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Tax cuts to boost US allure for cash-rich private equity

Tax reform could not come at a better time to help private equity flows in the U.S., boosting potential returns on targets just as buyout firms have more money than ever to invest in a market until recently constrained by uncertainty over government economic policy and high price tags.

Private equity fundraising in 2017 hit $453 billion, the greatest amount of capital raised in any year, according to alternative asset data provider Preqin. Of that amount, $272 billion or 60% was for funds focused on investing in North America, a 13-year high for the region and a 23% increase over 2016. That's likely to continue into the coming year, as 69% of limited partners Preqin surveyed viewed the region as presenting the best opportunities for investment an attraction that will only be boosted by President Donald Trump's corporate tax cuts.

"All of the private equity firms' success is derivative of their success of their portfolio companies," said Paul Seraganian, managing partner with law firm Osler, Hoskin & Harcourt LLP. The new 21% corporate tax rate for U.S.-based companies will make them "more attractive to private equity firms, dollar-for-dollar, because they will generate a higher after-tax return," he said.

A shortage of attractive and reasonably priced acquisition targets helped push the buyout industry's "dry powder," or money limited partners have committed to a fund that has not yet been invested, to a record of more than $1 trillion for the first time by the first half of last year, the most recent date for which data is available. But potentially higher returns on investments should help persuade private equity firms to part with these growing cash piles.

"High valuations, competition from corporate acquirers, and increased macro and geopolitical uncertainty have led to a flat market for new acquisitions," advisory firm EY said in its 2018 Global PE Watch report.

Buyout companies have a record nearly $2.4 trillion in assets under management, according to Preqin.

More equity

Corporate tax reform is not all positive for private equity, as a cap on interest rate deductions introduced to help pay for the corporate tax cut will mean buyout firms, which usually rely on debt, will have to put more equity into deals. But, in the balance, the overall impact of the tax measures will be to stimulate activity, said Jeffrey Hecht, EY's global private equity tax leader.

"Taken as a whole the reduced corporate and pass through rates, immediate expensing of assets, other changes coming out of tax reform and decreased regulation under the current administration will be positive for investment," he said.

Deal valuations already at historic highs of 11 to 12 times could rise even further, particularly as strategic investors, and not just private equity, will also have more reason to compete for M&A, said Mike Woollatt, CEO of the Canadian Venture Capital and Private Equity Association.

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Canada is one of the biggest sources of private equity inflows into the U.S. a situation likely to continue whatever the outcome of the renegotiation of the North American Free Trade Agreement.

Of the private equity holdings of the Toronto-based Canadian Pension Plan Investment Board, $123.4 billion, or 38.9%, was in the U.S., as of March 31, Preqin said. CPPIB, which was involved in the biggest leveraged buyout last year of a U.S. company that involved at least one foreign investor the $17 billion take-private of Houston-based utility Calpine Corp. had assets under management of $316.7 billion at the end of its fiscal year on March 31 and allocated $52.5 billion to private equity in 2017. The next biggest investor in private equity was sovereign wealth fund Abu Dhabi Investment Authority, with a $39.6 billion allocation.

Tax reform will only increase the incentive for Canadian money to flow south, whether NAFTA survives or not, Seraganian said.

"At the end of the day, the U.S. capital markets, banking system and capital are too integral to the way Canadian business operates," he said.