How private equity firms are rethinking tax to meet multiple pressures

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

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%.

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.

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.”

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.”

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.