AP Photo/Andrew Harnik, File
Section 13301 of the Tax Cuts and Jobs Act spans only 12 of the legislation’s 503 pages. It doesn’t cover the giant corporate tax rate cut, the trim to the top marginal rate, or changes to pass-through income. It wasn’t part of anyone’s talking points, whether touting or damning the tax overhaul. After passage, few even understood how it got into the bill.
But Section 13301 could affect the lives of millions of Americans. It could radically upend the balance sheets of some of the most powerful financial institutions in the country. It's hard to know at this point exactly how these firms will compensate for the changes. But it does show how small shifts in the tax laws can have wide-ranging, unanticipated consequences.
What does Section 13301 do? It limits the ability of corporations to deduct interest payments from their overall taxes. Previously, companies could take all of their interest payments as a deduction, making financing operations through debt more desirable than through equity. Those days are now over.
This obviously affects any company that uses debt financing, of which there are many. But it really targets the masters of debt in the modern economy: the private equity industry, which uses borrowed money to purchase companies—and, some would say, suck them dry. Those deals are predicated on the ability to load up on debt cheaply: the new tax limitations make such maneuvering more expensive.
So did the Republican Congress and Donald Trump unilaterally dismantle one of the most powerful industries in the financial sector? Did they inadvertently hand struggling companies, once prime targets for private equity vultures, a real shot to avoid capture? Well, not quite. It more likely just altered the structure of private equity deals, and perhaps the targets of their business model. “Private equity will adapt,” said William Cohan, former Wall Street investor and author of three books about the financial industry. “They are nothing if not an incredibly adaptive organism.”
But those adaptations could be seismic. Just as it might give workers and businesses a fairer chance to survive, it might simultaneously unleash wreckage on renters and homebuyers in marginal communities. It's like putting a finger in one spot of a leaky dam, only to see water shoot through another hole. Either way, the water gets out, but in different ways with different effects. Republicans didn't deliver a blow to the private equity industry, but they might have fundamentally altered it—and perhaps made it even more dangerous.
DEBT IS A POWERFUL ENGINE for financial gain: just ask the so-called “king of debt,” Donald Trump. If a business finances with someone else’s money instead of its own, it enjoys greater return on investment. Think of it this way: if you make a $10 profit on $100 of your own money, your returns are 10 percent. If you make a $10 profit on $100, $50 of which is borrowed, the returns on your $50 are 20 percent. Even after paying off interest – which until a few months ago was fully tax-deductible—your profit will be higher. And the more debt financing you use, the higher the returns.
But Section 13301 makes debt less attractive by altering a part of the tax code called Section 163(j). Now, businesses with revenues over $25 million will only be able to deduct net interest expense—their interest paid out minus any interest income they receive. And that net interest cannot exceed 30 percent of a company's adjusted taxable income for a given year. This restriction tightens over time: at first adjusted taxable income equals earnings before interest, taxes, depreciation and amortization (EBITDA); starting in 2022, the measure narrows to just earnings before interest and taxes (EBIT). The Senate version used EBIT and the House version EBITDA; the final law reflects a compromise.
Democrats played no role in crafting the tax legislation, and Republicans don't exactly have a reputation for defying big business. So how exactly did this happen? It was a matter of math, said Steven Rosenthal, a senior fellow in the Urban-Brookings Tax Policy Center at the Urban Institute. “This was a feel-good bill, so everybody got tax cuts,” Rosenthal said. However, Republicans were limited by self-imposed budget rules; the legislation could only cost $1.5 trillion over ten years and nothing after that. This required some revenue-raisers, and limiting the interest deduction was one of the most valuable in the entire bill. According to the Joint Committee on Taxation, it saves $253 billion over the ten-year budget window.
Rosenthal believes the numbers are something of a gimmick, because businesses can carry forward any interest payments not deducted indefinitely. “The score looks a lot larger than what will ultimately be collected,” he said. Plus, corporations won major benefits in exchange for this interest limitation. The overall corporate tax rate is far lower. New expensing provisions allow businesses to immediately write off capital expenditures and asset acquisitions. One cannot claim that the Tax Cuts and Jobs Act hosed businesses just because of a single setback on interest deductibility.
Nevertheless, the tax preference of debt is central to one type of transaction, known as a leveraged buyout. For the private equity firms that use this technique, it could have a major impact.
