Podcast transcript: Five post-US election considerations for private equity

29 min approx | 15 December 2020

Winna Brown

For the past several months, the attention of the US and indeed much of the world has been on two things: the pandemic and the US election, both of which continue to evolve.  I’m joined today by Jerry Whelan,  private equity tax technical leader at [Legal Entity name] and Ray Beeman, cohead of EY Washington Council, to talk through what should be top of mind for private equity in the weeks and months to come as the U.S unpacks the results of the election.  So Ray, this election will probably go down as one of the most dramatic elections in US history.  As someone who’s on the inside, I really just can’t resist asking you: what has the temperature been like on the Hill since Election day?

Ray Beeman 

Thanks, Winna, great to be here.  The activity in Washington has really picked up, and there’s a real focus on two areas.  One is the post-election end of the year Lame Duck session with a lot of important business to do.  Lame Duck sessions are always unpredictable.  There’s a saying in Washington, if you’ve seen one Lame Duck session, you’ve seen one Lame Duck session. And the most important point of business for Congress and the administration to get done is to keep the government open past December 11.  And I don’t think the risks of a government shutdown should be underestimated given the atmosphere in Washington right now.  Hopefully we get a good outcome there, but certainly no guarantees.  Of course there’s continued talk about more COVID-19 pandemic relief, and in the tax world we have a long list of tax, temporary tax provisions that are set to expire.  

The other big area, of course, is the transition to the new administration.  The parlor games have begun around who president-elect Biden will put into his cabinet.  Big emphasis on diversity, but also a recognition that the Senate’s very closely divided no matter what happens in Georgia. And these cabinet nominees have to get through a Senate confirmation process.  So big tension between the desires of the progressive wing of the Democratic party and the realities of who can get through.  As president-elect Biden continues to build out the cabinet and prepare for confirmation process in the Senate, we are going to keep a close focus on what that means for administrative policy.  There’s a saying in Washington that personnel is policy; that is absolutely true. And so whether it’s cabinet secretary or on down below secretary level, those are going to have major impacts on policy in the early days of the Biden administration.

Brown

For our audience and for context, we’re recording this on November 20.  A Biden victory is all but confirmed and the Senate hinges on the Georgia runoff, as Ray just explained.  And while there are a number of potential outcomes, for the purposes of today’s discussion, we’re going to assume that Vice-President Biden wins the White House and the Senate remains in Republican control.  While there are countless areas we can explore, we’ve selected five areas that we believe will be of particular interest to private equity leaders.  They are legislation tax and regulatory incentives, deal activity, the opportunity landscape both from a domestic and cross-border perspective, as well as sector big bets.  Jerry, let’s start with some tax and legislation.  What are some of the major tax changes and legislative scenarios that are either on the table right now or we think will be acted upon very shortly?  And which one of those really would be impactful for PE?

Jerry Whelan

From a tax regulatory perspective, we’re focused on what regulations have been issued in the last six months of this administration.  And, top of mind is carried interest regs, which came out in proposed form over the summer.  And we’re expecting final carried interest regs before year-end.  Uh, similar situation with respect to the interest limitation regulations.  And it’ll be interesting to see whether the change in administration drives either a pull-back or revision of those regulation packages.  I think the planning from a PE perspective has shifted from one of preparing for a blue wave and one of looking at income acceleration and deduction deferral to focusing on what’s likely to move from a bipartisan perspective and what gets pulled off of the shelf from a tax perspective to pay for those initiatives.  Likely it’s going to be bipartisan priorities such as infrastructure, climate, and those issues will have implications from a portfolio company perspective, in an industry sector perspective, but I think the biggest thing from a private equity modeling perspective is will we have tax certainty?  

And so I think the focus has shifted to look at things such as loss planning, some of the provisions under the CARES Act that people have held off pushing through, given the uncertainty of what was going to happen with the election, as well as some of the changes that are slated to happen with respect to the TCJA, the 2017 Act, and some of the key issues and variables from a cash tax perspective.

Brown

And do you think there are specific things that private equity should prepare for that need to be done before year-end or, or first up in 2021 and beyond?

