2021 Private Equity UpdateMarch 08, 2021
2021 will be eventful for PE firms as businesses continue to navigate challenges of the COVID-19 pandemic, potential tax changes and a renewed emphasis on due diligence. Here’s what you should know.
As the arrival of COVID-19 vaccines has increased optimism, private equity (PE) firms in 2021 are redirecting their efforts from stabilizing their existing portfolios to resuming investments. The combination of large amounts of “dry powder” (cash reserves), high multiples, low interest rates and the possibility of unfavorable changes to the capital gains tax rules and the corporate tax rate likely will lead to a surge in deal-making activity. But there are some substantial pandemic-related changes to navigate as well.
With Democrats in control of both the executive and legislative branches of the federal government, PE players are worrying about how tax law changes could affect their transactions and bottom lines. These concerns could prompt a burst of activity, as firms and potential portfolio companies rush to close deals before new tax provisions (or new regulations) take effect.
The Biden administration has proposed taxing capital gains as ordinary income for taxpayers earning more than $1 million — this would include carried interest. Biden also has proposed returning the top individual income tax rate to 39.6% from its current 37%.
Combined with the 3.8% net investment income tax (NIIT), that would leave high-earning PE executives effectively taxed at 43.4% on carried interests — or nearly twice the current rate of 23.8% (20% capital gains rate plus 3.8% NIIT rate). Deal prices probably would climb, too, as sellers look to offset the bigger tax bills on the sales of their businesses.
The corporate tax rate is garnering attention, too. The Tax Cuts and Jobs Act (TCJA) reduced the rate from 35% to 21%, but Biden wants to increase it to 28%. Some PE firms and portfolio companies may have converted to C corporations to take advantage of the lower TCJA rate. Those firms could see a hit to their earnings from a higher corporate rate. And an increased rate could affect companies’ cash flow, with a domino effect on deal-making ability.
Of course, no one can say for certain whether these proposals will be enacted, or, if they are, when they’ll take effect. Issues related to the COVID-19 pandemic and its effect on the economy are consuming much of the attention in Washington, D.C. Moreover, tax laws generally aren’t retroactive. Odds are, PE firms will have time to engage in the necessary tax planning to minimize the potentially adverse effects.
Rise of SPACs
Special purchase acquisition companies (SPACs), also known as “blank-check” companies, have been around for several decades, but they’ve gained in popularity in recent years. With no operations, the companies exist solely to raise capital through an IPO and then use that capital to purchase an existing private company in a reverse merger.
PE firms initially got involved with SPACs when looking to exit portfolio companies, as an alternative to a sale or a traditional IPO. But now firms are beginning to form their own SPACs to conduct acquisitions. SPACs require a relatively low upfront investment with significant potential upside and shorter investment timelines than typical in PE transactions.
A PE firm sponsoring a SPAC generally will buy 2% to 3% of the shares in the IPO, in exchange for a stake of around 20% of the equity in the post-IPO company. A SPAC can be a worthwhile option, because it gives a PE firm greater access to capital without the time commitment and other headaches associated with raising funds from limited partners.
Renewed Emphasis on Due Diligence
Due diligence will always play a critical role for PE firms, but the focus must evolve. That’s particularly so in the wake of something as dramatic as the COVID-19 pandemic — a disruption that revealed numerous previously hidden vulnerabilities in all kinds of companies.
For example, the pandemic has caused massive problems with breakdowns in transportation and other vital links to essential supplies. Going forward, due diligence will need to evaluate the resiliency of a target’s supply chains and the strength of its supply chain management.
Similarly, due diligence should scrutinize a target’s investment in technology, including cloud storage and user interfaces and experiences. While technologies have always been assessed, the pandemic demonstrated that current technological capabilities can be more important than potential future capabilities. Generally, those companies already armed with robust capabilities have proven to be more agile and better able to adjust to unexpected circumstances during the pandemic.
It’s also important to note that firms have had to modify their due diligence efforts to accommodate the movement toward virtual working arrangements. Technology — including the use of Zoom conferences, body cameras and drones — can help facilitate remote procedures. Today, many deals are vetted and completed in a virtual environment, eliminating the cost and time associated with traveling to conduct in-person due diligence and negotiation. That trend is expected to continue beyond the COVID-19 crisis, as the uptick in activity in the final quarter of 2020 made clear that appropriately equipped firms can pursue and execute deals even in a virtual environment.
The Hunt for More Diverse Talent
With piles of dry powder available in 2021, the PE market is expected to be competitive. The firms with the highest caliber talent probably have the best odds of securing deals. Although the general unemployment rate is high, qualified executives who can maximize investments have their pick of PE firms.
When evaluating applicants, PE firms would be wise to look beyond resumes and profit and loss statements. They also should think about personal backgrounds and experience. Events over the past year have highlighted the importance of recruiting, developing and retaining diverse staffs and boards of directors.
Both target companies’ management teams and potential investors increasingly prioritize the ability to tap a wide spectrum of perspectives. In addition to the value of “seeing themselves” reflected, they recognize that heterogeneous teams tend to be more innovative and creative. Outsourcing talent acquisition to executive search consultants with a proven track record can produce the kind of staffing that draws favorable attention.
Let’s Work Together
PE firms’ responses to the pandemic and the economic fallout should strengthen investors’ confidence and, in turn, fundraising. Contact our PEVC Group for assistance in pursuing, vetting and executing successful deals, as well as recruiting the necessary talent.