Increased carried interest holding period’s effect on private equity and M&A markets

In Part 4 of our article Tax reform’s impact on private equity and M&A markets, we recap the increased carried interest holding period brought about by the Tax Cuts and Jobs Act and how it could impact M&A market activity, buyers, sellers and the private equity industry as a whole.

The new law imposes a three-year holding period requirement for gains on the disposition of applicable partnership interests in order to be treated as long-term capital gains. Code section 1061(c)(1) defines an applicable partnership interest to mean any interest in a partnership which, directly or indirectly, is transferred to, or is held by, the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. An applicable trade or business is described as “any activity conducted on a regular, continuous and substantial basis that, regardless of whether the activity is conducted in one or more entities, consists (in whole or part) of:

  1. Raising or returning capital; and
  2. Either (a) investing in (or disposing of) specified investment assets (or identifying specified assets for investing or disposition), or (b) developing specified assets.”

This definition captures the activities of a private equity fund and the change in the holding period was directly aimed at the industry.

The carried interest period requirement likely won’t have an effect on M&A activity as private equity firms tend to hold their investments for more than the three-year holding period. Note that for purposes of applying the three-year holding period provision, an add-on acquisition by a private equity portfolio company funded by additional capital contributions by the partners may result in a bifurcated holding period for partnership interests. Further guidance will likely be issued in 2018 to clarify the exact meaning of the new requirement.

Implications

Market activity
While this change does influence private equity funds in their decision process to sell or hold, it has had a relatively small impact on M&A market activity.

Buyers
Other than the possibility of there being less assets on the market, as private equity funds may retain an investment to meet the three-year holding period requirement, we see little to no effect on the overall market for a buyer.

Sellers
Non-private equity sellers generally should not be impacted by this change.

Private equity
While there may be an incentive to hold a portfolio company and avoid an exit until meeting the new three-year holding period, disposition decisions are generally based on the overall economics of the market and the transaction. Therefore, the holding period is just another factor in the decision making process. We also note that according to Pitchbook, private equity deals that exit in less than three years accounted for only 16.9 percent of exits in 2017. Thus, the new provision will generally only capture a limited number of transactions. The more likely impact is how private equity funds make add-on acquisitions and whether such transactions are funded by additional capital contributions, which may result in a restart in the holding period for portion of their investment, or funding the acquisition through existing capital or additional leverage.

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