As unpredictable as Donald Trump was as a candidate, the impact of his presidency seems equally difficult to forecast. As a candidate, Trump’s economic and fiscal policies lacked detail, shifted frequently, and at times, were contradictory. As President-elect, he has already walked back several of his more signature campaign promises. Once his cabinet appointments are made and confirmed, and Republican leadership in the House and Senate galvanize around a set of legislative priorities, his administration’s policy objectives may become clearer. In the meantime, early signs of consensus between the incoming administration and Republicans on Capital Hill suggest significant changes could be looming for the U.S. private equity industry and deal-makers more generally.
Donald Trump’s electoral win and Republican control of Congress make it likely that significant tax reform is coming, perhaps in 2017. If passed via Congress’ budget reconciliation process, the bill could conceivably be enacted without Democrat support. Key features of President-elect Trump’s business tax proposals include:
— Reducing the corporate tax rate to 15%.
— Limiting the top individual tax rate on pass-through income to no more than 15%.
— A limit on the deductibility of interest expense (as a trade-off for full business expensing for manufacturers).
— Simplified individual income taxes, with a top income tax rate of 25% and a top rate of 20% for capital gains and long-term dividends.
— Taxing carried interest at ordinary income, rather than capital gains, tax rates.
The tax reform “Blueprint” released in June 2016 by Speaker Paul Ryan and House Ways and Means Chairman Kevin Brady is similar in many respects to the Trump plan, though with smaller rate cuts. Highlights of the Blueprint include:
— Reducing the corporate tax rate to 20%.
— Reducing the top rate for pass-though business income to 25%.
— A limit on deductibility of interest expense to no more than interest income.
— Full expensing for capital business expenditures.
— Simplified individual income taxes, with a top rate of 33%.
— Significant cuts in rates on investment income, allowing individual filers to exclude half of their income from capital gains, dividends and interest.
— The Blueprint is silent on carried interest.
The proposed rate cuts to pass-through income could be a focal point of debate, even among Republicans. Some observers note that if pass-through income rates fall dramatically lower than ordinary income rates, or even capital gains rates, taxpayers will restructure their business and income generating activities to take advantage. According to the Tax Policy Center, a consequence would be that, “carried interest would be taxed at a much lower rate than under current law, notwithstanding its reclassification as ordinary income (rather than capital gains), because the entities that earn carried interest income are organized as partnerships.”1 Carried interest is currently taxed at a rate of up to 23.8%, while under the Trump plan (absent higher rates for carried interest) it would be taxed at a maximum rate of 15%. Trump’s campaign advisors, including Wilbur Ross, the announced nominee for Commerce Secretary, insisted during the campaign that a set of rules would be adopted to exclude carried interest from eligibility for the 15% rate. So far, it remains unclear what these rules will be and when they will be advanced.
Whatever emerges on tax reform will likely involve a compromise of both the Trump Plan and the Ryan-Brady “Blueprint.” Even Senate Democrats appear prepared for compromise. Incoming Senate Minority Leader, Senator Chuck Schumer, has signaled a desire to compromise on a plan that would cut corporate taxes if proceeds from Trump’s proposal for a one-time tax on accumulated foreign earnings -- an estimated $2.6 trillion -- are reinvested in infrastructure improvements. Nonetheless, it remains unclear the extent to which Democrats in the House and Senate will be involved in shaping any compromise tax reform legislation and what any final reforms will ultimately entail.
If enacted, these changes will raise a number of important questions for funds, their investors and tax planning more generally. We will continue to monitor these changes closely. For more information on the details of potential tax changes coming in 2017, please see our recent update here.
Financial Services Deregulation
Dismantling regulation of the financial services industry is also likely to be an area of particular focus for the incoming administration. During his campaign, candidate Trump repeatedly pledged to “get rid of” Dodd-Frank, the set of sweeping financial services reforms passed in the wake of the 2008-9 financial crisis without a single House Republican vote and only three Senate Republicans supporting it (Senators Scott Brown of Massachusetts, and Olympia J. Snowe and Susan Collins of Maine).
Title IV of the Dodd-Frank Act mandated that many previously unregistered advisers to private funds (such as hedge funds and private equity funds, but not venture capital funds) register with the SEC, making them subject to its oversight and enforcement jurisdiction.
