Private equity and venture capital groups around the country have a lot of money but limited opportunities to spend it. This may not garner sympathy from the average American citizen; however, the record high estimate of $500 billion to $1.5 trillion in uncalled capital — better known as “dry powder”— that buyout funds currently have in their coffers as of the end of 2018 is an issue.
A burgeoning global economy has fueled a highly competitive environment for deals, which has resulted in a significant increase in valuation multiples. As multiples soar, reaching over 11 times earnings before interest, taxes, depreciation and amortization (EBITDA), private equity and venture capital groups find themselves in increasing competition with strategic buyers and family office funds.
This puts most private equity and venture capital groups in a quandary. On one hand, strategic buyers can better afford the ballooning multiples due to recognized synergies and a long-term investment strategy. Meanwhile, family office funds typically utilize a longer time horizon with their investments, which makes swelling multiples more palatable. Moreover, the passage of the 2017 tax law commonly known as the Tax Cuts and Jobs Act (TCJA) has introduced new challenges to this dynamic. Changes to bonus depreciation afford strategic buyers even more capital to dedicate to inorganic growth, while the implementation of a business interest expense limitation has the effect of drastically increasing the cost of debt.
Traditional private equity and venture capital groups are increasingly finding that their four-to-seven year investment window is unworkable. As multiples stretch, private equity and venture capital groups will be challenged to innovate the structure of their funds to seek the lowest possible cost of capital. While a shift toward the family office time horizon can help mitigate steep valuation multiples, there is one significant opportunity available through the TCJA for private equity groups to access tax-advantaged capital in a bid to stay more competitive in this dynamic and evolving marketplace.
Seizing the Opportunity
The TCJA, among the many large and systemic changes implemented, created a new program aimed at incentivizing investors with realized capital gains to reinvest those dollars in underserved and otherwise blighted communities across the country. Businesses and investors are only scratching the surface of the QOZ program. Perhaps the biggest opportunity to date was going to be Amazon’s headquarters expansion (HQ2) project in New York, which was going to be in a QOZ, before the deal fell through. Enthusiasm and attention toward the program has steadily grown over the past year and will probably pick up once investors have had a chance to dig into the details of the benefits in the QOZ program.
Generally, the QOZ program allows for any taxpayer with a recognized capital gain to elect—within 180 days or potentially 360 days if the gain was within a partnership—to reinvest those gains into a Qualified Opportunity Fund (QOF). The taxpayer can elect to temporarily defer the capital gains tax on the sale of the initial investment until the earlier of the date the QOZ investment is sold or Dec. 31, 2026. If the QOF investment is maintained for at least five years, the basis in the reinvested gains is increased by 10 percent. If the investment is held more than seven years, the basis in the reinvested gains is increased by another 5 percent—resulting in a 15 percent permanent exclusion of the originally deferred gain. Finally, if the QOF investment is held at least 10 years, the taxpayer can elect to step up the basis on the QOF investment to its fair market value on the date the investment is sold, thereby permanently avoiding any post-acquisition gain.
Accordingly, due to the close proximity to the exact type of limited partner investors with significant amounts of capital gains seeking deferral, private equity and venture capital groups appear to be best positioned to capitalize on organizing and executing a QOF. In terms of eligible investments, a QOF must invest in a Qualified Opportunity Zone Business (QOZB) where:
- Substantially all QOZB property is located in the QOZ (from 70 percent indirect to 90 percent direct ownership);
- At least 50 percent of the gross receipts are from the active conduct of the QOZB;
- A substantial portion of the intangible property is used in the active conduct of the QOZB;
- Less than 5 percent of the average unadjusted bases of property is attributable to nonqualified financial property; and
- The business does not include certain enterprises such as golf courses, country clubs, and liquor stores.
Concerning the list above, there is one challenge presented by the 50 percent gross receipts requirement. Uncertainty exists about how those gross receipts will be measured and whether those sales must occur within the QOZ; however, reports from the most recent public hearing indicate that forthcoming final regulations may lessen or altogether eliminate such a requirement. If that does become the case, the requirements outlined above would not significantly affect the nature of how a private equity or venture capital group evaluates and operates a portfolio company.
While many have been hesitant to finalize QOFs in the absence of Treasury regulations, those concerns will soon be alleviated. Moreover, once those final regulations are issued, the proverbial clock will start ticking due to the timeline of the incentives described above. In order to receive the full benefit of basis step-ups, investments in eligible QOFs will need to be finalized by Dec. 31, 2019, due to the requirement that taxes on deferred capital gains must be recognized on Dec. 31, 2026. That being said, if investors are merely interested in the 10-year basis step-up election, a QOF investment could be made as late as June 28, 2027.
Ultimately, while access to more capital does not directly resolve the swelling multiple problem for private equity and venture capital groups, access to cheaper capital might. With over 8,700 different QOZs designated across the country, it might take a bit of time to pare down that amount of data; however, the potential tax-advantaged benefit may be well worth the effort.
Seek Help When Needed
These new and changed provisions are highly nuanced and require careful analysis. A professional tax provider may be able to help analyze how your fund can best take advantage of the changes within the TCJA. For more information, please contact us.
Published on April 12, 2019