All eyes are on Washington—or should we say Manhattan—these days, searching for clues about where our ship is heading with U.S. President-elect Donald Trump at the helm. Recently, there have been cabinet appointments to scrutinize. Before that, there were the platforms of both the campaign and the Republican Party. And always there are tweets. Although the clues can be contradictory, and the ship is still under construction, we present here our prognostication based on where we have seen consistent overlap between Mr. Trump and the Republican Party on fundamental forces that can steer the private equity industry: taxes, deregulation, merger control and fiscal stimulus.
There is significant alignment between Mr. Trump and Republican legislators around the general goal of reducing taxes and some of the particulars. This includes lower corporate and pass-through income tax rates (including repeal of the net investment income, or “Obamacare,” tax), limits on the deductibility of interest expense, more favorable expensing for capital expenditures and lower individual income tax rates. In addition, Mr. Trump and many Republicans are in favor of a deemed repatriation of corporate profits held offshore at a one-time tax rate of 10%.
There is less clarity around the future treatment of carried interest. Mr. Trump has proposed taxing carried interest at ordinary income rates rather than capital gains rates. Whether or not a Republican-controlled Congress would approve this change is unclear. The Republican Party platform did not expressly address the point, but called for an end to “special interest provisions and loopholes.” Ultimately, the impact of a recharacterization of carried interest as ordinary income could be significantly offset by reductions in tax rates.
Many of these tax proposals could have a significant impact on the private equity industry. Lowering tax rates and removing incentives to hold profits offshore could increase capital available for domestic m&a activity, spurring demand. Lowering tax rates and the elimination of carried interest’s preferential tax treatment may result in changes to how management fees are structured, and may reduce the incentive for private equity funds to use partnerships as their vehicle of choice. Moving towards corporations for investments and, potentially, fund vehicles, could have the effect of significantly simplifying tax compliance for private equity funds and their investors. On the supply side, we could see more assets up for sale as sellers look to take advantage of lower tax rates. Limits on interest deductibility could lead to changes in the mix of debt and equity commonly deployed in capital structures, and more favorable tax treatment of capital expenditures could spur investments in manufacturing-focused industries.
Another area of broad general agreement is deregulation, particularly in the financial services and energy industries. Both Mr. Trump and the Republican Party platform have called for repeal of the Dodd-Frank Act and the Volcker Rule. Many advisers to private funds would not be registered with the SEC but for the requirements of Dodd-Frank. Curbing Dodd-Frank could substantially reduce the compliance burden and enforcement risk for many, particularly small and middle market, fund advisors. It could also lower the costs and barriers to entry of being a public company, perhaps increasing the likelihood of IPO exits for private equity sponsors. Meanwhile, curbing the Volcker Rule could result in U.S. banks regaining the ability to invest in private equity funds that they promote or manage, thereby boosting available capital in the private equity space.
The energy sector is also poised to benefit from alignment on deregulation, especially for fossil fuels like coal. This is likely to include reining in the EPA and regulations enacted under the Clean Water Act and streamlining permitting and approvals for pipelines and coal export facilities and access to public lands and the outer continental shelf. These steps could benefit producers and those in downstream and supporting markets, priming this sector for new investment. In contrast, an end to government incentives for clean energy could reduce opportunities in this sector.
The merger control environment, whether it is antitrust or national security review, could impact exit opportunities by changing the pool of potential buyers and bolt-on opportunities by changing the pool of potential targets. This is an area where the clues have been contradictory in some respects. Some of Mr. Trump’s pronouncements during the campaign, most notably regarding the AT&T/Time Warner deal and Amazon, suggest a vigorous approach to antitrust review. Additionally, in some cases blocking mergers could advance one of his often-voiced goals—protection and growth of American jobs. Yet, the appointments to Mr. Trump’s transition team responsible for antitrust issues, Joshua Wright and David Higbee, indicate a traditional Republican approach favoring less government intervention. Furthermore, Mr. Trump’s penchant for deal making suggests he would lean that way as well.
The one exception may be national security. Both Mr. Trump and other prominent Republicans have signaled their support for more vigorous scrutiny and restriction of foreign investment in the United States on national security grounds. Foreign buyers, even in industries outside the core defense and critical infrastructure space, might be more likely to come under review and less likely to skate through. This may be an area where no amount of concessions will save the deal.
There may be some hyperbole in all the talk of a great wave of infrastructure spending, but candidate Trump promised substantial investment in infrastructure, including: transportation, clean water, telecommunications and energy. Likewise, the Republican Party platform identifies investment in technology and modernizing the electrical grid as priorities for the next Congress. Furthermore, both Mr. Trump and the other leaders of his party are committed to ending the defense sequester and would like to increase the number of troops and troop readiness, particularly in space- and cyber-based offensive and defensive capability.
Although we do not see complete agreement on which infrastructure and defense projects should have priority, or on the right mix of private versus public spending, some increase in government spending on infrastructure and defense seems likely—at least as long as tax cuts, combined with government reduction, have their desired effect rather than increasing the deficit. More government spending in these areas should create opportunities for private equity funds investing in related sectors.
There is a lot of speculation about what a Trump White House and Republican Congress portends for private equity and industry in general. The signals are mixed and it is likely that there are many twists and turns ahead. But a good place to start is in the areas noted above where Mr. Trump and the Republican Party seem the most aligned. Perhaps the most reliable bellwether is what seems to be Mr. Trump’s core ethos: The Art of the Deal. Above all, Mr. Trump is a deal maker whose pronouncements can often be interpreted as the opening salvo aimed at gaining a tactical advantage in anticipation of the coming negotiation. Nothing is off the table on ideological grounds, but you better come ready to bargain—a proposition private equity should find familiar and workable.