Whelan

At this point, I’d say there really doesn’t need to be a focus on effectuating things before year-end.  In the run-up to the election, we did notice an increase in deal flow as people were trying to  effectuate transactions that were in the pipeline to take some of the risk off the table to do no regrets planning and mitigate the risk of a potential capital gains rate increase and, and corporate rate increase.  But those were really transactions that were already in the pipeline either from the buy side or the sell side on certain monetization transactions.  Now that the dust is starting to settle on the election and it looks like we’re going to have a divided government scenario, I think we know that the tax variables that are in play, and so I think the, the focus has shifted now to 2021 and beyond what to do from a modeling perspective and how to prepare for those mid to long-term issues.

Brown

Okay.  So if I’m a private equity firm and I’m looking to start modeling my tax scenarios, what would I be assuming in this scenario given what we anticipate the government to look like?

Whelan

I would break it up into two buckets.  First, some of the CARES Act provisions.  So the ability to carry back NOLs was a, a big benefit.  People were concerned that that might go away in a blue wave scenario.  Now that that scenario seems off the table, pushing through on those net operating loss planning opportunities from a refund perspective and a cash tax perspective.  And then depending on where investments are in the life cycle of the fund and with respect to the portfolio company, some of the other changes, specifically the interest deduction and changes that are automatically set  to start rolling off.  So I think that’s a big one given that private equity deals are highly leveraged.  The interest limitation, which is currently 50% of EBITDA, will drop back down to 30% of EBITDA next year in 2021, and then go to a more restorative 30% of EBIT in 2022.  

I think the other cash tax variables from a modeling perspective, the PE investment professionals are focused on are R&D expensing.  That drops down to R&D amortization, and then bonus depreciation, current expensing over your tangible assets starts to phase down in 20% increments starting in 2023.  And then some of the international inclusions and the rates associated with those inclusions start to rachet up.  So even though the focus was on corporate tax rate increases and the statutory rate is unlikely to go up in a divided government scenario, there are these stealth automatic changes that will increase cash tax.

Brown

And as they plan out for these tax scenarios, do they also need to consider implications of midterms that are really one, two years away? Or do you not see that as a threat to their tax planning?

Whelan

I think that people should keep that on their radar screen because it’s not that far off on the horizon.  Clearly given the partisan environment, people have said the midterms have begun.  And again, depending on where a private equity backed investment or portfolio company is in its life cycle, it is important to have a playbook of changing scenarios in the changing environment, whether that means the Senate flipping control over to the Democrats or the Republicans taking back control of the House and what that means from a tax planning and structuring perspective.  Do rates go up, do rates go down?  And some of the other variables that I mentioned from a modeling perspective.

Brown

So really you can never just sit back and assume things will be stable.  Is this the key message? (Laughs)

Whelan

That’s right.  It’s just so dynamic and fluid.  And I think what we crave from a tax planning perspective is certainty.  I think we have it momentarily depending on what happens with the Georgia runoff elections.  But that will be relatively short-lived, and we’ll have to keep an eye on what happens going forward.

Brown

Excellent.  So shifting gears slightly from the federal theme but still on tax considerations, obviously with the pandemic, we’re increasingly hearing how states are suffering, and they’ve been unable to earn the regular revenues that they are usually earning as a result of the pandemic.  So there’s a lot of speculation that there’s going to be potential tax increases in various states such as California, Connecticut, Illinois, Massachusetts, New York, et cetera.  Lots of PE firms are based in New York City.  Do you think that this potential for state tax increases is going to trigger a migration of PE firms?

Whelan

I’d break this out into two levels: the private equity principals and the management company and where that’s located, and then the portfolio companies.  So first, at the management company level, we have seen a lot of investment professionals especially in the context of the pandemic trying to break residency since they don’t need to be in their home state, whether that’s New York or Chicago or San Francisco, the locations of most of the private equity hubs.  And they’ve migrated to low-tax states like Florida and Texas, in some cases some of the California managers to Nevada and Arizona.  So that has caused the principals to reevaluate where should the management company be housed?  What makes sense going forward?  And that could be as mild as just changing the apportionment or moving the headquarters. 

And then I think the second bucket that I alluded to is the portfolio company.  I think this is always a big issue whether you’re a US portfolio company or an inbound fund or inbound formed portfolio company that’s investing in the US to consider state and local taxes.  You mentioned that states and localities are really in a dire fiscal situation because of the pandemic, and so I think they’ve been focused on rate increases but also enforcement from a administrative perspective. Are the states going to be very aggressive in terms of tax audits?  And so all of those considering factor in at the management company and then at the portfolio company in terms of where you want to be headquartered and where you want to locate your value drivers of your business.

