How Is the Trump Administration Impacting Private Equity?
In the Investors’ Outlook for 2017, dealmakers and other key mergers and acquisitions (M&A) experts said that a change in political administration and an increase in interest rates would have the greatest effect on U.S. M&A growth in the coming year. Nearly 10 months into President Donald Trump’s term, how are the policies he campaigned upon – from deregulation and infrastructure to protectionism and tax reform – impacting private equity?
A panel of experts – Gus Faucher, senior vice president and chief economist of The PNC Financial Services Group; Kevin Sullivan, partner at Katz, Sapper & Miller; and Erica Williams, partner at Kirkland & Ellis – recently gathered at The Kelley School Private Equity Conference to discuss the status of these legislative issues, how the economy is doing, and what private equity can expect from here.
One of Trump’s campaign stances was to simplify the tax code. Though recently released, much of the detail of Trump’s proposed tax plan has yet to be seen, and its impact has yet to be assessed. Some of the key points of the plan include the following:
|Reducing the corporate tax rate to 20 percent|
|Allowing businesses to immediately write off the cost of capital expenditures for five years|
|Limiting the net interest expense deduction incurred by C corporations|
|Establishing a maximum pass-through business tax rate of 25 percent|
|Reducing the number of income tax brackets from seven to three – 12 percent, 25 percent, and 35 percent|
|Eliminating most itemized deductions for individuals except for the home mortgage interest deduction and the charitable contribution deduction|
|Implementing a territorial tax system|
|Establishing a one-time repatriation tax for foreign earnings|
The impact of proposed tax reform upon private equity is yet to be determined, especially considering that the plan has not yet been through Congress. Though lower tax rates and tax changes on foreign earnings are designed to put more money back in the hands of businesses, there is skepticism that it would spur corporate investment and economic growth. In private equity, many firms have capital to deploy but have difficulty finding qualified operating companies in which to invest. Similarly, Sullivan noted that U.S. companies currently have trillions of dollars overseas and are holding those funds instead of reinvesting them. The panel pointed out that tax reform faces a higher hurdle of congressional approval than simple tax cuts, so full tax reform could be more difficult to enact.
Carried Interest Provision
Though not discussed in his tax plan, Trump campaigned to eliminate the carried interest provision. Often referred to as a loophole by critics, carried interest allows fund managers to pay a capital gains tax rate as opposed to ordinary income rates on their carried interest, or share of profits received from investment gain. Sullivan pointed out that it is unclear whether the proposed changes will apply only to hedge fund managers or other fund managers as well. If carried interest is eliminated, it is possible that a new equity interest structure would be designed to compensate fund managers, and that new structure could potentially leave them with some sort of capital gain.
SEC Examinations & Enforcement
According to Williams, who previously served as deputy chief of staff at the U.S. Securities and Exchange Commission (SEC), the SEC will not be letting up on exams of investment advisors under the Trump administration. In fact, the SEC has conducted recent surprise examinations, showing up to as many as 12 firms in one week without announcement, and continues its focus on firms that have not had previous examinations. Additionally, the agency’s Private Funds Unit is comprised of those who worked in the private equity industry, which means exams could be conducted at greater length and in more detail by people who have deep industry knowledge.
While the issues being examined – including undisclosed fees and expenses, conflicts of interest, pay-to-play, and valuation violations – remain largely the same, there is an increased focus on cybersecurity. Cybersecurity is one of the greatest compliance risks for financial firms, and private equity firms are encouraged to design and test procedures to prevent cyber breaches.
SEC Chairman Jay Clayton has said that the SEC will continue focusing on enforcement cases, which include insider trading, accounting fraud, Ponzi schemes, and other malpractice issues. However, the Supreme Court recently set the SEC’s statute of limitations for disgorgement – or repayment of ill-gotten profits from violating SEC regulations – to five years, which will likely force the SEC to move more quickly. Additionally, the SEC has a hiring freeze, which could limit the number of enforcement cases the agency addresses.
The proposed Financial Creating Hope and Opportunity for Investors, Consumers, and Entrepreneurs Act (known as the Financial CHOICE Act) seeks to roll back much of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which enacted regulatory requirements for banks and financial institutions in the hopes of preventing another financial crisis. The Financial CHOICE Act, which passed the House of Representatives earlier this year, would allow some firms to deregister with the SEC, scale back reporting requirements, and repeal the Volcker rule, which limits the ways in which banks can invest. If this proposed legislation becomes law, some private equity firms might choose to remain registered because SEC registration typically exudes benefits, such as legitimacy with investors. The Volcker Rule, however, could be addressed separately from the Financial CHOICE Act. Recently the U.S. Department of the Treasury recommended significant changes to the Volcker Rule, which could provide some regulatory relief.
The Obama administration had a particular focus on antitrust, seeing increases in the number of enforcement cases and resulting fines. His approach to antitrust was to incentivize sector-specific government agencies to find ways under their regulations to increase competition. Interestingly, this may not change. The Trump administration said they are focusing on having the Food and Drug Administration (FDA) continue this trend by increasing competition for drug prices. Though antitrust regulations could decrease, it appears the Trump administration is still determining other ways to increase competition and lower prices for consumers.
Trump, who campaigned on the issue of protectionism as a means of protecting U.S. jobs and businesses from foreign competitors, withdrew the U.S. from the Trans-Pacific Partnership (TPP) earlier this year and has begun renegotiation of the North American Free Trade Agreement (NAFTA). Protectionism has implications for all private equity firms but especially so for those engaging in cross-border investments. The expanding global economy is increasing opportunities for trade growth overseas, particularly in Asia and other developing economies.
Though anticipating only micro-changes to the existing NAFTA framework, Faucher said there is concern that leaving the TPP means the U.S. will miss an opportunity to help establish the trade rules for the fastest growing economies of Asia, thus ceding leadership to China and resulting in missed opportunities for U.S. investors.
When compared to the issues of healthcare and tax reform, the Trump administration’s plan for infrastructure has received less attention. That is, in part, because there is still much to be determined – particularly whether the funding for infrastructure improvements will be funded by the government or by public-private partnerships. If Trump’s plan relies on financing these improvements using private capital, there would be opportunities for private equity involvement. However, given that there is no formalized, proposed legislation, it seems unlikely that any infrastructure bill would be voted on until 2018.
It almost goes without saying that the state of the U.S. economy has huge implications for private equity. Changes in the U.S. economy, such as interest rate hikes, unemployment, and inflation, have a ripple effect for private equity investments and strategy.
Citing a strengthening U.S. economy, the Federal Reserve recently announced it would begin reducing its nearly $4.5 trillion balance sheet, a result of purchasing mortgage-backed securities and long-term treasuries in an effort to stimulate the economy after the 2008 financial crisis. Though the national unemployment rate dipped to 4.3 percent earlier this year – its lowest since 2001 – the Federal Reserve would like to see stronger inflation, closer to its 2 percent target. According to Faucher, there could be an increase in long-term and short-term interest rates, with short-term rates rising more quickly. However, these rates will be lower than they have been in past economic expansions, and these gradually rising interest rates will allow for economic growth without causing imbalances.
Given that much of the detail of these policies remains to be seen and could change significantly as it makes its way through Congress, private equity firms would be wise to know about pending legislation while continuing with their investment strategies. If you are looking for a partner to help navigate a transaction, our team of transaction experts is here to help.
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