A proposal put forward to the US Congress to change the way private equity deals are categorised for tax purposes may reduce the flow of private equity money originating from America and, in turn, increase the risk associated with these projects, according to a senior executive of a global fund manager.
The recommended changes involve defining private equity arrangements going forward as general corporations rather than partnerships, which means the capital gains tax levied on these projects will be 34 per cent instead of the current 15 per cent.
Putnam Investments head of investments Kevin Cronin said: “If you think about that 20 per cent differential in taxes, that has significant implications for the amount of deals you want to do and how you want to do them.”
According to Cronin, most parties involved in private equity transactions are looking to recoup a targeted internal rate of return, and the new level of capital gains tax that is likely to confront them will lower these internal rates of return in general and, as a consequence, make some deals less likely to happen.
Cronin also believes the new tax laws may have the effect of increasing the amount of leverage incorporated in private equity deals, which means they will be done with a heightened level of risk.
“We have seen a general increase in the amount of leverage that some of these private equity firms have put on companies that they buy in terms of leverage to earnings before interest, tax and depreciation loss,” he said.
Cronin observed that some private equity deals currently being negotiated are employing a leverage ratio of 10 times this earnings figure as opposed to five times, which was previously the standard level.
“Those are certainly more risky deals from a bond holder perspective, but also from the probability of success for a private equity investor,” he concluded.
