Is Obama trying to kill private equity?

Feb 23, 2012

Private equity stands to lose big from Obama's corporate tax overhaul.

President Obama yesterday unveiled plans to reform the corporate tax code, including an item that strikes at the very heart of private equity. No, I’m not talking about taxes on carried interest, even though Obama did reiterate that they should be treated as ordinary income. Instead, this is about the deductibility of interest on corporate debt (i.e., the "L" in LBOs).

Before continuing, let me stipulate that the odds of Congress passing this package in a presidential election year are only slightly better than of me batting cleanup for the Red Sox on Opening Day. Okay, moving on...

Obama’s basic framework is to lower the corporate rate from 35% to 28%, and to remove dozens of deductions. In other words, a simpler, more streamlined system.

Private equity firms would uniformly support the lower rate, since it would benefit every one of their portfolio companies. But Obama also wants a reduction in the deductibility of interest payments on corporate debt – a longstanding exemption that is credited with helping to fuel the private equity industry’s massive growth. And for PE-backed companies with major leverage loads, this is not an even trade-off.

For example, take a look at hospital chain HCA Holdings (hca), whose private equity sponsors include Bain Capital and Kohlberg Kravis Roberts & Co. (kkr). For 2010, it reported $2.23 billion in income before income taxes, and nearly $2.1 billion in interest expenses. Let’s imagine everything else is equal, except that the corporate rate is now 28% and there is no deductibility for interest payments. HCA’s tax bill would climb by $587 million ($156m in savings plus $734m in new taxes).

Same thing goes for a smaller PE-backed company like Dunkin’ Brands (dnkn), which would see its tax bill grow by nearly $38 million.

Obama argues that reducing the deductibility of corporate debt interest would consequently “will reduce incentives to overleverage and produce more stable business finances, especially in times of economic stress.” Probably true, and it also would likely kill off dividend recaps. So that’s two net positives. On the other hand, I happen to still believe that private equity is a net positive for the economy – more good than evil – and much of the model is based on this particular tax quirk.

The question, therefore, becomes how big of a reduction to the deductibility is Obama looking for? If he’s just looking to reduce the deduction from 100% to 80%, then HCA would actually save money under Obama’s plan (again, based only on these two variables – excluding other “lost” deductions). But it would lose money at a 70% deductiblity threshold. Wish I could give you an answer on his thinking here, but all I have is a source at Treasury telling me that they haven’t yet gotten into that level of detail.

For me, my initial bias would be to go to around 65% or so – thus achieving the goal of reducing leverage while not making the tax hike so onerous as to destroy the profit potential of debt-heavy LBOs. And probably add in an exemption for companies with revenue below a certain level ($20m?), so as not to discourage the creation of capital-intensive small businesses in markets like manufacturing.

What should be very interesting is how Obama’s proposal is treated by trade groups like the Private Equity Growth Capital Council. On the one hand, its charter members will clearly be opposed – given their use of big debt (even though mid-market deals actually had a lower equity percentage contribution in 2011 than did large-cap deals, according to S&P). But PEGCC also now represents a bunch of growth equity firms, many of whom either don’t use debt at all or use it very rarely. They would likely welcome the rate-for-interest-deductibility swap (as would venture capitalists).

My assumption is that PEGCC will side with its larger members – they pay the highest membership dues – particularly when you also factor in the loss of other deductions like those affecting foreign income, flow-through entities and oil and gas preferences. But it’s not so simple like the group’s stand on carried interest, which affects every one of its members in the same way.

Again, this isn’t going to become law. But it is going to be an interesting campaign issue, particularly if one candidate is trying to make life more difficult for most of the other candidate’s former colleagues.

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