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December 30, 2010

How Private Equity Tackles Taxes

Private equity firms sidestep earnings management, but use other aggressive tax planning practices that produce big tax savings for portfolio firms.


While transactions by private equity firms have declined since 2007, in large part due to the recession, it’s widely accepted that they have become a permanent presence in the market, and there is mounting evidence that these firms create value by improving governance, financial management, and operational efficiency in their portfolio firms, the companies in which they are stakeholders. Competitors and other market players are eager to understand just how top private equity firms consistently produce superior results.

Private equity firms and their portfolio firms are not typically subject to financial reporting, so researchers have come up with creative sources of proxy data that shed light on their inner workings. But researchers have not placed particular focus on tax planning strategy, despite its potential to generate value.

One reason for this is that on its face, tax planning does not appear to be an attractive strategy for private equity, Professor Sharon Katz says. As serial deal-makers, private equity firms are particularly concerned with avoiding negative scrutiny from investors, the IRS and other regulators, since this could damage their reputations in the marketplace as true value builders, curbing the potential for future deals. Reputational considerations, which are associated with legal but aggressive tax planning, have intensified with the recent public scrutiny of the favorable tax treatments private equity firms receive, such as the low tax rate for carried interest.

But over the last two decades, corporate tax departments have increasingly become profit centers. Katz was skeptical that private equity firms’ reputational concerns would outweigh the use of aggressive tax planning to generate efficiencies, particularly because they have been so successful capitalizing on other opportunities to retain value.

Companies that use aggressive tax planning typically engage in more aggressive earnings management, but Katz’s research for other papers found the opposite to be true in the case of private equity — results show less evidence of earnings management and higher earnings quality despite aggressive tax planning. “These methods, while raising reputational concerns, reduce cash payments to the IRS and hence add real value to shareholders,” Katz says. “In contrast, earnings management strategies are mostly a matter of moving numbers around on the financial statements, or between reporting periods, to make things look better than they are, and can lead to negative reputational consequences without adding real value.”

While most private firms are not subject to the SEC’s public disclosure laws, private firms that issue public debt are an exception. Katz worked with Brad Badertscher of Notre Dame and Sonja Rego of the University of Iowa, using combined data and financial statements from SEC filings, COMPUSTAT, and Thomson Financials between 1980–2005 to determine whether private equity ownership influences tax planning at portfolio firms. The researchers identified and compared data for all private equity–controlled firms that issued public debt during this period to data for management- or employee-owned companies issuing public debt during the same period.

The researchers used book-tax differences, cash effective tax rates, marginal tax rates, and discretionary permanent differences as their primary measures of tax aggressiveness. Generally, high book-tax differences, or the differences between what firms report to investors and what they report to the IRS, indicate more tax aggressiveness. Comparatively low effective and marginal tax rates signal tax aggressiveness. To distinguish between differences that are merely due to financial rules that affect all firms and those that are permanent and can be attributed to management decisions at an individual firm (for example, the use of corporate-owned life insurance) the researchers established a measure for discretionary permanent differences.

Katz and his co-researchers also scoured financial tax footnotes for a sub-sample of firms, looking for other signals that the firms were practicing tax aggressiveness, such as having a high rate of foreign operations where tax rates are lower, the use of tax credits, sale and lease back transactions or the use of tax exempt income. Compared with independent firms, portfolio firms that employed a variety of these tax strategies experienced an average reduction in cash effective tax rates (the actual tax a firm pays) of between 3 and 4 percent, a rate that easily translates into millions of dollars.

Control and size matter, too. Katz and his co-researchers found that when private equity firms owned majority stakes (50 percent or greater) in portfolio firms, those portfolio firms were more aggressive with tax planning than minority-stake private equity firms. Likewise, private equity firms with more than $6 billion in assets under management (between 1980 and 2005) were, on average, more tax aggressive than their smaller counterparts. “The size and expertise of larger private equity firms, combined with majority stakes, give them greater resources and ability to influence company operations,” Katz says. “So it makes sense that larger, majority-stake private equity firms show more evidence of tax aggressiveness.”

Other firms could mimic these successful tax strategies, with one big caveat. “The KKRs and Carlyle Groups of the world are big and have tremendous resources, which probably reflect greater sophistication,” Katz says. “Given the ability of large private equity firms to attract talent, other firms would likely see less impressive results.”

Sharon P. Katz is assistant professor of accounting at Columbia Business School.

Read the Research

Brad Badertscher, Sharon Katz, Sonja Olhoft Rego

"The Separation of Ownership and Control and Corporate Tax Avoidance"

View abstract/citation  View Research  


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