Making tax part of the private equity value creation plan

Having a proper understanding of your mergers and acquisitions tax needs is critical when going through the diligence process—whether on the buy-side or sell-side. In fact, M&A tax can also be used as an offensive tool to maximize returns and create value for your business.

George Douvris, a partner in RSM’s M&A tax practice and the leader of the firm’s business acquisition and sales advice practice, joined the Middle Market Growth Conversations podcast to talk about the role that M&A tax plays in creating value in a private equity deal and why it’s a growing area of focus for investors. Listen to the conversation here:

Middle Market Growth (MMG): I want to start off with our a really broad question just to set up the discussion before we delve into some of the more specific areas. George, at a very high level, can you talk about how M&A tax contributes to value creation for private equity and why this is something that investors should be paying close attention to?

George Douvris: Yeah, sure, Katy. So at a high-level M&A tax can contribute in a variety of ways as far as value creation is concerned for private equity. One of the areas we look at is really maximizing the tax benefits of a particular structure that either private equity wants to have or maybe retrofitting a structure based on the target they're looking at.

This means considering entity choice, what tax attributes are the private equity group acquiring when they're looking at a target, and understanding the investor mix with respect to really reducing overall tax rates for the private equity group and their limited partners (LPs). Some of the ways we can do that are to really try and identify value drivers like step-up and tax basis or areas that can really lead to increasing returns and reducing the overall cash tax burden at the target level.

MMG: I mean, based on everything you just said, it sounds like M&A tax deserves the attention it's getting from private equity. But I wonder if there's a reason that it's such a growing area of focus now and if something changed that's made M&A tax more attractive as a tool for creating value for firms.

Douvris: Yeah, well, the M&A environment is very competitive. And so private equity groups are looking for anything they can get as far as finding different ways, innovative ways to deliver value. One of the ways private equity groups we've seen get more proactive is around tax structuring and making sure that they understand what the cash tax modeling may look like when they acquire a business.

Obviously, private equity groups and their investors and really all of us over the course of time want to pay as little amount of tax as possible. And so that hasn't changed. I think the volatility around tax legislation coming from the Trump tax cuts back in 2017 really accelerated that process. While trying to make the tax environment more streamlined and simpler, they actually made it more complicated. And so, over the course of the last four or five years, we've been coming in the transactions much earlier because our private equity clients are really looking at us to help get them on the right path from a tax perspective earlier in the process so that they're armed with that information as they're negotiating the transactions or structuring the transaction.

So what we found is that on both the buy- and the sell-side, tax is just becoming a more prominent piece of the overall transaction process.

MMG: That's really helpful context. From there, I want to get into each side of the negotiating table. From a buy-side perspective, George, what are some of the tax-related things to consider when deciding how to structure an acquisition?

Douvris: You know, one, you really need to look at what is available from a target perspective, but assuming that you have flexibility around structure, you know, you can look at this in a variety of ways.

The key item is, what kind of acquisition vehicle are you going to use? Are you going to use a pass-through entity like an LLC? Or do you need to use a corporate entity for either the target's incorporation or a fund that's structured where you have tax-exempt or foreign investors that can't have income flowing up to them as opposed to the past infrastructure? But one of the areas that clients are looking at on the buy-side is what are the benefits, what are the pros and cons of each of those two structures, either a pass-through structure or a corporate structure?

One of the ways we can come in and assess and help them make that decision is, as an example, if it's a corporate entity, can they qualify for section 1202 to gain exclusion on exit and help them structure around that. Or, if they want it to be a flow-through, how do you structure it in a manner where, one, you're maximizing the step-up in tax bases that you receive when you acquire the business, but also have that eye toward five years from now when you're trying to sell the business and making sure that you're going to be able to deliver a step-up to the next buyer. Those are some of the areas that we look at and consider. And we come in like I mentioned before; we come in very early and assess so that clients can determine what their paths should be.

MMG: You mentioned the section 1202 gain exclusion. Can you say more about what that is?

Douvris: Sure. Section 1202 is a code section that was put in place about 30 years ago, and essentially it was put in place to incentivize investment in certain small businesses, and corporate businesses. Typically, there are several key criteria investors need to meet in order to qualify for the exclusion. You need to hold the corporate stock for five years. When the stock is issued, the basis in the assets of the business needs to be below $50 million and needs to be in a certain type of business. Typically, you know, there are some excluded services in any sort of manufacturing or service business. But, you know, assuming you can meet all the criteria, the benefit is quite substantial. You're eligible to exclude the gain on the sale of the corporate stock.

The exclusion is the greater of two numbers. It's $10 million, and that's on a per investor basis or 10 times your stock basis. So if you invest $2 million in corporate stock, it qualifies for section 1202. You sell it five or six years down the road, and you're able to exclude up to $20 million of gain. And again, that's on a per investor basis.

So when you look at a private equity group, you would look up to your LPs, and if you have 10 LPs, each of them will get a $10 million exclusion, as long as they're not a corporate entity themselves. So it’s a pretty lucrative benefit that a lot of our private equity groups are starting to see more of, especially in the middle market.

MMG: So we talked about some of the structuring considerations. Are there other tax attributes that your buy-side clients tend to focus on during a deal?