THE TRADITIONAL PRIVATE-EQUITY MODEL involves buying a struggling company through borrowing as much as six times the company’s EBITDA or more. The company takes on the debt; the private-equity firm uses management fees, special dividends and other payments to pull out profits. Thanks to the interest deduction, the company can offset much of its earnings for tax purposes, but the debt overhang also requires cutting labor and maintenance costs to the bone. With little personal investment, private equity can strip most of the profits out of the company and make a killing, leaving the carcass along the road in the aftermath. Even if the company falls into bankruptcy and the private equity firm gets wiped out, they’ve already made their money back.
We've seen this repeatedly, with terrible outcomes for businesses and workers. The so-called “retail apocalypse” has roots in over-building and the rise of e-commerce like Amazon. But Toys ‘R’ Us, Payless ShoeSource, The Limited, Wet Seal, Gymboree, rue21, and True Religion were all acquired by private equity in leveraged buyouts, and they all went bankrupt in 2017. Toys ‘R’ Us was actually increasing in profitability when it failed; it couldn’t survive the massive debt payments.
“There's this idea that Amazon disrupted retail, but retail is constantly being disrupted,” said Eileen Appelbaum, co-director of the Center for Economic and Policy Research and co-author of Private Equity at Work, a critique of the leveraged buyout industry. “Zara came along and changed high fashion every two weeks. The difference with private equity is that traditionally retail is low debt, which gives them breathing room. It’s not that they didn’t know to do e-commerce, they had no resources.”
In all, 40 percent of retail bankruptcies between January 2015 and April 2017 were private equity-owned chains. Another study points to private equity accounting for 61 percent of all retail job loss over the past two years. And it’s not just retail: venerable gun manufacturer Remington and restaurant chain Macaroni Grill have filed for Chapter 11 protection in the past several months.
Debt is the common thread, the grease that makes leveraged buyout deals happen, and the lead weight that forces struggling companies to the bankruptcy court while their private equity masters cash out. And because of the full deductibility of interest, that debt was inexpensive. Section 13301 attacks this, making the same deals not nearly as profitable. Private equity firms often have tax-sharing agreements with their portfolio companies, where they take some of the deductions, such as on interest. So the firms’ personal bottom lines will suffer as well.
Private equity lobbied heavily on a separate piece of the tax bill involving closing the carried interest loophole, which allows managers to take their earned income as capital gains. They won that fight; the law barely touches carried interest, adding only a provision that investments must be held for more than three years, which private equity nearly always does. But in working so hard to preserve carried interest, private equity lost track of this other flank. “I don’t think anybody expected this, wanted it or lobbied for it,” said William Cohan. “The industry is used to getting its way, used to not changing its behavior.”
Even without Section 13301, the lower tax rate means that the government will cover less of an interest payment. And structuring new deals, as well as dealing with old ones, will be frustrated by the limitation provision. Private equity would likely have not become the economic phenomenon it is today if this were in effect. “Limiting the deductibility of interest removes one of the incentives to use high leverage to juice returns,” said Jim Baker of the Private Equity Stakeholder Project, which spotlights industry practices.
Make no mistake, private equity will not be decimated by the tax law.
Mike Sommers, president and CEO of the American Investment Council, the industry's trade group, said in a statement that, while his organization advocated against the deductibility limits, “we believe that overall the new law will support the kind of long-term investing that allows private equity to provide superior returns to investors and creates jobs across our country.” Similarly, a report from Hamilton Lane, an advisory firm to private equity clients, argues that when all corporate tax changes are factored in, private equity will see a boost in value of between 3 and 17 percent.
But the report quietly adds that highly leveraged businesses will have a problem. “Once a company's debt level is more than five times EBITDA, the inability to deduct interest begins to cancel out the benefits of the law,” according to an analysis of Hamilton Lane's report by the Wall Street Journal (Hamilton Lane declined to make their report available to me).
This disproportionately harms portfolio companies with bigger debt loads. That disrupts the worst kind of vulture fund private equity deals. In addition, older deals with high levels of debt aren't exempted from the law, meaning private equity could need to apply funds to deals with new tax liabilities. And companies struggling under debt loans won't have the tax lifeline to extend their lifespan; the likelihood of more Toys ‘R' Us-style bankruptcies looms large.
In a general sense, reducing corporate debt across the board by eliminating the incentives to borrow in the tax code is a very good thing. Debt-loaded companies are riskier, with less of a safety net in an economic downturn. Most corporate debt operations finance financial engineering with little productive value, like share buybacks or acquisitions. We could certainly use less of that in America.
