Private Equity-backed Retailers That Source Their Products Offshore Oppose Border-adjustment Tax

January 31, 2017

Bloomberg - In Donald Trump's world, the long list of "losers" includes Cher, Rosie O'Donnell and Mark Cuban.

Now, as he proposes an overhaul of U.S. tax and trade policies, President Trump is poised to create a new list of losers -- for private equity.  

The introduction of a potential border-adjustment tax could erode profits at some of the businesses owned by buyout firms, enough to make them not worth hanging onto any longer. That may speed up the timetable for putting them on the auction block or on laying the groundwork for an IPO.

As firms review their portfolios, key considerations for determining which fall into this "loser" category include the percentage of a company's inputs that are originated outside of the U.S. and how truly flexible supply chains are if the concept of border adjustability becomes law.

So which companies could be culled? One possible "loser" is American Tire Distributors Holdings Inc., which imports and manufactures some of its tires in Asia and is backed by Ares Management LP and TPG. Another is NBG Home, which leans on Asian manufacturers for many of its products and is owned by Kohlberg & Co. Then there's also Isola Group, which has offshore manufacturing operations that make laminates for use in the production of printed circuit boards, which is backed by TPG and Oaktree Capital. These are just a few -- there are many more that fall into this bucket.

Private equity firms will likely have to reset their expectations around valuations and accept lower prices than they otherwise might. But in an industry where one's ability to raise new funds depends on past performance and decent returns, minimizing losses is crucial.

On the subject of losses, the border-adjustment tax could exacerbate problems for private equity-backed retailers that source their products offshore, including but not limited to J. Crew Group Inc., Claire's Stores Inc., Toys "R" Us Inc., Nine West Holdings Inc., Rue21 and True Religion Apparel Inc.

These companies are already operating at various levels of distress, mostly due to heavy debt burdens -- a feature that could crush them even more if interest deductibility is scrapped under the new tax code. Worse still, most of these companies carry deferred tax assets which will become less valuable if the corporate tax rate drops as planned. And unlike the potential "losers" mentioned above, these situations are even more difficult for private equity firms to extract themselves from.

Blackstone Group LP has already forecast that the collective impact of tax code changes, in their draft form, will be neutral to slightly positive on its private equity portfolio -- even if some rejiggering is in order. Publicly-traded peers Apollo Global Management LLC, Carlyle Group LP and KKR & Co. -- each set to report their own fourth-quarter results in coming weeks -- will likely echo the same message. It's about self-preservation, after all.

Another such company that was exploring sale options even before the election was Springs Window Fashions, a Golden Gate Capital-backed maker of blind, shade and other window coverings. The Middleton, Wisconsin-based company has sizable manufacturing operations in Mexico which could mean its profits are dented by the border-adjustment tax.

Private Equity Assets Under Management Approach $2.5 Trillion as the Industry Doubles in Size Over the Past Decade

The total assets under management for the private equity industry have grown to a record $2.49 trillion as of June 2016 (the latest figures available). Preqin’s 2017 Global Private Equity & Venture Capital Report finds that industry assets rose from $2.39 trillion as of the end of 2015, continuing eight consecutive years of expansion in the wake of the Global Financial Crisis. Strong fundraising has driven this latest growth in assets: the dry powder component of industry AUM increased by $117 billion in the first six months of 2016, while the total value of assets held by fund managers (the unrealized value component of AUM) fell slightly.

Christopher Elvin, Head of Private Equity Products said:

“2016 was another stellar year for the private equity industry, and total AUM now stands at a record $2.49 trillion as of June. The question on many people’s minds is ‘how much longer will it continue?’ While the reality is that only time will tell, the industry is well positioned for another strong year in 2017. In a low-interest-rate environment, the asset class continues to appeal to investors looking for high absolute returns and portfolio diversification.

“This is borne out in the state of the market going into 2017: investor sentiment is extremely high, and there are currently record numbers of funds seeking investment. Many investors are looking to redeploy the capital returned to them back into the asset class, which in turn is stoking an active fundraising market. While asset pricing remains a very real concern for both fund managers and investors, 2017 has the potential to match the successes seen in 2016.”

Key Facts from the 2017 Global Private Equity Report:

• Total assets for the private capital industry – including private equity, private debt, real estate, infrastructure and natural resources funds – rose to a record $4.46tn as of June 2016, up from $4.27tn as of the end of 2015.
• The global private equity industry has doubled in size over the past decade, rising from $1.16tn in assets as of the end of 2006.
• The rate of growth in industry assets has accelerated in recent years: total AUM grew by 2.5% in 2014. This pace increased to 6.6% in 2015 and was 4.2% in the first half of 2016.
• Dry powder levels have risen consistently, reaching a peak of $869bn at the end of H1 2016. This represents an increase of 16% compared to December 2015.
• Strong fundraising has seen private equity funds secure over $1tn in the period 2014-2016, driving dry powder levels and competition for assets up.
• Consequently, dry powder accounts for the bulk of recent AUM increases: the total value of invested assets held by fund managers fell 1% in H1 2016.
• This is indicative of the level of capital that fund managers have distributed back to investors. Annual distributions exceeded $400bn in both 2014 and 2015, and reached $257bn in H1 2016, a record pace.
• The rate of capital being returned to investors is promoting a high level of satisfaction; 95% of investors said in December 2016 that private equity had met or exceeded their expectations in the past year.

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• 2016 Preqin Global Private Equity & Venture Capital Report
• Despite $100B In Ouflows, Hedge Fund Industry AUM Surpasses $3.2 Trillion In 2016