Why Banks Should Worry About Private Equity's "Tax Loophole"

Why Banks Should Worry About Private Equity's "Tax Loophole"

It's easy to be a good bank, but few will ever become great banks. The difference between good and great is competitive advantage -- a differentiator that makes a bank a better choice than its peers.

How banks compete
I'm a firm believer that only a few banks have a real durable competitive advantage that can stand the test of time.

  • Bank of America and Wells Fargo both have a firm grasp on retail banking, and their deposits are cheap, which makes it possible to lend at rates other banks can't match. Both banks create more value by increasing their "share of wallet," or maximizing the number of services sold to each customer.

  • Goldman Sachs has long-lasting franchise value in that it is a name that everyone (well, at least everyone in finance) respects. The Goldman Sachs name always makes a good impression on an IPO tombstone in the Wall Street Journal, making the firm a go-to investment banker.

Recently, however, I've come to believe that a small subset of the financial industry may get a leg up on traditional banks from tax code advantages.

The BDC advantage
The tiny business development company industry, which has a total combined market cap smaller than Goldman Sachs, could steal substantial share of the banking world in the next few years.

Your average corporate banker has a big tax bill to pay, equal to as much as 35% for all profits on the income statement. Private equity business development companies, however, pay nothing in federal income taxes. Instead, shareholders pay taxes on dividends equal to their income tax rate.

Most BDC investors hold shares in tax deferred accounts like a 401(k) or IRA. Doing so can limit investors' tax liabilities to their post-retirement tax rate, which is generally much lower than the investors' tax rate in their working years and, most importantly, lower than the tax rate a corporation would pay.

Prospect Capital is making waves in consumer lending, using its tax-free status to drive returns for shareholders. At its annual analyst day, it proudly showcased how this competitive advantage is paying off for the company.

The company says it can earn returns of more than 20% buying out consumer lenders, whereas the traditional financial industry -- think corporate banks -- would earn in the "low teens." Simple arithmetic says 20% returns to untaxed BDCs is only 14% after-tax for the traditional banking industry.

A deeper look into taxation favoritism
In January, Prospect Capital acquired a 93.8% stake in Nationwide Acceptance Holdings, a company that provides subprime automotive loans. It's wildly profitable, generating 31.57% returns on equity, as it makes high-interest loans, which it then leverages with inexpensive financing at the corporate level.

Prospect Capital paid just 7 times earnings for the Midwestern lender, implying that it paid just 2.2 times book value, and should earn 14% annual returns from its investment.

It also made in-roads to take on traditional mortgage bankers by purchasing a stake in a small credit provider, First Tower, which will finance anything from a personal loan to a mortgage. The company's purchase multiple implies a similar 14% return.

If another major banker were to buy either lender, they would earn just 9.1% on the same investment assuming a 35% corporate tax rate.

The rise of BDCs in consumer lending
Traditional banks have always faced tax-free competition from credit unions. However, credit unions aren't out to make money for their shareholders. They're simply not hungry for money. BDCs are hungry much like traditional banking institutions -- they have to deliver returns for shareholders to drive performance compensation and asset growth.

As the business development company industry grows, it will play a much bigger role in consumer finance, infusing a little more competition into a business that is largely owned by taxed commercial banks.

It all boils down to simple mathematics.

BDC investors receive up to 60.4% of all reported pre-tax income assuming a worst-case taxation rate of 39.6%. Bank shareholders only receive 49.5% of each pre-tax dollar after all taxes -- corporate income and dividend taxation. BDCs can under-earn banks on their assets yet deliver more value to shareholders.

A growing BDC industry may just be a banker's worst nightmare as they begin to capture a bigger share of consumer finance.

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The article Why Banks Should Worry About Private Equity's "Tax Loophole" originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Bank of America, Goldman Sachs, and Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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