In Part 1 of our article Tax reform’s impact on private equity and M&A markets, we recap the reduced corporate tax rate 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.
The Tax Cuts and Jobs Act has simplified the corporate tax rate from a graduated system with a top rate of 35 percent to a flat corporate rate of 21 percent. This change should remove uncertainty regarding the level of future tax rates for both acquirers and targets. The lower tax rate may allow for more free cash, which may also drive higher enterprise valuations. The increased valuations could drive more sellers into the market and also provide more cash to buyers looking for growth through M&A.
With the change in the corporate tax rate, a corresponding benefit was provided for businesses in pass-through structures to reduce the gap in the tax rates between the new reduced corporate tax rate and that assessed on pass-through earnings. Newly added section 199A allows for a 20 percent deduction of qualified business income (QBI). The QBI deduction is fairly complex, as the deduction is limited to the greater of:
- 50 percent of W-2 wages with respect to the qualified business, or
- The sum of 25 percent of W-2 wages with respect to the qualified business plus 2.5 percent of the unadjusted basis of qualified tangible depreciable property
Even with the QBI deduction, certain businesses currently in flow-through structures are considering converting to a corporate structure to take advantage of the lower corporate tax rate.
The reduced tax rates may have a positive influence on M&A market activity with additional funds available for investment, potentially increased valuations, reduced tax cost for certain corporate sellers and more tax efficient exits for noncore assets and carve outs.
A decrease in the corporate tax rate increases free cash flow for buyers, leading to more cash to spend on growth. Additional free cash flow may likely increase seller valuations, making acquisitions more expensive than in the past, if all other factors are equal. Also, while still beneficial, the lower tax rates going forward have reduced the relative value of tax attributes such as net operating losses or basis step-ups. This is due to the tax benefits offsetting income taxed at a lower rate and should be considered when ascribing a value to any acquired tax attributes.
The increase in valuations may make selling more appealing to owners looking to sell their business. When looking to sell and maximize sale price, consider the impact of lower corporate income taxes on current operations versus the potential benefits of a pass-through structure.
The decrease in corporate tax rates could increase the free cash flow of portfolio companies and, therefore, increase the amount of dry powder for making future investments or returning capital to investors. For holding investments, private equity is also reconsidering the benefits of a pass-through structure versus corporate structure. Under a corporate structure, the impact of the lower tax rates on operating income can be weighed against the ability to return capital on a tax-free basis and the ability to provide a step-up in tax basis under a pass-through structure.
In deciding which is most beneficial for private equity, a pass-through structure is generally more attractive, with typically a shorter holding period. It is important to model out the specific expectations of an investment when making such a decision. These expectations include the footprint of the portfolio company (including international operations), cash flow and exit planning.