November 27, 2017
With the details still subject to additional sausage making on Capitol Hill, the framework proposed in the tax reform bills now being reviewed in Congress could have significant impacts on the values of US companies in multiple ways, with knock-on effects in the M&A environment.
A mixed bag of impacts
The key headline in the tax reform discussion is clearly the reduction in corporate rates. In isolation, the drop to a 20% rate should increase after-tax corporate cash flow, driving up company values and the prices acquirers would be willing to pay in an M&A context. Although there will likely be a countervailing valuation impact resulting from the increased cost of capital resulting from lower tax rates, the rise in cash flows should generally win that tug of war and result in higher valuations. To some extent, the stock market already has begun to price in the prospect of tax reform.
But, of course, nothing’s that simple. Along with the decline in tax rates comes a host of reductions in credits and deductions. Interest expense deductions, a favorite tool of private equity acquirers and many corporates, could be capped at 30% of adjusted taxable income. Although the loss of some interest deductions may not be a deal killer in today’s low interest rate environment, the adverse impacts on long-term costs of capital can’t be ignored in any valuation or deal modeling. Then there’s the immediate expensing of certain qualified property, which will accelerate tax benefits (albeit at a lower tax rate), thereby increasing cash flow, value and returns, all else being equal.
When you mix all of these competing impacts together, there are bound to be winners and losers. Companies with currently high effective tax rates, low leverage, limited tax attributes and high capital intensity will likely come out ahead in terms of corporate value and shareholder returns, while the results are more mixed when you take away any or all of those characteristics. Also, the proposals don’t really simplify the corporate tax regime, and we haven’t even discussed the impact of tax reform on pass-through entities.
What about the international elements of reform?
But that’s not all. The movement from a worldwide system of taxation towards a territorial system, the addition of a 20% excise tax on payments to foreign affiliates and the proposed tax on “foreign high returns” are generally expected to incentivize the on-shoring of overseas profits.
This increase in US profits, coupled with the “deemed repatriation” of profits back to the US, could create additional “dry powder” for investments, including acquisitions. The current M&A environment is still being defined in part by high valuations and a limited supply of targets, rather than a shortage of capital. And CFOs have other options for their repatriated cash, such as paying down debt and buying back shares. But with more money available for deals, acquisition multiples could expand in the near-term.
Don’t forget your macroeconomics
Of course, none of these changes happens in a vacuum without broader macroeconomic repercussions. The proponents of tax reform are hoping their proposals, including the key components of individual reform, lead to increased economic growth – a scenario that would certainly boost the values of most companies and the attractiveness of acquisitions. However, it’s not yet clear what the impacts of tax reform will be when it comes to interest rates, the relative strength of the US dollar, tax policy changes outside the US, and near- and long-term inflation.
Under a scenario in which interest rates rise and the ability to deduct interest expense or use other previously available tax attributes becomes limited, there could be adverse consequences to company values and the M&A market in general. Even the basic premise that reform will jumpstart economic growth is not a slam dunk when you consider the potential negative impacts on household after-tax income from the proposed loss of state and local tax deductions and the cap on mortgage interest deductibility.
The markets think something could happen
Some of these potential influences on value ultimately may fade as the tax bills in the US House and Senate evolve in the days and weeks ahead. But investors expect at least some adjustments to the current tax laws. Following Donald Trump’s campaign pledge to lower taxes, the S&P 500 has risen more than 20% since his election.
Since the House bill was released, homebuilder stocks have fallen with news of the reduction in mortgage interest deductions, and tech investors view the proposed toll charge on repatriated offshore earnings as higher than expected. The largest private equity groups also saw declines over concerns about the cap on interest expense deductions.
As they await the legislation’s fate, companies, investors and potential acquirers should consider all of the above benefits and detriments in aggregate. There will be some clear value winners and some clear value losers, but many companies and acquisition targets will be left with a fair amount of modeling to do to quantify the true impact on value and determine what they may need to change to succeed in a new tax climate.