Brown

Yeah.  And I imagine if we think about this in a historical context, a lot of organizations and people were potentially reluctant to move out of some of the states such as New York or Massachusetts, California.  Whereas now with the pandemic everyone’s remote anyways, so maybe some of the past resistance to moves might go away because people are just getting used to working from anywhere.  So why not a low-tax state?  If we now kind of shift a little bit and start talking about, uh, regulatory changes, are there any particular regulatory changes that we should be expecting once President-Elect Biden takes residence in the White House that would impact private equity? 

Whelan

Yeah, I think we’re focused on a number of things and then some of the administrative agencies, the SEC and some of the other enforcement agencies, and what will the executive orders look like? President-Elect Biden has said that he wants to join the Paris Climate Accord and also incentivize, um, alternative energy and bring back some of the EPA regulations.  So we’re looking at the sector impact on portfolio companies in the energy industry and other portfolio companies that might be affected by a regulatory shift.  I think the other big thing from a deal flow perspective is anti-trust. 

You know, is anti-trust enforcement going to rachet up?  And this can be a dual-edged sword in that anti-trust scrutiny for existing portfolio companies that are expanding such as those that are roll-up platforms, that might damper some of their M&A activity.  But this might create some opportunities for private equity funds.  As large corporates continue with M&A activity, they might have to dispose of more businesses and assets in order to get anti-trust approval and as a result, private equity can sometimes come in and purchase those assets that are shed as a result of large corporate M&A.

Brown

Okay.  And, and if we think about some of the regulatory leanings that we expect a Biden White House to adopt, let’s take a look at some of the incentives.  So Ray, we understand the priorities and policy of a Biden Administration will be focused on infrastructure, manufacturing, climate change.  How do you think they’re going to look at incentivizing businesses to invest in these types of US-based businesses?

Beeman 

Well, I think you have to look at two areas.  One is what can get done legislatively, and as we all know, really regardless of what happened in Georgia, we’re effectively going to have divided government with limited opportunities for legislation to get through the Senate in particular.  And the real focus on what are those bipartisan areas that both sides can work on?  And I think you just put your finger on really the two big areas that we’re seeing.  You know, one is infrastructure.  Another one is the whole onshoring theme.  And those are not mutually exclusive; there’s a lot of cross-walking between those two subjects.  And at the center of course is climate.  And so I think one big area will be whether the parties can actually come to some consensus around some legislation dealing with these areas around incentives as well as the stakes(?) as well penalizing is certainly on the agenda as well.  But to the extent that cannot be done legislatively, the Biden Administration is going to have control of the regulatory levers and can certainly get a lot done by regulation and otherwise without the help of Congress.  And I think President-Elect Biden and the Biden Administration are going to really be looking at these areas where they can incentivize US manufacturing.  And President-Elect Biden has already issued a directive across all agencies to consider climate and green as part of all of its activities.  And so we’re already seeing changes along those lines.  I think, uh, there’s going to be initially a lot of rolling back of what the prior administration has done by regulation or executive order, and then moving forward with a more affirmative agenda around these areas.

Brown

And do you think that to the extent that there are government incentives to entice interest and investment in climate-conscious businesses, US-based manufacturing, et cetera, do you think that PE-backed companies will actually be eligible and qualify for these incentives?

Beeman

Right.  So candidate Biden of course already rolled out a Made in America agenda that included several non-tax as well as tax incentives and penalties and the like.  And the good news really was, you know, there really wasn’t a focus on private equity during the campaign either (Inaudible) or generally.  I think we’re all a little scarred from the CARES Act experience and, and I don’t necessarily see that as a template going forward in terms of discriminating against private equity when various incentives are rolled out.  I think the CARES Act was kind of a one-off thing and going forward I think a Biden Administration will recognize — or at least we hope they’ll recognize — that whether you’re owned by PE or not, these incentives are designed to incentivize taxpayer behavior or corporate behavior.  And so the idea that you would distinguish between private equity owned and otherwise wouldn’t seem to make a lot of sense.

Brown

That’s indeed good news because I know you and I had lots of conversations with PE-backed companies as the … unpacking the CARES Act.  And it was frustrating at times to see how many companies couldn’t access some of the provisions of the CARES Act.  So this is great.  Jerry, have you been looking at deal volumes and do you have a sense of what that trajectory will look like over the next 12 months?