Douvris: Yes, I think the biggest attribute that buyers will typically look at is whether they are able to step up the tax basis of their assets acquired in order to get an amortization deduction over time? So in a transaction where a buyer is able to get a tax basis step-up, to use an example here, if you buy a business, you pay a premium of $15 million. Under the tax rules, you're able to take that $50 million and amortize it over 15 years. So the buyer would be able to get a $1 million amortization deduction annually that they can use to offset against operating income.

Buyers like to do it. They do a lot of analysis. They ask us to do that. We're able to analyze what the tax savings would be under certain purchase price scenarios and set discount rates and present values to determine what that might be worth. And they use that in their modeling internally. So that's typically the biggest attribute where we’ll see buyers look at a lower level.

If you're acquiring a corporation, corporations may have what's called net operating losses, and buyers essentially inherit those net operating losses. The ability to utilize those losses really depends on the valuation and a rather complex utilization calculation. But sometimes, you'll see buyers look to if they think they're going to be able to utilize those losses. You'll see them assign value to that as well.

MMG: How do buyers assess value for a possible stepped-up tax basis?

Douvris: They'll typically try to identify how much the step-up in tax basis is. So they'll compare their purchase price to the tax basis of the assets being acquired, and once they're able to determine what that step up looks like, using a kind of present value in discount rates, they're able to assign a tax shield in the current value of that tax shield.

Obviously, with a tax shield, that's less tax going out the door, that's more cash in the business, and they can use that to reinvest and grow the business. So typically, the way they model it is they'll have us come in and do an analysis, and then they can utilize that as they do their internal modeling.

MMG: You've mentioned a few times, George, working with clients very early to look at these tax attributes and some of the structuring questions. When is the right stage in the deal to start delving into these tax-related considerations? When is early?

Douvris: The best practice with our clients is typically before signing a letter of intent. So we always welcome our clients calling us even a couple of weeks before letting us know, “Hey, I'm looking at a business. Here's some information. Is there step-up available here? Is there a section 1202 available here?”

We're able to have those preliminary conversations with really limited information, so we can really just dive into the overall theory of what they are looking at and what paths they have to explore as they go further along. We always welcome our clients to call in well before they engage us for diligence or any other kind of substantive analysis to identify structuring. And so a lot of our clients, they're calling me very early to say, “Hey, we're a few weeks out, but here's what I'm looking at. I'm looking at an S-corp, you know. How can we get a step up here?”

We can have those conversations, and we're often able to identify possible obstacles very early in the process. And so that just gives them more time to head off those obstacles and find a way around and if possible.

MMG: In switching gears and looking through a sell-side lens, how might the chosen structure affect the tax outcome as a private equity firm exits a portfolio company?

Douvris: So now you have this structure that you put into place when you acquired the business in the first place, and now you're looking at the exit structure. This is where some of the structuring that was done on the buy-side would potentially bear fruit on the sell-side in two areas. One, if you have a corporate portfolio company looking at whether we have something like section 1202 as an example. At a higher level, we need to make sure that we understand the proper exit structure for a particular portfolio company.

The conversations usually start again before going to market. The conversation will start with getting a call. The client tells us, “Hey, we're looking at market X, Y, Z; let's talk about what the right structure is on the way out.” And so that's a corporation. It's pretty easy; you say you got to sell the stock.

But we also help with modeling out the gain and the implications of a possible sale. A couple of times, we've had clients who brought us in pretty early, and we helped identify a section 1202 opportunity. They didn't even realize they had it. And so, it drastically changed the way they modeled the exit proceeds in the exit scenario. We were able to deliver more value to their LPs than they realized they were going to deliver. Obviously, happy client, happy investors.

Suppose you’re not a corporate entity, and you're looking at a flow-through, then you're talking about trying a model to see what a step up might look like to a potential buyer: how do you minimize areas that could create tax depreciation recapture or other implications of sale that we can help get off. We also like to put on our buy-side hat, so they understand how the buy-side team will look at various attributes and the kind of value they are going to assign or possibly assign. So we can help be kind of a sounding board for our clients in that regard.

MMG: You mentioned that clients are approaching you before going to market for these sell-side services. I'm interested to know whether you've seen growing interest in this area. I know, across the market, sell-side services, in general, have been growing in popularity. Have you seen that for tax as well?

Douvris: We have. It's in the areas of modeling and determining the proper structure, helping mitigate issues that need to be mitigated before going to market, and helping clients get their tax profile ready for a sale process that’s been a significant growth area for us and our practice.

We've seen a substantial growth in that area, and it's part and parcel with the broader acceptance of sell-side financial due diligence and sell-side quality of earnings. In this competitive market, it's almost expected to have a sell-side quality of earnings as a starting point for the overall transaction process. We've definitely seen the benefits of that wider acceptance of employing sell-side services.

MMG: I guess my last question, as we wrap up here, is there anything you'd like to add for listeners or key points from the conversation that you'd want them to leave with as they take out their AirPods and turn off the podcast?

Douvris: It's never too early to start the tax planning process. Whether you're on the buy-side or the sell-side, it's important to cover off on proper exit or buy structure, assess attributes, discuss management rollover, making sure that all those items are addressed well in advance of the transaction coming to a head. Having those conversations early on just makes for smoother transactions.

I'd say that understanding that M&A tax is not just a defense in trying to survive the diligence process. But it can also be used as a kind of an offensive tool around value creation in some of the areas that we've talked about, like assessing structure, helping find section 1202 opportunities, helping find other types of credits and incentives where we can be useful.

Podcast was originally published by Middle Market Growth.