As one tax expert put it, “Private equity is a tax gimmick with an acquisition attached.” We’re going to discuss a very big tax gimmick that virtually no private equity investors seem to be aware of. The failure of private equity general partners to publicize a tax scheme that on paper should benefit their limited partners strongly suggests that it does not pass the smell test.
This gimmick, um, device, is called a tax receivable agreement. When a private equity firms sells a company via an IPO, in some cases (more on the particulars soon), it has the IPO entity enter into a contract called a tax receivable agreement (TRA) with a predecessor entity. As a portfolio company executive who modeled TRAs put it:
What happens is the PE firms end up having an asset stream of 29% to 32% of the company’s income before tax for a long period (I calculated it could be 15 or more years) even after they have sold all of their interest in the company.*
Needless to say, this is a ginormous amount to suck out. From the New York Times on TRAs in 2013:
“It drains money out of the company that could be used for purposes that benefit all the shareholders,” said Robert Willens, a corporate tax and accounting expert in New York.
Perversely, because the TRA is booked as a liability to the IPO company, payments on the TRA are not treated as an expense, but as a debt payment, so they reduce the company’s economic value (its free cash flow, which is the bedrock measure of what a company is worth) without hitting its income statement.
A competent buyer would negotiate a price reduction for a company encumbered with a TRA, as he would for any unfavorable tax attribute. But IPO investors, being a not terribly attentive lot, don’t haircut the price the way a private party would.
The fact that TRAs extract value from clueless IPO buyers was first brought to the attention of the broader public in the New York Times article cited above. Matt Levine then weighed in with his usual “nothing to see here, move along” shortly after that. Aside from more technical treatments, such as a a June 2013 story in Practical Law, and an early 2014 paper by Victor Fleischer of the University of San Diego and Nancy Standt of the University of Southern California, they’ve gotten perilous little attention since then….until last week.
The conventional wisdom is that TRAs, by exploiting the valuation naivete of IPO investors, is a type of financial engineering that works to the advantage of private equity investors. And frankly, why should PE general partners get out bed, much the less gin up costly legal talent, save but to benefit themselves, and one hopes their limited partners too.
But we’ve been bothered by the total lack of disclosure to private equity limited partners about TRAs. Given the large amount of cash involved, and the well established propensity of private equity to use dubious and too often illegal means to take more than they are entitled to, the large and opaque payments made under TRAs look like a perfect opportunity for more mischief.
They’e also attracted the interest of Michael Flaherman, former board member of CalPERS, former private equity managing director, and now a research fellow at Harvard’s Sarfa Center for Ethics. Flaherman distributes a newsletter summarizing the findings of his research. We recapped his first one, which discussed the (over)use of private jets. His latest piece, on TRAs, explains, contrary to conventional wisdom, why TRAs exploit private equity limited partners as well.
On the one hand, I have to commend Flaherman for getting further than I have on TRAs, and it appears to have been by virtue of extensive and careful review of public information. On the other, it’s frustrating to see him bury his findings at the end of his detailed article and dilute their impact by giving the industry party line on TRAs a more prominent position. Flaherman did not respond to our request for comment.
His conclusions (emphasis ours):
At a minimum, as we have already noted, TRAs can extend a fund’s life to upwards of 20 years….the existence of long-lived TRA assets can significantly complicate the ongoing monitoring and winding down of a fund.
Also, we consider it critical that a fund’s financial statements should record a TRA receivable as an asset distinct from the underlying portfolio company equity interest. Failure to do so complicates the tracking of the TRA asset once the portfolio company shares are sold…
We also wonder whether TRAs benefit large institutional investors, like pension funds, that are likely to beneficially own a PE portfolio company that executes a TRA, and then also own the same company in an index fund once it undergoes an IPO. In such a scenario, the public company shareholders are having cash flows shunted away from them back into the hands of the former PE investors. But in the pension fund example, the public company investor and the PE investor are ultimately the same entity. If all of the TRA cash flows were “in the money” on carry, the pension fund would give away 20 percent of the cash flow to the PE manager simply for moving the TRA’s contribution to net returns from the pension fund’s public equity pocket into its private equity pocket.
Flahemran is right as far as private equity investors moving income from one pocket of its investors to another in order to rip out more fees for themselves. Virtually all public pension funds, as well as other sophisticated investors, don’t own only private equity investments. They are diversified by asset class. That means they hold public stock portfolios that are generally larger than their private equity positions. And they are typically indexed.
But as we’ll discuss later, his “they are taking a profits interest, aka a ‘carry fee’ at your expense” is likely a best case, rather than a worst case scenario. But first we’ll explain a bit more how TRAs work.
A TRA is the monetization of tax benefits. As Flaherman points out, the TRAs entered into between private equity fund sellers and IPO investors have undesirable features like cash out options that mean that the former owners may extract more cash than the tax bennies are worth.
In more general terms, as one tax expert put it, the beneficiary of the TRA takes the position that, “if I were a father, I’m telling the mother I own the child because I fucked her.”
To be fair, the TRA beneficiary generally seeks to own only 85% of the child. But what is this child and how was it created?
The tax benefits that are monetized via an IPO are typically net operating losses that occurred during the time when the fund owned the portfolio company or via being able to step up the basis of depreciable assets during the IPO process. Let’s use the latter as an example.