In 2012, after the SEC’s Office of Compliance Inspections and Examinations launched a Presence Exam Initiative, examining more than 150 private equity firms, the SEC very publicly intensified enforcement activity over fund expenses, expense allocation, undisclosed fees, conflicts of interest, and issues related to the marketing and valuation of private equity funds. This left many private equity funds, particularly those in the middle market, to view themselves as having been unwittingly swept up in an impulse to over-regulate. In a July 2015 article in The Hill marking the 5-year anniversary of Dodd-Frank, the Association for Corporate Growth’s President, Gary LaBranche wrote:
Regulating private equity has not enhanced the robust and highly rigorous due diligence process already performed by PE's sophisticated investors, before committing to a ten-year partnership. This due diligence is precisely why private equity outperforms most other investments over 3, 5, and 10 year periods… Dodd-Frank has caused small and midsize private equity firms to divert resources from investing activities to navigating the Act’s complex regulatory framework. Instead of focusing on what private equity does better than any other investment class – providing returns for investors – private equity firms have been forced to spend roughly $100,000 annually on compliance.2
Another cornerstone of Dodd-Frank that has impacted private equity is the “Volker Rule.” Among its restrictions, the rule restricts banks and their affiliates from investing in and sponsoring private equity funds. Notwithstanding his opposition to Dodd-Frank, when asked about the rule during the campaign, Trump was noncommittal.3
House Financial Services Chairman Jeb Hensarling introduced legislation earlier this year that could become the foundation of a body of financial services deregulation moving through Congress in early 2017.4 Hensarling’s proposals, referred to as the “Choice Act,” include repealing the Volcker Rule and lifting the threshold for bank regulation by the Consumer Financial Protection Bureau from $10 billion in assets to $50 billion.5 The Volker Rule is blamed (rightly or wrongly) for hurting institutional fundraising by virtue of its restricting investment capital from banks. The Volker Rule is also widely credited with leading to the significant growth of the secondaries market after banks were forced to divest their “higher risk” investments. Many fund managers point to these regulatory changes as having had a negative impact overall on general lending activities among banks, leading to a decline in loan origination for buyouts and the corresponding rise of unregulated institutional investors lending via private markets funds and business development companies.6
In light of the above, it is reasonable to expect a roll-back of Dodd-Frank, or at least portions of it, though timing, and the fate of some of its more controversial aspects remain unknown.
Deal-makers in the private equity industry will be keeping an eye on the direction of antitrust enforcement under the new administration.
Under President Obama, antitrust review and enforcement was widely regarded as more aggressive than in prior administrations, as evidenced by an increasing willingness by regulators to challenge transactions that fell below filing thresholds of the Hart-Scott-Rodino Antitrust Improvements Act of 1976.
While Republican administrations are generally viewed as less aggressive in their enforcement posture, the Trump administration’s populist orientation could mean a more idiosyncratic antitrust posture. Citing AT&T’s bid to acquire Time Warner as an “example of the power structure I’m fighting,” Trump famously pledged during his campaign that he would seek to block the deal.7 Moreover, if Trump makes good on pledges to clamp down on global trade, U.S. companies could be forced to find M&A opportunities at home, leading them to buy their domestic competitors, and potentially complicating competition regulation.
For more information on the antitrust implications of a Trump presidency, please see our partners’ Logan Breed’s and Janet McDavid’s article in Concurrences here.
National Security Review
The incoming Trump administration’s approach to foreign direct investment (FDI) in the United States and to national security reviews conducted by the Committee on Foreign Investment in the United States (CFIUS) is difficult to predict, but private equity investors would be well advised to keep an eye on developments in this area in the coming months. CFIUS is an inter-agency committee with the power to review the national security implications of transactions that could result in control of a U.S. business by a foreign person. CFIUS member agencies include the Departments of Treasury, Justice, Homeland Security, Commerce, Defense, State, and Energy, as well as the White House Offices of the U.S. Trade Representative and Science & Technology Policy. Therefore, the individuals selected to head these agencies may be the best early indication of the direction of CFIUS reviews under a Trump presidency.
Mr. Trump has criticized certain foreign investments in the United States8, but his trade-related critiques have focused largely on U.S. free trade agreements and the loss of U.S. manufacturing jobs to foreign countries. Nonetheless, according to CNN9, a Trump transition team draft memorandum outlining Mr. Trump’s trade policy for the first 200 days of his presidency indicates that Mr. Trump would mandate that CFIUS reviews be expanded to consider food security and reciprocity by foreign countries in their treatment of U.S. investments abroad.
Members of Congress previously have made similar proposals related to food security, including in connection with Chinese acquisitions of pork producer Smithfield Foods, Inc.10 and the U.S. subsidiaries of Swiss agribusiness Syngenta AG.11 In a September 15, 2016 letter12, members of Congress, noting the upcoming presidential transition, called for the U.S. General Accountability Office (GAO) to examine whether CFIUS’s regulatory and statutory powers “have effectively kept pace with the growing scope of foreign acquisitions in strategically important sectors in the U.S.” and to consider whether CFIUS should (i) use a net economic benefit test in its reviews of foreign investments and (ii) mandate reviews of Chinese government-backed investments. GAO agreed to conduct the review. Last month the U.S.-China Economic and Security Review Commission, created by Congress in 2000, advocated outright barring Chinese state-owned enterprises from acquiring or otherwise gaining control of U.S. companies.13
Under existing law, CFIUS reviews are focused on threats to U.S. national security. “National security” is not a defined term under the relevant regulations and statute, so even without regulatory or statutory changes, the Trump administration could seek to expand the scope of CFIUS’s reviews by interpreting “national security” to include food security and reciprocity in cross-border investments. Chinese media reports and our discussions with Chinese investors suggest that, at least in the short term, some Chinese investors might be cautious about certain investments in the United States until they better understand the Trump administration’s likely approach to FDI in the United States.
For more information on the incoming administration’s approach to FDI and potential CFIUS changes, please see our most recent information here.
It remains too early still to predict the precise contours of Trump’s policy agenda, and because of that, the impact he will have on private equity and deal-making generally. Nonetheless, changes are coming, many potentially profound. We will continue to monitor these developments closely and inform you of their potential impacts.