Private equity groups around the country have lots of money but limited opportunities to spend it. This may not garner sympathy from the average American citizen; however, the record high estimate of $500 billion to $1.5 trillion in uncalled capital—better known as “dry powder”—that buyout funds currently have in their coffers as of the end of 2018 is an issue.

A burgeoning global economy has fueled a highly competitive environment for deals, which has resulted in a significant increase in valuation multiples. As multiples soar, reaching over 11 times earnings before interest, taxes, depreciation and amortization (EBITDA), private equity groups find themselves in increasing competition with strategic buyers and family office funds.

This puts most private equity groups in a quandary. On one hand, strategic buyers can better afford the ballooning multiples due to recognized synergies and a long-term investment strategy. Meanwhile, family office funds typically utilize a longer time horizon with their investments, which makes swelling multiples more palatable. Moreover, the passage of the 2017 tax law commonly known as the Tax Cuts and Jobs Act (TCJA) has introduced new challenges to this dynamic. Changes to bonus depreciation afford strategic buyers even more capital to dedicate to inorganic growth while the implementation of a business interest expense limitation has the effect of drastically increasing the cost of debt.

Traditional private equity groups are increasingly finding that their five-to-seven year investment window is unworkable. As multiples stretch, private equity groups will be challenged to innovate the structure of their funds to seek the lowest possible cost of capital. While a shift toward the family office time horizon can help mitigate steep valuation multiples, there is one significant opportunity available through the TCJA for private equity groups to access tax-advantaged capital in a bid to stay more competitive in this dynamic and evolving marketplace.

Seizing The Opportunity

The TCJA, among the many large and systemic changes implemented, created a new program aimed at incentivizing investors with realized capital gains to reinvest those dollars in underserved and otherwise blighted communities across the country. Surprisingly, in the immediate wake of the passage of the TCJA, the qualified opportunity zone (QOZ) program was generally overlooked by the media and investors alike. That oversight, however, has been acknowledged. Enthusiasm and attention toward the program has steadily grown over the past year.

Generally, the QOZ program allows for any taxpayer with a recognized capital gain to elect—within 180 days or potentially 360 days if the gain was within a partnership—to reinvest those gains into a qualified opportunity fund (QOF). If the QOF investment is maintained for at least five years, the basis in the reinvested gains is increased by 10 percent. If the investment is held more than seven years, the basis in the reinvested gains is increased by another 5 percent—resulting in a 15 percent permanent exclusion of the originally deferred gain. Finally, if the QOF investment is held at least 10 years, the taxpayer can elect to step up the basis on the QOF investment to its fair market value on the date the investment is sold, thereby permanently avoiding any post-acquisition gain.

Accordingly, due to the close proximity to the exact type of limited partner investors with significant amounts of capital gains seeking deferral, private equity groups appear to be best positioned to capitalize on organizing and executing a QOF. In terms of eligible investments, a QOF must invest in a qualified opportunity zone business (QOZB) where:

1. Substantially all QOZB property is located in the QOZ (from 70 percent indirect to 90 percent direct ownership);

2. At least 50 percent of the gross receipts are from the active conduct of the QOZB;

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