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Does US Corporate Tax Reform Endanger Private Debt Strategies?

Cambridge Associates

Tod Trabocco

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

No. If the interest expense deduction is eliminated, debt issuance may drop slightly, but the demand for senior and mezzanine debt will be little changed, and the risk/reward proposition is still attractive for investors.

Under the new tax regime outlined in the GOP’s Tax Reform Task Force’s Better Way “blueprint,” the highest corporate tax rate would be reduced from 35% to 20%. While the reduction in tax rates should improve corporate fundamentals, tax reform also touches private debt in two other ways: (1) through the possible elimination of the interest expense deduction and (2) the proposed introduction of a capital expenditure (capex) deduction. The segments of the private debt market that will face this issue head-on are mezzanine and senior (i.e., direct) lenders, whose stock and trade is providing debt capital to corporate entities.

The possible loss of interest expense deductibility affects the interest tax shield, which reduces the effective cost of debt by the borrower’s tax rate. Any reduction in corporate tax rates would axiomatically reduce the interest tax shield and elevate the weighted average cost of capital, thus pushing down valuations. Lower valuations could mean less borrowing capacity and, therefore, smaller appetite for debt.

If the interest expense deduction is eliminated as part of corporate tax reform, two things will lessen the impact. First, a reduction in corporate tax rates would increase cash flows retained by a borrower, and somewhat offset the higher-weighted average cost of capital. Second, if capex is permitted to be expensed as incurred rather than recognizing it as depreciation over the useful life of the asset (as proposed in the blueprint), the new regime would replace the interest tax shield with a capex tax shield. So while the weighted average cost of capital applied to cash flows will rise, the lower tax rate and potential tax savings from capex (particularly for capital intensive industries) will increase the stream of cash flows to which that cost is applied. The impact on valuations and debt capacity will depend on the individual cash flow profile of the borrower, making it difficult to formulate an outlook general to all firms.

While the loss of an interest tax shield may elevate the cost of debt, that new elevated cost will still be cheaper than equity. Debt will still retain the protection offered by the US Bankruptcy Code that lowers its risk profile relative to equity. Private equity sponsors have two primary choices of capital to deploy when making an acquisition or growing a platform: their equity or lenders’ debt. Given the choice between using their own capital or less expensive debt, private equity sponsors will continue to prefer debt. The question is how much less, if any, they will use.   The answer to that question lies in the practical side of loan structuring. Sponsors can creatively reduce tax burdens through targeting businesses with large operating losses, sizable depreciation charges, or other similar elements. Changes in the tax regime are, therefore, likely to bypass a large portion of the buyout universe.

Further, lenders will likely adapt their loan packages with respect to cash interest in order to remain an appealing source of capital for private equity sponsors. For a typical direct lender, coverage ratios are an integral part of the covenant packages they negotiate with borrowers to help mitigate losses. Obviously, eliminating the interest expense deduction means higher taxes, which translates into a lower numerator and a lower ratio. The immediate reaction for many is to assume that the only way to maintain healthy coverage is to lower the interest component in the denominator. The next reaction is to assume that lower interest in the denominator requires less debt. And these two assumptions lead to the conclusion that the new tax regime will lessen the demand for debt.   We are not so easily convinced, primarily because coverage ratios track cash interest, not total interest. One way to maintain coverage is to reduce the cash component of interest and to introduce more paid-in-kind (PIK) interest or reduce (if possible) scheduled principal amortization to alleviate cash flow stress on borrowers without sacrificing protection or easing covenants. Of course, most direct lenders rely on current cash interest from their borrowers as a source of the current yield that appeals to so many investors. They may be forced to sacrifice a sliver of that, but the PIK component should vouchsafe their overall return.

In sum, the elimination of the interest expense deduction should not unilaterally diminish the appeal of private debt. Demand for debt should endure, in part because valuations should not change dramatically under a new tax policy that supplants the interest expense shield with a capex shield and lowers the overall effective tax rate. More importantly, debt will remain the cheaper alternative to equity, regardless of tax regime, for both privately held and sponsor-backed companies.

Tod Trabocco is a Managing Director in Cambridge Associates’ Credit Investment Group.

Originally published on March 28, 2017

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