Terrain shifts for private equity M&A deals

Tax reform changed the landscape, adding complexity and uncertainty

Terrain shifts for private equity M&A deals The one sure thing for private equity (PE) firms to know as they go into acquisitions these days is how complex the process has become under the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA was viewed as a big plus for much of the business community because of the dramatic drop in the corporate tax rate. Its provisions also resulted in more capital for investment opportunities, and more opportunities like the aptly named Opportunity Zone Funds. Yet it has also added intricacy, and near-term uncertainty, to how it fully applies in the domestic and international arenas for PE firms. And many of its provisions unwind in the near future, said Layne Albert, a Tax partner with Grant Thornton’s Financial Services – Asset Management practice. “Nobody in the private equity world likes uncertainty with regard to taxes, and tax reform has created a complex regulatory framework. So the cost of compliance and real time consulting will likely go up as a result.”

Tax reform has added a lot of “extras” around M&A deals, Albert said, such as extra spreadsheets, extra analyses and extra disclosures. “The amount of data we’re now required to disclose and the new calculations we have to perform are significant. Regulatory compliance involves more pieces and unknowns than ever before. Tax consulting post-tax reform has also become extremely complex.”

Some wins with tax reform Some aspects of tax reform make deals more appealing to PE firms, said Tracy Hennesy, a partner with Grant Thornton’s Mergers & Acquisitions Tax Services practice. A big one is the immediate expensing of tangible property acquired as part of a transaction, especially for companies that are fixed asset intensive such as manufacturing businesses. “This favorable change makes asset transactions more attractive from a tax perspective.”

Some misses A drawback of the TCJA, given the level of leverage PE clients bring to transactions, is the creation of interest expense limitations. “We’ve been helping several of our PE clients work through their deal models and understand that they face new interest expense limitations under Section 163(j),” Hennesy said. Section 163(j), as amended under the tax act, basically disallows – or defers – a deduction for the net business interest expense, in excess of 30% of a business’s adjusted taxable income. “So in one way or another, even with the lower corporate tax rate, PE clients may face significant add-backs year over year, which can drive up taxable income.”

Albert agreed. “In a way borrowers are losers under the tax act, whereas prior to tax reform, simply stated, having as much leverage as possible created the best tax approach.” This has essentially “changed overnight,” as he put it. It’s not easy to undo leverage, nor is it simple to push borrowing overseas, given changes to international tax rules. A deal could inadvertently wind up creating taxable income without cash to pay for the tax. The rules deferring interest expense deductions get more severe in a few years. PE firms need to continually assess the leverage they employ.

“Again, you have a lot of provisions that everyone’s dealing with, and trying to figure out how it impacts them,” Albert said. “This has led to extra analyses, limitations, carry-forwards and other things we have to manage that we were not doing last year. We spend a lot more time analyzing whether gains produce good carry or not, and it’s not simple. The devil is in the details.”

Grant Thornton Insight “All the changes that are driven by tax reform are still being identified and debated. And there’s a new need to have a tax professional and perhaps multiple subject-manner experts involved when doing a deal, to reveal all the things you haven’t thought of that are new and complex.” – Layne Albert, Partner, Tax Services, Grant Thornton

Albert cited three areas where details matter yet can be tricky to calculate.

  • Provisions around carried interest (carry), with little regulatory guidance. A lot of PE firms are wondering how TCJA provisions apply to carry and how to analyze transactions to figure the correct amount of carry for purposes of the new provisions. Said Albert, “We’re making inferences and debating planning ideas with little guidance from Treasury.”
  • The interest expense limitation. Calculations now must be done at each entity level and for each trade or business in a PE structure, whether or not it’s a flow-through, for potential limitations on the deductibility of interest, which could impact an effective tax rate and cash rate of return. Parts of the provision could even convert ordinary losses into capital losses, “which in the private equity world are generally not welcome,” said Albert.
  • Current expensing. A key component of the current expensing provisions is bonus depreciation. Formerly at 50% and now at 100% (until Dec. 31, 2022, when the percentage decreases by 20% each year until it is zero), bonus depreciation is now applicable to “used property” as well as new — meaning funds are not limited in writing off investments as they swap assets among themselves. This has changed formulas for calculating deals and purchase price allocations to determine whether to take advantage of bonus depreciation, or not, and asset dispositions, or not. Calculations should be done to understand where the deduction ends up in a PE structure. Does it flow through to an individual investor, a blocker or a tax-exempt investor? Does it get stuck at a fund and aggregate with other items? Is it needed, and how much is needed? Acquisition attributes should be put into an overall model of an investment over a given time period – say three to five years – and an exit strategy should be modeled as well.