But we cannot assume that the private equity industry will be static in their reaction to the tax law. “They have the best lawyers and accountants in the world,” said Steve Rosenthal. “I know, I used to work with them.” Unquestionably, creative deal structuring and re-prioritizing will seek to sidestep the tax liabilities. But we don't know exactly how. Here are some possibilities, and their implications.
FIRST OF ALL, the price of leveraged buyout deals could fall. “To get the kinds of returns that they typically expect, because now they can’t use as much leverage, they’ll end up paying less for companies they buy,” said William Cohan, who wrote about the issue for The New York Times.
But interest deductibility is hardly the only factor in skyrocketing deal prices. More firms are chasing fewer deals than ever, and fundraising has reached decade-long highs. And publicly traded firms, newly flush with cash from the tax law and without as much reliance on debt financing, could prove a formidable rival for acquisitions. Private equity firms have a lot of competition and over $1 trillion in funding on the sidelines, so they may not be able to reduce deal prices, even if they want to.
Firms could engage in complex deal structuring to evade the taxman. Investors could take a preferred equity stake in portfolio companies instead of lending money. They would still receive regular payments, but as a dividend instead of interest. Functionally speaking, this gives the private equity firm the same amount of leverage, while running afoul of the deductibility restraint. A partnership structure that invests in portfolio companies instead of purchasing them would not create debt, but would generate capital for the private equity firm without their personal expenditure. Additionally, the firm could engage in a leasing arrangement instead of buying the portfolio company outright. That would embed interest payments in the cash flow of the lease and possibly avoid deduction limits.
We're likely to see this kind of creativity. But that could highlight loopholes that future Congresses and presidents who are less inclined toward the financial industry might be keen to close. Plus, private equity investors may prefer to be creditors than equity holders, with more control in bankruptcy. The easiest way for firms to compensate for the interest deduction is simply by throwing more equity into the deals. We've seen this in one of the first post-tax law deals: Rhone Capital buying Brazilian steakhouse chain Fogo de Chao for $560 million, all of it in cash.
This would have several salutary benefits. First, it would put more of the firm's skin in the game, making them more sensitive to risking portfolio company bankruptcy. Second, it would reduce the overall leverage in the system, which may mean lower returns but also more economic stability. Leveraged loans add risk to the banking sector, and private equity firms themselves have become lenders, even into their own deals. While this has lowered borrowing costs, it has shot up the availability of debt, which has been growing to heights not seen since the financial crisis. A lid on that debt level would reduce the acceleration of catastrophe in a downturn.
But more equity would lower returns, and this is an inopportune moment for that. The industry already is struggling to convince investors that their business model is worthwhile. Some analysis shows that private equity does not consistently beat the market, and this weak performance could lead key sources of funds like university endowments to change their investment mix. You could imagine a vicious cycle of lower returns leading to withdrawals of capital leading to even lower returns. The tax law could be just the spur to a long-anticipated re-evaluation of portfolio alignment.
Fortunately for private equity firms, there's one other option, a gaping loophole in Section 13301. Several business types are exempted from the interest deduction limitation, including car dealerships, electric and water utilities, and agricultural cooperatives. But for private equity's purposes, the big exemption is for “any electing real property trade or business;” in other words, real estate.
“I can only assume that that's because of Trump,” said Robert Goulder, a senior tax policy counsel with Tax Analysts. But the serendipity of the president being a real estate tycoon has widespread implications for private equity firms. “The incentives are not to be in leveraged buyouts and way more to be in real estate,” Eileen Appelbaum said. “I expect them to set up their own little real estate companies.”
This could work a couple different ways. Many portfolio companies targeted in deals have significant real estate assets: think of a retail or restaurant chain that owns its own properties. Those real estate holdings could be spun off of the business and acquired with debt, and all of the interest payments on that debt could be deducted. Companies with lots of real estate on the books could become prized commodities, and not just retail firms that own store space, but hotels or casinos.
But the more likely play is to bulk up investments in a burgeoning industry large private equity firms have pioneered: buying up and renting out single-family homes. If you think it's a good idea for Wall Street to become your landlord, just wait until the tax code pushes more money in that direction.