Whelan

Deal flow will continue to be strong.  The, the low interest rate environment is key for private equity given the need to finance deals and leverage companies.  And so I think all indications are that deal flow will continue to be strong right through 2021 and beyond.  Winna, I think another important thing to keep in mind in terms of deal activity given how important interest rates are is the interplay of the stimulus measures that Ray mentioned earlier and what the Fed can do in terms of being accommodative.   And what happens with interest rates, whether they start to tick up, that could have a, abearing on deal flow and also on valuations.

Brown

Excellent.  And do you think there’s any particular variables that are likely to impact valuations over the next 12 months or so?

Whelan

Private equity keeps an eye on what’s happening in the capital markets and in the public markets, and clearly valuations are lofty.  The deal flow has been focused on industries that have organic growth, so we’ve seen a lot of deal flow in terms of technology and health care and biotech and education.  And as you have a lot of private equity funds looking at the same industries and similar targets and in some cases the same target, that does have the effect of increasing valuation.  But apart from that, I don’t think there should be any major swings in the next year or two.  And so that certainty in locking down those variables should allow investment professionals to really have a good sense of where they should land on perspective targets as well as existing, valuation of existing portfolio companies.

Brown

Okay, and Ray, we talked about incentives and certain sectors that we think will incentivize greater investment.  What do you think might be some of the greatest opportunities for private equity in terms of expansion?  Do you think it’ll be more, uh, domestic growth, or do you think that there is a greater opportunity for cross-border expansion?

Beeman

Well, all of this really I think is dependent on how the pandemic plays out.  I think the optimistic scenario is that we get out of this in the relatively near term, in which case I think there’s an abundance of opportunities both domestically and cross-border if we can resolve this on a global basis.  And so that’s the optimist scenario.  I think more on the ground, if you are looking at government policies around the environment, climate and encouraging US manufacturing, you know, those could impact that balance.  So if, if there’s a strong push out of the government for US manufacturing that’s real, I think that will impact the tilt towards domestic investment.  If the global economy really starts to kind of rebound from the pandemic, that could cause private equity firms to look at targets all over the globe.  And so the reality is probably it’s going to be a mix of both, right, depending on where the specific opportunities are.  But I do think in a Biden Administration, government policy whether it’s through legislation or more likely through executive fiat, is going to impact, how private equity views its investment opportunities.

Brown

And based on what we understand is a Biden’ Administration’s view on, on trade policy, how do we think that’s going to impact the growth of private equity backed portfolio companies?

Beeman

The Biden Administration is going to in effect continue the policies of the Trump Administration, if not necessarily the tactics or styles.  If you look at China, one of the Trump legacies is going to be the fact that he moved us from words to actions.  You can critique the actions that have been taken, but we are now beyond words, and I think that’s going to continue in a Biden Administration as it pertains to China.  There are other areas where it could be very different, you know, perhaps less reliant on tariffs, less targeting of allies.  At some point I do think a Biden Administration, probably not initially, is going to get us back into the multi-lateral trade deal game that the Trump Administration really pulled away from.  There are some important things that are facing the Biden Administration.  A deal with the EU.  We’re now farther down the Brexit road, so what do we do with the UK?  That would obviously be more bilateral than multi-lateral.  

So I think trade is con-, continue to be front and center in terms of private equity thinking about what direction to go in.  And a lot of these topics overlap.  You know, trade overlaps with onshoring, which overlaps with supply chains. And all of this stuff is not separate silos, and there’s a lot of interaction across all of these areas.

Brown

Yeah, look, I think that’s right.  You can never make an investment decision with your blinders on, right?  You need to consider all aspects of what’s happening, both the trends in terms of sectors that are growing, in terms of global policy, and in terms of the economy, environment, you name it.  So certainly not going to get any easier, is it?

Beeman

No, it’s not going to get any easier.  It’s going to be as complicated at it has been.

Brown

So Jerry, perhaps if we step back and we think about what we envisage over the next four years, a Biden Administration, their priorities, their value systems and how they’re going to focus, how do we think that’s going to play out across different sectors?  And which ones do you think are going to be, call it the winners, and which ones do you think are going to be the losers?

