7 minute read 18 Feb 2021
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How private equity firms are rethinking tax to meet multiple pressures

By EY Global

Multidisciplinary professional services organization

7 minute read 18 Feb 2021

Amid regulatory change, margin pressure and technological shifts, PE firms are turning to co-sourcing for their tax and finance functions.

In brief
  • Private equity firms, faced with multiple existing pressures, which have accelerated under COVID-19, are having to rethink their tax operations.
  • Finding the most effective balance of co-sourcing, outsourcing and in-sourcing can be critical to maximizing the tax function for the future.

Changes within the global tax landscape are putting immense pressure on all business sectors. Amendments to legislation on an international and domestic level, along with shifts in reporting and compliance requirements, have added layers of complexity, making the majority of organizations reconsider their tax operating models.

The PE sector is not immune from these pressures. Indeed, it has to face them along with additional challenges from the competitive environment, demands from limited partners (LPs), an increased emphasis on value creation, the number of funds being managed, and complexity created by multi-asset strategies. Add disruption from the COVID-19 pandemic into the mix and PE firms can no longer overlook investment in operations if they want to protect their share of institutional asset allocation and maximize return for investors.

Indeed, in the EY Tax and Finance Operate (TFO) global survey, published in April 2020, 100% of PE firms are making changes to their tax operating model – based on 100 respondents from PE firms across 34 jurisdictions. Yet they are having to do this in the face of cost pressures – almost two-thirds of PE firms have a plan to reduce costs over the next two years, with an average target cost reduction of 9%.

Operating model changes

100%

of PE firms are making changes to their tax operating model.

While the PE industry is not alone in operating in a complex landscape, like other sectors it has its own discrete challenges. For instance, it has been subject to margin erosion over the past few years. While fee structures – and the 2/20 model – have remained resilient, increasing costs from growing assets under management (AUM), demands from LPs for new types of information and new delivery models, and the need to invest in functions like sourcing means margins are under constant pressure.

As a result, in the TFO survey, responses from PE professionals delivered results that demonstrated they feel significantly more pressure in certain areas than other business sectors. These are covered in more detail below, along with some of the potential solutions that PE firms plan to implement.

Increase in tax risk

The legislative and regulatory tax landscape has evolved at speed in recent years, and tax functions are under pressure to remain compliant. As tax authorities around the globe move to a more digitized model, so those pressures increase.

When asked how compliance with emerging digital tax filing requirements – such as country-by-country reporting, Standard Audit for Tax (SAF-T) and other electronic transactional government filings – would impact the tax and finance function, 92% of PE firms anticipated an increase in workload, slightly higher than all respondents (at 84%).

It was around tax risk, however, that the difference was far more significant, with 90% of PE firms expecting an increase compared with only 51% of all respondents.

Tax risk

90%

of PE firms are expecting an increase in tax risk.

There are likely a number of factors in play here, not least the fact that the PE firm itself has its own tax function, as will the portfolio companies that it sits above. Tax considerations that span multiple industries, sub-sectors, and regulatory jurisdictions add to complexity.

But Petter Wendel, EY Global Tax Private Equity Sector Leader, also points to a question of visibility. “In the market, many medium-sized PE firms don’t have a sizeable internal tax function. Even when you look at some of the larger funds, they might have tax departments of 20 or 25 people, but when you compare that to a financial institution or bank they are still comparatively small. PE firms rely heavily on their accounting firms, so I think when they are asked a question like that, they don’t have clear sight of the risk and therefore the perception is high.”

In the market, many medium-sized PE firms don’t have a sizeable internal tax function.
Petter Wendel
EY Global Tax Private Equity Sector Leader

That said, this doesn’t mean the risk isn’t real – and the size of the typical tax function within PE firms can create a capability problem, when there is inadequate resource to deal with the issues. While they know the environment is changing and this risk is on the horizon, firms don’t have the time or bandwidth to put a plan in place to ring-fence it.

As a result, this new digital environment and the associated tax risk may well lead to reconsideration of sourcing models and, critically, the role that technology has to play.

Behind the technological curve

Despite a recognition that technology will play a significant role in transforming their operational models, 79% of PE firms cite a lack of a sustainable plan for data and technology as the biggest barrier to delivering their tax function’s purpose and vision. This, again, is much higher than the 65% of all respondents who said this was the case.

While, admittedly, PE firms are gradually moving away from the era of spreadsheets and investing in sophisticated technology as part of their focus on overhauling the long-term operating capabilities, the transition is still at an early stage.