AFTER THE FINANCIAL CRISIS, whole neighborhoods suffered from mass foreclosures. Among the few buyers left were private equity investors, who scooped up foreclosed properties at bargain-basement rates in a handful of metropolitan areas. While waiting for the economy to turn around and home prices to increase, they splashed a fresh coat of paint on the properties and rented them out, often to families who had lost their homes to foreclosure.
But a funny thing happened on the way to the cash-out: the rental business itself became profitable. “You had financial firms come in and turn single-family rentals into a new asset class,” said Julia Gordon, executive vice president of the National Community Stabilization Trust. “Suddenly this was all online and you could just buy foreclosed houses anywhere from your cell phone without getting out of bed. It's like a giant casino.”
Blackstone, the world's largest private equity firm, built its single-family rental portfolio under the aegis of Invitation Homes, acquiring over 48,000 homes since 2012. At one point they were spending $150 million a week on properties. Along with other firms like American Homes 4 Rent and Tricon, Blackstone formed a lobbying group for single-family rental companies, the National Home Rental Council. Several companies went public, raising billions in the stock market to put toward more purchases. And they started to securitize the rental revenue, selling bonds to investors backed by the stream of payments, in an eerie similarity to mortgage-backed securities whose implosion rocked the economy in 2008. Currently there are $17.5 billion in outstanding bonds on the market. (The SEC is currently investigating whether these rental bonds have been sold with overvalued property appraisals.)
Last year, Invitation Homes merged with Starwood Waypoint, the nation’s number-three rental empire, with the combined company owning 82,000 properties nationwide. The total number in the asset class is at least 200,000. While this represents only 2 percent of single-family rentals nationwide, they’re concentrated in so few regions that the market impact is much higher. Invitation Homes is currently the largest landlord in Sacramento, and the second-largest property owner besides the city itself. Atlanta, Houston, Phoenix, Charlotte, and several cities in Florida have high concentrations of private equity-owned homes as well.
The group that hasn't made out well from this, as you might imagine, are renters, as a report from three advocacy groups details. “Our report showed what we know, that huge national and global private equity firms are hurting communities,” said Amy Schur of the Alliance of Californians for Community Empowerment, one of the co-authors of the study.
Private equity-fueled rental companies offer substandard properties with rampant habitability issues, like dangerous concentrations of lead in paint and soil, leaky pipes, and malfunctioning appliances. Tenants find it difficult to get problems repaired; some companies have produced DIY videos to encourage the tenants to fix things themselves. One family reported that Starwood Waypoint responded to a giant hole in one wall by putting a mirror over it.
Single-family rental companies promise “competitive rents” to keep bond ratings high and investors happy. Before their merger, Starwood Waypoint and Invitation Homes estimated 4.7-5.3 percent quarterly rent growth on their properties, nearly double the national average. In areas with high concentrations of single-family units, rent increases are far higher, with some tenants reporting spikes of hundreds of dollars a month. Plus, the single-family rental market has managed to evade rent control laws that apartment owners are subject to.
To minimize losses, private equity landlords promise high fees and fast evictions, with no forgiveness for late or partial payments. Almost one-third of Atlanta tenants in Starwood Waypoint homes got eviction notices in 2015, according to the report. When rental markets were local businesses, tenants had more direct ties to landlords and could appeal to them for assistance. But with these companies, there's often no human being with whom to negotiate a work-out.
While evictions can be expensive, landlords have devised ways to cover costs.
They bill tenants “charge-backs” for routine repairs. Even if tenants identify repair needs upon move-in, and even if landlords are responsible for supplying functioning electrical and plumbing systems, firms take repair costs out of monthly rent, retain security deposits, or send unpaid charge-backs to debt collectors. Charge-backs at the second-largest landlord, American Homes 4 Rent, rose from $1.5 million in 2013 to $120 million in 2017, with rents only increasing six-fold in that time period.
Other hidden fees include service charges for putting in a security system or “smart home” feature; the tenant pays directly for amenities meant to attract them to rent the house. They've even charged “pet rent,” a special fee for families with dogs or cats.
These businesses have already capitalized off government policies. Single-family rental firms already enjoy tax breaks, because they are set up as tax-exempt real estate investment trusts (REITs). The Federal Housing Administration has sold a shocking number of homes to private equity firms to bulk up their portfolios. And government guarantees now spur the market, like with Fannie Mae backing a $1 billion Blackstone securitization last year.
