Changes within the global tax landscape are putting immense pressure on all business sectors. Amendments to legislation on an international and domestic level, along with shifts in reporting and compliance requirements, have added layers of complexity, forcing many organizations to reframe — if not transform — their tax operating models.
The private equity sector is no different.
Indeed, it has had to face additional challenges from a competitive environment, demands from limited partners, an increased emphasis on value creation, the number of funds being managed, and complexity created by multi-asset strategies. And with the added disruption from the COVID-19 pandemic, PE firms can no longer overlook investment in operations if they want to protect their share of institutional asset allocation and maximize return for investors.
As a result of such challenges, all PE firms are making changes to their tax operating model, according to the 2020
Increased tax risk
The legislative and regulatory tax landscape has evolved at lightning speed in recent years and tax functions are under pressure to remain compliant. As tax authorities around the globe move to a more digitized model — a reality accelerated under the strain of the COVID-19 pandemic — those pressures increase.
Tax risk poses a particularly big challenge for PE firms, with 90 percent of those surveyed expecting an increase in tax risk, compared to only 51 percent of all other respondents.
There are likely a number of factors in play here, like the fact that PE firms have their own tax function, along with the portfolio companies that they manage. Tax considerations that span multiple industries, subsectors and regulatory jurisdictions add to such complexity.
But there is also a question of visibility. Many medium-sized PE firms don’t have a sizable internal tax function. Even when you look at some of the larger funds, the tax departments are still relatively small when compared to financial institutions or banks.
Behind the technological curve
Despite a recognition that technology will play a significant role in transforming their operational models, 79 percent of PE firms surveyed cite the lack of a sustainable plan for data and technology as the biggest barrier to delivering their tax function’s purpose and vision. Again, this is much higher than the 65 percent of all respondents who said this was the case.
While it is true that PE firms are gradually investing in sophisticated technology to overhaul their operating capabilities, the transition is still at an early stage. For many PE firms, leading-edge technology is simply not a priority. They are typically more focused on cost savings, streamlining, reducing internal headcount and making the business operation simpler.
This could mean that PE firms are missing out on transformational opportunities. From a technology perspective, much of the compliance work is outsourced to advisors, so PE firms are providing the data and the advisor is doing the respective tax filings. But those firms should be thinking about what data they need now and what they need in the future, because the requirements might increase and that information might need to be more readily available.
From a more critical standpoint, the ability to analyze data and to use systems proactively — at the fund level and at many of the portfolio companies — is often lacking. Many firms are only starting to automate the data from a tax and finance perspective. They have a lot of data but don’t have the systems to do anything meaningful with it.
Battling a skills shortage
Amid the increases in regulatory reporting and the need to focus on technology and data, PE firms also struggle to find the required talent to meet these challenges.
Indeed, 70 percent of PE firms struggle to attract and retain skilled talent for their tax and finance functions (versus 39 percent of all respondents), while 72 percent face difficulties in providing new responsibilities and career advancement for their existing tax and finance personnel (compared with 45 percent in the overall sample). Subsequently, the cost to hire and retain talent is challenging for PE firms.
This is arguably due to the way they tend to structure their tax teams. At both the fund and the portfolio company levels, PE firms typically run a very lean model and they are reluctant to bring people in unnecessarily because of the cost implications.
Refining the sourcing model
Taking all this into account, it is perhaps unsurprising that PE firms are increasingly turning to co-sourcing to meet the increased demand for transparency and reporting, and to achieve cost efficiency. Indeed, 91 percent of PE companies say they are more likely than not to co-source over the next two years compared to 73 percent of the overall sample.
Capability is key here, with many PE firms already co-sourcing because of bandwidth. Faced with a range of issues — including the Foreign Account Tax Compliance Act (FATCA) and Common Reporting Standard (CRS), withholding tax, income tax, the Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) requirements, and the potential for new regimes — they’re unlikely to change the way their infrastructure is designed from a tax perspective, and so they will just continue to outsource.
Finding the right mix is imperative. While it can be time consuming and expensive to keep and develop operating infrastructure internally and to train employees, outsourcing some functions allows firms to save costs and focus on their core capabilities.
Many firms might find a hybrid approach more suitable, where they continue to own some tax and finance functions, while co-sourcing others. Either way, for PE firms attempting to navigate a complex tax landscape, doing nothing from a sourcing perspective can present challenges.
Private equity firms are facing internal operational pressures and challenges from the competitive landscape while navigating a rapidly shifting regulatory and legislative landscape — all of which have been exacerbated by the COVID-19 pandemic. Added to this are emerging pressures from new digital tax requirements. The tax and finance function of these businesses will play a critical role in ensuring that present and future compliance requirements are adhered to. But this will mean reimagining those functions, and the role that co-sourcing plays, to ensure the right people are in the right place to optimize operations.
