Before you ask (and you shouldn’t need to ask), a private equity firm’s first best friend is carry. Coming in a distant second, a very distant second, a private equiteer’s next best friend is tax.
Here are the reasons:
- The typical private equity investment is highly geared, ipso facto, it has high interest expenses. Those high interest expenses provide a tax shield, which means private equity investees often don’t pay a cent of tax. And not paying tax while receiving the benefit of others paying tax is a private equiteer-friendly concept.
- Tax gives private equiteers a bargainning chip. All of a sudden, they can justify paying a lower price because of the tax implications. They can refuse to grant management options because of the tax implications. They can make a case for their preferred legal structure because of the tax implications. They can gear the business up to its eyeballs because of the private equity tax implications. They can justify just about anything because no sane person understands the Internal Revenue Code (or whatever applicable tax code) in enough detail to debate it.
- Lastly, a private equiteer’s heartfelt campaign to have the vendor pay less private equity tax creates an alignment of interest. “I want you to pay less tax because it increases the value of the transaction for you, it helps us both create a better business for your employees, and… no one likes the tax man (chuckle, chuckle).” How could you turn down a line like that? You’d love it if you were a vendor, wouldn’t you?. Now that we’re best buddies with a common enemy, I proceed to show why I should pay you less for the business, why the strike price on your options should be higher (so they don’t incur private equity tax) and why the business should be geared at 6 x EBITDA.
So, to recap, private equity firms love tax because they don’t have to pay it and still get the benefit, it creates a bargaining chip, and it helps to show alignment with vendors. I’d be a billionaire if I was paid a million dollars every time I heard a private equiteer raise the strike price on management options citing private equity tax implications. My advice, just give it to people straight; they tend to value that.