But if the deductibility of interest limitation shifts more private equity firms into real estate, that could enable a second wave of rental buying. “You can't buy in Phoenix and the suburbs of Atlanta anymore, but you can push further and further into more distressed markets,” said Julia Gordon. The returns down-market are even higher, because tenants have fewer options. Blackstone hasn't directly purchased in these at-risk communities, perhaps because of the potential reputational hit for being slumlords. But they have funded several smaller investors through a unit called B2R, and have sold off their down-market homes to newer entrants who have ramped up purchases.
As a new wrinkle, private equity firms are constructing single-family and multi-family properties specifically for rentals, going well beyond the initial strategy. American Homes 4 Rent has its own building unit for this purpose, and others supply financing to buy the homes upon construction.
The homes investors purchase share characteristics with properties that are attractive to first-time homebuyers. This makes it harder to find a starter home; how can a first-time homebuyer to compete with a connected investor promising all cash? Sometimes the homebuyer never even sees the listing before a financial institution sends it to investors. So not only are longtime residents who can't afford skyrocketing rents being displaced; potential homebuyers are being denied one of the few wealth-building strategies left in America.
Because supply gets constricted, it actually drives up the costs for all homebuyers, not just those shut out of the market by investors. And absentee landlords likely put less money into fixing up homes than homeowners, degrading the quality of neighborhoods as well. All of this disproportionately affects people of color, who see more Wall Street landlords in their communities. “When Wall Street owns something, their feelings about it are just different,” said Julia Gordon. “They’re not in it to provide quality housing for Americans. It’s just a numbers game.”
If you doubt private equity would turn on a dime to become real estate tycoons rather than corporate raiders, consider that Blackstone just named Jon Gray, its longtime head of real estate, as president and heir apparent to chairman and CEO Steven Schwarzman. While outwardly, Blackstone and other firms promise business as usual after the tax law passage, moves like this, and the continuing strength of the rental sector—there are eight million more rentals today than in 2005—suggest the potential for a sea change. And the tax law actually hurts homeowners by limiting deductions for property taxes and mortgage interest. That diminished desire for homebuying also sets up well for a private equity takeover. “This is already causing bankers, because it’s what they do, to call clients and say you should do this and this,” said William Cohan.
A flood of new money into the rental markets would just exacerbate existing problems: the squeezing of renters, the lack of housing supply, the changing composition of neighborhoods, the potential for mass evictions and blight in a downturn should the rental bonds fail. “The government has been bending over backwards for decades to grease the way for these Wall Street actors to get control of housing,” said Amy Schur. “Our members actually would like to see the government taking action to protect communities, protect housing stability, and advance homeownership. Yet we see them taking actions that line the pockets of Wall Street investors and hurt us.”
SCHWARZMAN, THE BLACKSTONE CEO, chaired Trump’s now-defunct Economic Advisory Council and remains a close confidante. This has already helped him secure lucrative deals, and it’s highly unlikely that anything Trump signs will threaten Schwarzman’s $786.5 million annual take-home pay. The tax law falls into that category. Nevertheless, the ways the interest deduction limitation will alter private equity dealing may have extreme, unpredictable effects, as I have shown.
Limiting the interest deduction remains an important policy to reduce leverage and make corporate America more stable. Even if Democrats return to power and toss out the Trump tax cuts, they should keep this. It's just not a sufficient way to defang the private equity industry, whose tax planning and legal departments far outpace whatever the government can come up with. If you really want to go after private equity, you must look at other options.
Just having private equity conform to a reasonable standard of performance measurement would give investors more information to understand whether it's worth seeding these firms with cash. Private equity could be required to supply more information to the Securities and Exchange Commission, like other investment firms, increasing transparency on monitoring fees and other ways they leak out profits. Firms could be responsible for worker retraining and pension liabilities instead of the companies they field-strip, perhaps by making them joint employers for that purpose. And on the tax side, you could close the carried interest loophole if you really wanted to treat private equity managers' income the way every other income-earner gets treated.
“What's underlying our proposal is that you treat private equity as an employer,” said Rosemary Batt, Appelbaum's co-author of Private Equity at Work and a professor at Cornell University. “They’re calling the shots. They should be regulated in ways that are similar to public corporations. That would destroy the private equity model.”
What you can't do is expect a small provision of the tax code, however disruptive, to do all the work of bringing these firms out of the shadows. “Tax reform replaced complexity with other complexity,” said Jim Baker of the Private Equity Stakeholders Project. “These firms have been masters of using that complexity to their own benefit.”
