Private equity’s tax trouble?

May 9, 2012, 5:23 PM UTC

FORTUNE — The Private Equity Growth Capital Council yesterday released a study, conducted on its behalf by Ernst & Young, that analyzed the impact of reducing the tax deductibility of corporate debt.

As you might recall, President Obama proposed such a reduction back in February, as part of a broader corporate tax reform framework that would have lowered the general corporate tax rate from 35% to 28%. Obama didn’t put a specific figure on the reduction, but subsequent legislation co-sponsored by Sens. Ron Wyden (D-OR) and Dan Coats (R-IN) but the figure at around 25% (i.e., reducing the deduction from 100% to 75%).

E&Y found that the two proposals – reducing the tax rate to 28% and limiting the interest deduction to 75% — would increase the marginal effective tax rate on companies from 31% to 33.1%. The authors write:

“This significant increase in the METR indicates that business investment would decline in response to lower after-tax returns. The resulting lower level of investment would have the potential to impede rather than encourage economic growth.”

First, I find no fault with the math. When first discussing this situation, I discussed how such proposals would increase the overall tax bills of PE-backed companies like HCA and Dunkin’ Donuts.

But I do have to quibble with the conclusion: The implementation of such proposals needn’t necessarily lead to lower ROI prospects and, thus, less investment. Instead, it simply could result in private equity firms altering their equity-to-debt ratios in a way that takes better advantage of the tax rate cut and minimizes the damage of the interest deductibility reduction. In other words, put more equity and less debt into deals.

To be clear, I’m not among those who believes private equity creates systemic risk. But, at the same time, I do believe that over-leveraging – particularly when done via a dividend recap – can cause severe corporate damage for the sake of marginally-higher sponsor profits. If private equity firms improve a company, then the return will be there – even if the original transaction included a few extra equity points.

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