Wendel feels that for many PE firms, cutting-edge technology is simply not a priority. “While data and technology can provide the business with a lot of useful information, this is something you would typically see higher up the agenda for corporates,” he says. “In the corporate world, there is more discussion on how to take information and technology and use that to run the business better. Private equity firms are more focused on cost savings, streamlining, reducing internal headcount and making the business operation simpler.”

This lack of a progressive approach to technology could mean that PE firms are missing out on transformational opportunities. As Alexander Reiter, EY EMEIA PE Tax Leader, notes, “From the technology perspective, much of the compliance work is outsourced to advisors, so PE firms are providing the data and the advisor is doing the respective tax filings. But those firms should be thinking of what data they need now and what they need in the future, because the requirements from LPs and reporting might increase, and that information might need to be more readily available.”

Firms should be thinking of what data they need now and what they need in the future.
Alexander Reiter
EY EMEIA PE Tax Leader

From a more critical standpoint, the ability to analyze data and to use systems proactively – at the fund level and at many of the portfolio companies – is often found lacking. Many firms are only at the beginning stages of automating the data from a tax and finance perspective. As such, they have a lot of data but don’t have the systems to do anything meaningful with it.

Battling a skills shortage

Amid the increases in regulatory reporting and the need to focus on technology and data, PE firms face greater difficulties than most companies to find the required talent to meet these challenges.

Indeed, 70% of PE firms struggle to attract and retain skilled talent for their tax and finance functions (against 39% of all respondents), while 72% face difficulties in providing new responsibilities and career advancement for their existing tax and finance personnel (compared with 45% in the overall sample). Subsequently, the cost to hire and retain talent is becoming challenging for PE firms.

This is arguably because of how PE firms tend to structure their tax teams as, for the most part, they’re not looking to expand the tax group. At both the fund level and the portfolio company level, PE firms typically run a very lean model. They often won’t bring people in unless necessary because of the cost implications. PE houses have long turned to trusted advisors and to either co-source or outsource because of infrastructure or budget limitations.

An added dimension to this is when people from the PE firm use a solution from a third-party provider that involves internal staff moving over to the external team – reducing headcount further in the process. As Caspar Noble, International Tax and Transaction Services Partner, Ernst & Young LLP, points out, “This can be a very practical solution and one that has proved popular in the US, not least because of the complex K-1 reporting for investors.”

“The dynamic is slightly different in Europe, however. While tech transformation of the tax function is definitely gathering momentum, the shift in headcount isn’t as prevalent because European tax departments are typically smaller to begin with.”

Refining the sourcing model

Taking into account this complex picture, it is, perhaps, unsurprising that PE firms are increasingly turning to co-sourcing to meet the increased demand for transparency and reporting from LPs and regulatory bodies, focus on their core competencies, and achieve cost efficiency. Indeed, 91% of PE companies say they are more likely than not to co-source over the next two years – much higher than 73% of the overall sample. This holds particularly true for relatively young and small general partners (GPs) who have limited operational infrastructure and capabilities. 

Operating model

91%

of PE companies say they are more likely than not to co-source.

Capability is key here, with many PE firms already co-sourcing because of bandwidth. Faced with a range of issues – including FATCA and CRS, withholding tax, income tax and BEPS, and the potential for new regimes – they’re unlikely to change the way their infrastructure is designed from a tax perspective, and so they will just continue to outsource.

Finding the right mix of the operating model is clearly imperative. It can be time-consuming and expensive to keep and develop operating infrastructure internally and require significant effort and resources to train employees. Whereas, outsourcing some functions will allow firms to save costs and focus on their core capabilities.

Many firms might find a hybrid approach more suitable to their requirements, where they decide to continue to own some tax and finance functions they consider to be critical, while co-sourcing others. Either way, for PE firms attempting to navigate a complex tax (and indeed corporate) landscape, doing nothing from a sourcing perspective does not seem a pragmatic option.

Summary

Private equity firms are facing internal operational pressures and challenges from the competitive landscape while navigating a rapidly shifting regulatory and legislative landscape – all of which have been exacerbated by COVID-19. Added to this are emerging pressures from new digital tax requirements. The tax and finance function of these businesses will play a critical role in ensuring that present and future compliance requirements are adhered to. But this will mean reimagining those functions, and the role that co-sourcing plays, to ensure that the right people are in the right place so that operations are optimized.  

About this article

By EY Global

Multidisciplinary professional services organization