How Much Do Private Equity Funds Benefit From Debt‐related Tax Shields?

In 2008 the German government enacted a measure designed to curb excessive leverage in LBOs by limiting tax‐deductible interest to 30% of EBITDA. And in the U.S., legislators are currently reviewing several regulatory measures, including limits on tax‐deductible interest, that are intended to reduce the leverage of portfolio companies in U.S. LBO funds. In their recent study of 56 German LBOs transacted after the tax law change in 2008, the authors analyze the importance of debt‐related tax savings and the economic consequences of their reduction for the PE business model. The study begins by confirming that LBO debt tax shields are a material component of LBO purchase prices, contributing as much as 20% of the average estimated total enterprise value. At the same time, however, the study finds that the effects on LBO fund returns of limits to the taxdeductibility of LBO interest payments are likely to be modest, in part because a large portion of the value from expected tax savings is effectively paid for upfront by the private equity firm in the form of higher LBO purchase prices. Moreover, the authors do not expect to see LBO funds change their business model in response to this change in taxdeductibility. Based on their findings, the authors expect neither a significant decline in LBO leverage nor a notable change in the pricing of PE deals. As finance scholars have suggested, there are significant benefits associated with the use of debt that have nothing to do with the tax shield provided by the deductibility of interest. The authors' results provide yet another piece of evidence suggesting that taxes have at most a second‐order effect on corporate financing decisions—and that the gains to private equity come mainly from improvements in operating performance.