Mendoza School of Business

Buying Big Tax Break

Published: September 2, 2009 / Author: Josh Kosman

When private-equity firms engage in leveraged buyouts, Uncle Sam loses out.

According to a study to be presented at New York University this month, the companies that PEs buy slash their taxes by more than half. For every dollar of pretax income, they pay 15 cents less in income tax than similarly sized competitors.

Most of this is because of a giant tax break that enables a company to deduct loan interest from taxes, said Notre Dame Professor Brad Badertscher, one of the authors of the academic study.

Private-equity firms structure acquisitions like mortgages. But while homeowners pay their mortgages, PE firms have the businesses they buy take the loans, making them responsible for repayment. Typically, PE firms put down cash equal to between 30 percent and 40 percent of the purchase price, and their target companies borrow the rest.

Then the companies deduct the interest they pay on their loans from taxes.

“If you remove this deductibility, it would be a huge benefit to the government,” Badertscher said.

When studying buyouts of 80 public companies, his team found those businesses paid about a 22 percent marginal tax rate before being bought, and only 10 percent the year of going private.

Badertscher said the study shows how important the tax breaks were for private-equity firms, and that if the government even limited them it would have a huge impact on the PE industry.

Yet even with the tax breaks, several studies over the years have shown that after collecting fees, most PE-owned firms generate lower returns than the Standard & Poor’s 500 index.

Private-equity firms bought more than 3,000 US businesses from 2000 to 2008, for a total of $1.2 trillion, according to the Government Accountability Office. In the biggest years of the buyout boom — 2005 through 2007 — they paid an average of 2.08 times revenue, according to CapitalIQ.

By paying 15 cents less income tax per dollar, a quick calculation shows those firms saved billions a year.



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