Tax Cuts Could Urge LBO Firms to Releverage Holdings, Pay Dividends

Private equity firms are expected to seriously shake up their present investment and exit strategies to seize advantages of the new law that chops the rate on corporate dividends to 15%. Among other outcomes, they might be slower to sell portfolio companies and more intent on boosting interim cash flows to pay dividends. As a result of the reduced tax load, major new tactics could include retaining portfolio companies longer than in the past and releveraging the businesses that have paid down most of their debt to generate money for parceling out big dividends. A new road map that could emerge if those strategic alterations materialize would have LBO sponsors focus harder on conservatively run cash flow producers capable of funding dividends and servicing later-stage rounds of debt. Financial acquirers also would be forced to strengthen management and operations of their companies between purchase and cash-out to ensure that they could pump out dividends to investors in the interim. With dividend streams, leveraged owners could be less dependent on pure exits to calculate returns and payoffs to investors. These prospects could result if the tactics suggested in a PricewaterhouseCoopers impact analysis of the law known as the Jobs and Growth Tax Relief and Reconciliation Act (JGTRRA) actually materialize. A recent issue of the firm’s Deal Flash prepared by partners Michael Kliegman, Mark Boyer, and Jonathan Davies noted that the strategy of releveraging is especially appealing “if interest rates remain low.” “Funds holding a portfolio companies that are not yet ripe for sale, but have solid cash flows and little debt, might seriously consider releveraging these companies in order to pay a large dividend,” they said. But they further noted that when it does come time to sell, private equity firms would benefit from the reduction in the long-term capital gains tax to 15% from 20% through 2008. On the flip side, the Deal Flash warned, U.S.-based private equity funds that park overseas investments in so-called tax haven countries might lose many of the benefits of JGTRRA. The 15% tax, the PWC partners noted, applies only to dividends paid by U.S. companies and “qualified foreign” firms that are incorporated in a U.S. possession, issue shares traded on a U.S. exchange, or can receive benefits from a treaty between the U.S. and another country. If the company is situated in a tax haven, it can say goodbye to the reduced rate on dividends and capital gains. “This may seem an academic point, since most leveraged investees do not pay dividends,” the Flash said. “However, when a U.S.-owned foreign company is sold, a portion of the resulting capital gain is taxed at the dividend rate, based upon the portfolio company’s accumulated earnings during this period.” The PWC partners recommended that offshore holding companies in future deals be located in tax treaty countries “so their dividend (or sales proceeds) will qualify for the reduced rate.” “We also recommend that firms examine their existing portfolio companies and consider reorganizing them in more favorable tax treaty jurisdictions,” they added. Interim payments to investors Whether considered from the dividend side or the sale side, the new tax law could increase the flexibility of LBO firms in reaping full payoffs from their investments. The reduced dividend rate could be a handy device for paying off investors when a portfolio company isn’t quite ready to be sold or taken public. Perhaps even more importantly, the staggered dividends could substitute for a large one-shot payoff when the company has ripened but the m&a market is too weak to allow a lucrative sale or the IPO window is closed – or both the exit and deleveraging channels are blocked. Besides influencing the character of the companies they buy, the tax law also might impact the way LBO sponsors shape their fund-raising efforts, whether they can utilize the more hospitable tax climate to appeal to new classes of investors, and how deal structures may be varied. There are also questions about the mix of domestic and foreign investments at a time when an increasing number of funds are eyeing overseas pastures in search of investable companies. Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com