strains, lenders have become more strict when financing private equity-backed deals, ultimately threatening the industry's primary ingredient in amplifying returns: debt. As the horizon looks bleak for these two essential components, PE firms will need to gamble that Biden keeps his promises of unity in his recent inauguration speech: only then can these players begin to hope for a resurgence in their industry.

Note: All figures in USD unless stated otherwise