Impact of business interest expense limitation on M&A and private equity markets

In Part 5 of our article Tax reform’s impact on private equity and M&A markets, we recap the business interest expense limitation brought about by the Tax Cuts and Jobs Act and how it could impact M&A market activity, buyers, sellers and the private equity industry as a whole.

Business interest expense in excess of 30 percent of “adjusted taxable income” is no longer deductible. Adjusted taxable income for purposes of the interest limitation is essentially EBITDA for tax years through 2021, but then shifts to a more restrictive 30 percent of EBIT limitation for tax years after 2021. Disallowed interest expense above the 30 percent of adjustable taxable income limitation is allowed an indefinite carryforward and would be deductible in a later tax year subject to the same 30 percent limitation. Note that following a change of control of a C corporation, utilization of the interest expense carryforward amounts by an acquired would be subject to section 382 limitations, similar to acquired net operating losses (NOLs). This limitation is applied to all interest, including debt obligations that were signed before the new law. While this change doesn’t appear to have had an immediate impact, it will have some businesses looking to adjust their capital structure as they see their effective cost of borrowing increase. The limitation will also affect leverage acquisitions, as well as general capital raising decisions.

Implications

Market activity
It is expected that the interest expense deduction limitations may provide downward pressure on valuations for highly leveraged deals as the ability to fully deduct interest expense decreases and increases the cost of additional leverage.

Buyers
Buyers may likely use less leverage and more equity to complete a deal. Buyers need to model out the cost of the leverage taking into consideration the ability to deduct the interest growing forward as part of the decision making process. In addition, with the transition to a 30 percent limitation based on EBIT beginning in 2022, the impact of bonus depreciation and overall depreciation and amortization deductions on the deductibility of interest needs to be modelled into the evaluation.

Sellers