Optimizing the tax function is a key in PE acquisitions When PEs and their portfolio companies make acquisitions, they typically have a limited time frame for holding onto those investments. That makes it important to understand all changes created by the TCJA and rulings such as Wayfair. Having a solid grasp on a company’s tax function can help prevent unexpected tax issues or surprises down the road when PEs look to exit an investment.

“It has become increasingly important to have the right tax function,” said Layne Albert, a partner with Grant Thornton’s Tax Services. The tax part of acquisitions takes a lot of thought and consideration, he said. “It’s not a few calculations but many, and you want to get it right.”

Decision-makers should optimize the tax function to have easy access — at all levels of the transaction process — to data they can pull to uncover risks at any given time. Michael Colagiovanni, Grant Thornton partner, Tax Reporting & Advisory Services, explained. “For instance, with sales and use tax or state nexus under the Wayfair ruling, immediate access to information is a must as low-level sales thresholds in certain states could trigger new tax requirements. Technology solutions exist where data can be accessed in real time for quicker, more informed decision making. If PE owners are able to view trends across their entire portfolio and manage that real-time through technology, they’ll be able to see these different risk areas and make quicker, more value-added decisions.

“What you’re trying to do is optimize your tax function,” he said. “It’s all about understanding your people, processes, technology and data, and re-designing your model, to achieve the most value for the organization This can be achieved through an insourced, outsourced or co-sourced tax function. Whether it be access to data, running various planning models or achieving operational efficiency, what worked before does not work today. And that has to be a key consideration.”
Rules around net operating losses (NOLs) have changed, too. Prior to the TCJA, if a transaction caused a company to report an NOL due to a short period and/or significant transaction tax deductions, the NOL could be carried back two years to offset previously reported taxable income and create a refund opportunity for the sellers. Now NOLs can’t be carried back, so significant transaction tax deductions such as transaction costs and compensation-related expenses can only carry forward and are subject to limitations potentially under both Section 382 (traditional change of control provisions) and the 80% taxable income limitation (new for NOL utilization post-TCJA).

Inherent risks PEs making acquisitions need to know the inherent risks when acquisition targets have not properly embraced the changed landscape that has come out of the TCJA. Risks should be assessed during the due diligence process, and identified risks should be addressed so that PEs are sufficiently protected from issues that may arise post-closing. For example, PEs should be prepared if the taxing jurisdictions come knocking and uncover tax exposures that relate to periods prior to the PE’s investment. If tax is assessed, who is going to pay it? These items are critical to think through during the closing process.

Said Hennesy, “Whether the PE is starting a new portfolio platform structure or integrating an acquired entity into a current portfolio platform structure, it is important to make sure that the PE company brings in resources with sufficient technical tax expertise. We see companies tackle this in a number of different ways including building a team internally and relying on advisers externally. It is also key to make sure that a company has the right tools and technology in place to keep up with all the changes that came out of tax reform and Wayfair.” For more on how the Supreme Court’s ruling in South Dakota vs. Wayfair affected M&A, see Wayfair sparks new complexity in M&A deals.

In a way, it’s a whole new world The bottom line is that the TCJA has led to whole new analyses for PE deals. Prior to the TCJA, deal analysis and understanding tax code provisions — and how all elements worked together — led to a certain way of preparing for acquisitions, with little change for 28 years. PE companies and their advisers grew to be comfortable with their general understanding of tax and their own particular issues and models. Now calculations and models have been upended, and the implications of a transaction, a bonus election, an NOL deduction and more all have ripple effects that have not been fully fleshed out and connected.


Layne AlbertLayne Albert
Tax Partner, Financial Services – Asset Management
T +1 212 624 5335

Michael ColagiovanniMichael Colagiovanni
Partner, Tax Reporting & Advisory Services
T +1 216 858 3565

Tracy HennesyTracy Hennesy
Partner, Mergers & Acquisitions Tax Services
T +1 832 476 3737

Michael PatanellaMichael Patanella
National Asset Management Sector Leader, Audit Partner
T +1 212 624 5258