Whelan

I think it will be a doubling down on those sectors that we’ve seen outperform in 2020.  So I think of tech, I think of health care, biotech and education.  I think what will be interesting to see is in the bankruptcy and workout context, if some of the distressed industries create compelling opportunities for private equity.  So energy, real estate, hospitality, travel, even retail are some of these industries, uh, so beaten up and beleaguered and emerge from either restructuring workouts or bankruptcies and then become appealing to private equity buyers?  And do they shift from their current focus of tax and growth businesses to value plays once they have their house in order from a financial perspective.  And then I think the other big issue from a cross-border perspective, and Ray alluded to the Biden Administration’s potential change in tone and tenor on issues like trade and multi-lateralism, and I think that’ll be important as well from a sector perspective and on … as it relates to cross-border portfolio companies as you’re dealing with issues outside the US.  We’ve been talking about the US elections but we’re also monitoring the elections outside of the US and then some of the issues like, uh, the base erosion profit shifting, Pillar 1 and Pillar 2 negotiations.  Does the US get on board with that and help drive that construct?  And does that give us winners and losers from a sector perspective?  Is there a disproportionate effect? 

And then there’s a lot of anti-abuse rules, anti-trust rules, whether you’re looking at the EU or an Asia Pac, and just the sentiment from an investor perspective investing into, you know, uh, jurisdictions like China and India.  Does that multi-lateral tone and tenor or shift in tone and tenor create a, a better environment for private equity investors investing in those regions and in the sectors that have been winners so far?

Brown

I think we touched on a really good point there.  I mean there are certain sectors that have been really going strong, and [that] we expect to continue to grow, and, you named a couple. The health care, the tech sectors, probably the energy and green sectors given the greater focus on, on the environment and climate change.  But with sectors that are potentially suffering, that also creates a great opportunity.  Because one of the biggest areas that’s growing within private equity are the funds that are being raised, and they’re credit funds.  And there’s a lot of distressed assets out there.  And distressed assets creates opportunity.  Perhaps that’s what we’re going to see a balance.  There’ll be continued interest in investment in those areas that are strong and are growing, and there’ll be credit funds and alternate funding that’s available to help those distressed assets in certain sectors that perhaps are not doing so well right now to help restructure and rebuild.

Beeman

Absolutely.  I mean there’s been a lot of continued fundraising in the credit space and to a certain degree in the distressed space.  And there’s a lot of dry powder on the sidelines, and so, um, it’ll be interesting to see how that plays out in 2021 as funds really seek to deploy that capital.

Brown

I know there’s a lot of uncertainty out there right now.  But what would be great is perhaps if each of you could summarize what you think is the most important thing that private equity leaders should be on the lookout for over the coming months Jerry, maybe I’ll start with you.

Whelan

Yeah.  I think from a macro level, what happens legislatively, do we get some momentum from the Biden Administration?  Is President-Elect Biden going to be able to work with Mitch McConnell if the Republicans retain control of the Senate?  And if we get some momentum and focus on issues that Ray mentioned like infrastructure and climate and green investing, what happens next? Are we able to get some momentum on some other initiatives?  And so from a private equity perspective, just keeping an eye on what that means from a legislative perspective.  Again, what they use from a tax perspective to pay for that legislation and some of those initiatives.  And then again, to keep an eye on what’s happening from a global perspective.  We touched on some of those multi-lateral issues, trade and some of the, um, issues outside the U.S.  So a lot on the horizon, a lot to keep on the radar screen.

Brown

And Ray, any thoughts?

Beeman

I think there’s a lot of anticipation in Washington of a return to a more conventional approach to governing combined with divided government has given people a sense of perhaps much needed policy continuity, given the divided government.  And some degree of certainty, at least for the time being.  But I think it’s important that people not take their eyes off the road and remain agile as we’ve gotten accustomed to through the last year for sure, because I think we are going to see policy shifts, uh, coming out of Washington if not legislatively, certainly by the administration.  And so we might get into a period where we can start planning a little longer-term in terms of government policy, but government policy is always going to be on a pendulum swinging back and forth.  And so it’s always important to be prepared to pivot or shift at least when the time comes. 

Brown

Well, thank you both.  This is really great insight and words of advice.  There’s definitely a lot to unpack and watch out for as the implications of the elections continue to evolve.  And I know all of us in the private equity community will be watching very closely.  I hope you enjoyed this episode of the Next Wave Private Equity Podcast.  Please subscribe, review and of course share it with your colleagues and friends.  To find out more about the topics we discussed, check out ey.com/privateequity.  I’ll see you the next episode, and in the meantime please stay safe and healthy.