Bailing out your debt

The $838 billion US economic stimulus plan approved by the Senate in February included language that could help private equity firms looking to reduce their portfolio companies' debt burdens.

Under current laws, a private equity firm that buys back a portion of its portfolio company's debt, or a portfolio company that buys back its own debt, will incur taxable income in the amount of the reduction in its debt load. Under the new bill, language introduced by Senate Finance Committee Chairman Max Baucus would allow parties that realise cancellation of indebtedness (COD) income in 2009 or 2010 to defer recognition of that income until 2011, at which point they would begin recognising the income over an eight- year period.

“The motivation in the Senate is really not to impose a tax cost on entities that are trying to reform their capital structure in a way that is necessary and probably desirable in today's capital markets”

The bill applies to transactions in which the issuer or a related party purchases the debt. A related party is generally defined as a party that owns 50 percent of more of the equity of a company, which can be fairly complicated to determine if multiple vehicles and investors own a portfolio company, but in general private equity firms assume there will be COD income when they are buying portfolio company debt, says Rick Bronstein, a partner and co-chair of the tax practice of Paul, Weiss, Rifkind, Wharton & Garrison.

“The motivation in the Senate is really not to impose a tax cost on entities that are trying to reform their capital structure in a way that is necessary and probably desirable in today's capital markets,” Bronstein says.

The bill does not apply to debt-for-debt exchanges, including deemed exchanges resulting from a modification of debt terms.

The Joint Committee on Taxation estimates that the proposal could cost around $26 billion over the next three years if enacted. At press time, the House version of the stimulus bill did not include the same proposal, so the Senate and House versions still needed to be reconciled in committee, a process Bronstein said would most likely be concluded in February.

One problem that isn't addressed by the legislation though, notes Bronstein, is that most credit agreements prohibit related parties from buying the debt.

“There's a desire among the lenders to make sure that payments made to the lenders are made pro rata to all the lenders,” he says. “There are a number of instances today where it's not the tax laws preventing people from buying back debt, but the indenture provisions that they're having difficulty getting around.”

Many private equity firms have already taken advantage of widening spreads on LBO debt, and the new bill would help make that process even more appealing for US firms. Apollo, The Blackstone Group and TPG bought back £2.5 billion of Alliance Boots' debt last year for around 91 cents on the dollar. A Danish telecom company, TDC, owned by Apax Partners and Kohlberg Kravis Roberts bought back €200 million of its own debt last year as well, reportedly for between 60 and 65 cents on the dollar. Freescale Semiconductor, owned by Blackstone, The Carlyle Group, Permira and TPG, also bought back $85 million in debt last year.

In another boon for portfolio companies, the bill also contains a provision to allow net operating loss (NOL) carrybacks for up to five years, instead of two under current laws. As this provision is included in both the Senate version of the bill and the version still being debated in the House of Representatives, it is very likely to pass, Bronstein says.