Leveraged Recaps and tax rates

sharky7 · January 28, 2016, 11:06pm

Why is a leveraged recap appropriate if the tax rates are expected to increase? If the owner retains ownership that will be sold when tax rates are expected to be higher, I don’t get the point why it’s better… I might also be exhausted as well.

Note aside, I think the data table for the classification of the thread is outdated, isn’t it? Single concentrated positions is Study Session 5: PWM (2).

Cheers

cpk123 · January 29, 2016, 1:19pm

Maybe this is being talked about in the sense of “taking on debt” in a higher tax environment.

You leverage your position, (take on a loan) - by placing your asset as a collateral. Pay interest on the loan, get tax advantage at the higher tax rate for the interest on the loan?

DaRook1e · January 29, 2016, 4:49pm

that seems reasonable. If your interest rate is 10% on the loan and tax rate today is 20%, but expected to increase to 40% next year, you will benefit 20%x10%, getting 2% tax advantage on the debt amount. This translates to 20% more after-tax cash flow which can be reinvested accordingly.

At the same time, as you apply this strategy when you cash out a major stake of your holding, you pay less taxes today. So you benefit from the current tax environment and makes the best out of the future one when tax rates are going to increase.

sharky7 · January 30, 2016, 12:35pm

I think I’m missing something. The way a leverage recap works is like this (please correct me if I’m wrong):

Owner has a 100% position in a private business
Private equity firm approaches and buys from the owner 80% of the company (I assume the PE firm does this with external debt)
The owner immediately pays taxes on the 80% position sold (at today lower rates)
The PE firm changes capital structure by putting debt on the company, and in 3-5 years sells the company (either IPO or strategic buyer)
At that moment, the owner sells the 20% remaining stake, and pays taxes at the higher rates.

I still don’t see where is the advantage on future higher rates… Except for the fact that the owner sold most of her stake at today lower rates.

cpk123 · January 30, 2016, 12:46pm

you are partially right if my read of the book is correct. The Owner receives PART CASH - on which portion he pays taxes NOW, and remainder is invested in the STOCK (Equity) of the new company formed after the recapitalization.

from the book:

“A leveraged recapitalization is essentially a leveraging of a company’s balance sheet, usually accomplished by working with a private equity firm. The private equity firm generally invests equity and provides or arranges debt with senior and mezzanine (subordinated) lenders. The owner transfers a portion of her stock for cash and retains a minority owner- ship interest in the freshly capitalized entity. Doing so allows the owner to monetize a large portion of her business equity (typically 60–80%) and retain significant upside potential (20–40%) from that point forward. Because of the retained stake, the owner should remain highly motivated to grow the business. From a tax perspective, the owner is typically taxed currently on the cash received. If structured properly, a tax deferral is achieved on the stock rolled over into the newly capitalized company. This strategy should be especially appealing to business owners who are considering cashing out in the near future and are domiciled in jurisdictions where tax rates are either scheduled to increase in the near future (such as Japan, at the time of writing) or viewed as likely to increase in the near future (such as the United States, at the time of writing). The after-tax cash proceeds the investor receives could be deployed into other asset classes to help build a diversified portfolio.”

crosstheevil · February 1, 2016, 6:39am

IMHO, the tax advantage here is that you can pay a portion of the total tax liability at a lower rate now thanks to leveraged recap, instead of having to pay the full amount at a higher tax rate later on.