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Could Potential Tax Changes and a Private Equity Black Hole Undermine the Value of Your Business?

Tax and Financial News

June 2017

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Could Potential Tax Changes and a Private Equity Black Hole Undermine the Value of Your Business?

Until a few years ago, the average private equity fund’s multiyear performance materially outperformed the S&P 500. More recently however, the average private equity fund is performing more in-line with this benchmark, causing a growing number of people to believe private equity as an investment asset class is “maturing.” So what does this have to do with how much your business is worth? First, let’s go over a little background.

Market Categories

Generally speaking, markets categorize private companies into groups based on their annual revenue. There are a few broadly recognized categories of private companies considered “middle market” with revenues of $500 million-plus, $100 million to $500 million, $5 million to $100 million and finally micro business with annual revenues of $5 million or less. Typically, private equity focuses on the three larger groups and doesn’t touch companies in the $5 million or less range.

Low interest rates for nearly a decade meant it was cheap to borrow money and leverage your purchase of a company. Coupled with low return on fixed income and their performance track record, this combination of factors has pushed a lot of money into private equity funds – and as a result, private equity funds have been on a buying spree. All this translates into higher valuations for companies, creating a seller’s market. It also means that most of the “good deals” (for the private equity firms, that is) are already taken.

Market Cycles

Studies of middle market mergers and acquisitions activity show approximate 10-year cycles. Generally, during this 10-year cycle it will be a seller’s market for five years and then a buyer’s market for the next five. Essentially, many in the field see the private business landscape as picked through; combined with the cycle timing, it is creating a sense that we are approaching the top of the seller’s market cycle.

It’s not just the turn of the private equity market cycle that could impact the value of your business. There are potential tax changes that could combine with it to further drive down the price private equity funds are willing to pay.

Changing What We Tax Changes How We Value

There are currently a few proposals that are stepping stones toward a flatter tax system. An essential part of that is a move toward taxing Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) instead of net income. Taxing EBITDA instead of net income means that interest expenses would no longer be deductible. So why would this tax change matter? Well, typically private equity firms value companies as a multiple of the EBITDA they will receive; but if the “I” for interest no longer applies, it could alter valuations.

Not all private equity funds have the same strategy, but a common one is for funds to be financial buyers. Financial buyers craft deals primarily based on the financial structure of the purchase, often through what is called a leveraged buyout (LBO).

Why the ‘I’ for Interest Matters

LBO models typically include a number of financing sources as part of the deal structure. Typically, the buyer will provide a small part in cash, another small portion as a note from the seller and the majority remainder is borrowed (about 75 percent or more).

By using mostly borrowed funds to finance a purchase, LBOs mean that the new company structure will have a lot of debt – and therefore, a lot of interest expense as well. Currently, this is irrelevant if the private equity fund is valuing the company as a multiple of its EBITDA, since their valuation is based on the company’s performance without factoring the interest.

Under some new tax proposals, the interest will no longer be deductible and this messes up the whole LBO model – it essentially breaks it. As a result, financial buyers will have to start valuing the company with the interest expense factored into the target company’s earnings, but while still applying the same valuation multiples. Let’s look at an example to better understand.

If a company had an EBITDA of $10 million and the private equity fund was willing to pay a multiple of 5x, then they would buy the company for $50 million ($10 million x 5). Under the new rules, the private equity buyer would further reduce EBITDA by the amount of the now non-deductible interest expense, so the company’s earning base for the valuation multiple would now be say $1.5 million less (a very rough approximation of the interest expense). The private equity fund would then apply the same multiple of 5x the earnings base at $8.5 million ($10 million EBITDA, less $1.5 million in interest expense) and only be willing to pay $41.5 million instead of $50 million.

Implications

The result of this tax change could mean that financial buyers will be offering less for private companies. Coupled with the perceived market cycle timing, and we could be looking at private equity funds being willing to pay a lot less for private companies in the near future.

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These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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