Lower-rated firms at risk from US tax changes

NEW YORK (Reuters) - Proposed changes to the U.S. corporate tax system could hurt at least a quarter of highly-leveraged companies and cause more defaults in an economic downturn, ratings agency Moody’s said this week.

A limitation on interest deductibility could increase costs for highly indebted companies with lower credit ratings and up to 44% of single B rated borrowers and 80% of Caa rated firms could be worse off.

Sectors with high leverage and with significant leveraged buyout (LBO) activity such as technology, healthcare and aerospace and defense are expected to be hardest hit, along with gaming and business and consumer services.

Although the proposals will benefit higher-rated companies, they could increase junk-rated companies’ vulnerability to any downturn in earnings and boost defaults. Speculative grade companies are already exposed to financial risks including interest rates and declining credit quality.

“Most of these guys will take a small hit from the interest deductibility,” one banker said.

Although the bill is beginning to take shape, U.S. legislators have yet to cast the final votes on proposals that also include cutting the corporate tax rate to 21% from 35% and allowing tax deduction for capital expenditure, which will primarily benefit investment-grade companies.

Under the House plan, 26% of junk rated companies will be worse off if interest deductions are capped at 30% of earnings before interest, taxes, depreciation and amortization (Ebitda). The Senate plans to use the same cap with Ebit, which would put 36% of non-investment grade companies in a worse position.

Paying more on interest-related expenses would soak up more of declining earnings for highly-leveraged companies, which could increase defaults in an economic downturn, Moody’s said.

“For example, with more than 75% of Caa and lower-rated companies worse off even under the less onerous House proposal, the tax overhaul could hasten defaults,” the note states.

Less than 7% of higher-rated Ba-rated companies will be worse off under the House and Senate plans.

OVERALL WIN?

Private equity firms have not been shy about loading up on debt this year with tax changes looming. Deals with leverage above 7.0 times make up 26.4% of leveraged buyouts this year, according to LPC data. This is the highest level since 2007 when 28.4% of buyouts had leverage of greater than 7.0 times.

This trend could be tough to continue even if interest deductibility limits are pushed through. Moody’s said under the House plan, 66% of single-B issuers and 93% under the Senate plan would lose the chance to deduct a portion of their interest expense.

Even so, most businesses are viewing the tax changes as net positive and gains from capital spending deductibility and the corporate tax reduction could offset the interest deductibility hit.

As such, it’s business as usual for private equity firms, which typically use high levels of leverage to buy companies before taking them public or re-selling them.

“Financial sponsors are not waiting for the tax bill to go through,” said another banker. “If anything, there’s been an acceleration recently.”

(Reporting by Jonathan Schwarzberg; Editing By Tessa Walsh)