PE Fund buys Hipster Food Truck Company. Hipster owns one truck and has a super loyal clientele. When PE Fund buys Hipster for $100, its truck is already fully depreciated. PE Fund writes the truck up to its then fair market value of $20. The rest of the value is goodwill. The truck is again depreciated back to $0 by the time of the IPO. But because PE Fund is very clever, it puts Hipster in an LLC and then sell it to a C Corp, which is the legal entity that will sell shares to the public. That allows PE Fund to step up the truck’s basis again. This time, they find a way to write it up to $40.
In order to redepreciate Hipster’s truck and amortize its goodwill, the IPO sale has to be structured as an asset sale for purposes of tax law. That means that PE Fund’s general partners and limited partners, to the extent they are taxable, have to pay tax on any asset gain (which may be a function of previous derpciation, as in the case of the truck).
Since the overwhelming majority of limited partners are exempt from US taxes,** the only “justificatiion” for a TRA is for the general partners to be compensted for the capital gains taxes on asset gains. But as you can see, the amount of cash extracted from the IPO company is widly disproportionate to the total tax liability of the previous owners.
The value of the TRA is set based on a model of “with and without” tax benefits to determine the expected value of the TRA. The assumptions include Hipster’s future earnings and tax rates. While there are a lot of degrees of freedom in what assumptions that are permissible in these models, we are told (quelle surprise!) that the sellers use ones that will increase the value of the TRA, such as that Hipster will pay the highest tax rates it possibly could. That leads to an estimate of the TRA liability.
The IPO company then makes payments each year to the former owners by doing a with and without tax benefit computation each year based on actual results, and is required to send the contracted amount (typically 85% of the difference) to the previous owners. The TRA benefit recipients generously allow the IPO company to keep 15% to induce it to claim the tax bennies. This annual computation and payment continues until the TRA liability is paid off.
This type of TRA also has an undesirable feature you do not see in TRAs between related corporate entities, that Hipster must pay interest on the TRA remaining on its balance. So if the tax benefits that get paid out to the PE Fund sellers over time show up more slowly than expected (say Hipster’s customers move on to a new food fad and its profits plummet), it has to pay interest on the remaining amount of the tax liability. And as we indicated earlier, because the TRA is a liability, the payments on it are analogous to principal payments on debt. They don’t hit the income statement (which is why IPO buyers are less sensitive to them than they ought to be) but they suck cash flow out of the company.
Why TRAs are Bad for Private Equity Limited Partners
TRAs are a liability to the IPO company. They pull out a substantial amount of cash flow. They have a typical term of 15 years but can be extended because the underlying tax goodies that the private equity firm is trying to exploit can last as long at the life of the company itself.
Thus the TRA has the effect of levering up the IPO company in a way that most investors don’t appreciate. Levered companies are more fragile than unlevered companies. The the IPO company has less money to make investments or withstand adverse developments.
In addition, reducing the IPO company’s cash flow by diverting to the prior owners reduces its value. Anyone who is properly schooled in finance values companies using free cash flow, not on poor proxies like EBITDA.
As Flaherman pointed out, private company investors are also public company investors, so what they gain on the private company side, they lose on the public company side. And this isn’t a wash, since large investors typically own stocks via index funds that charge razor thin fees, while private equity takes fees and costs every way it can, including ways the SEC has found to be tantamount to stealing.
Flaherman’s scenario charitably assumes that the TRA payments to the previous owners are shared pro-rata according to their ownership. That means that if that deal is profitable enough to beat the hurdle rate set forth in the investor agreements, the TRA payments will be subject to the upside fee split, which is typically 20% going to the general partners once a hurdle rate is met.
Given the utter lack of disclosure to the limited partners regarding the disposition of the TRA payments and the long history of private equity grifting in every way they can dream up, it’s hard to imagine that they’d limit themselves to a “gee we get something extra if the deal does really well overall” posture. I’ve assumed that the private equity firms at a minimum pay themselves a TRA arrangement fee of some sort. After all, they collect what Oxford professor calls a “fee for doing nothing,” the so-called monitoring fee, as well as charging transaction fees and financing fees when the general partners essentially have the portfolio companies pay twice for those services, since the general partners hire financial firms to do that work for them and have those bills paid by the portfolio companies.
There are also troubling possibilities raised by TRAs being such long-lived assets. On the one hand, as Flaherman alludes, they could serve to extend the life of a fund, which means investors paying more out in management fees and expenses than they would otherwise. But just as disturbing is the thought that the general partners could wind up a fund and leave the remaining TRA payments stranded in such a way that the only place they can go is to the general partners or a general partner affiliate. This is a realistic concern if a company is IPOed relatively late in a fund’s life, say after year 8, when funds are typically wound up between years 10 and 15.
Flaherman points out that TRAs raise other concerns:
Finally, we see broader corporate governance and public policy issues associated with TRAs. It seems very possible that lawmakers and the public might view TRAs as a form of “dead hand” asset stripping by PE managers, where, in non-arms-length transactions, companies are forced to make dividend-like payments to former shareholders. However, these payments are contracted for without the legal safeguards that otherwise would protect debt holders, workers, and current shareholders from traditional asset stripping tactics. This is especially concerning when TRAs undergo “early termination” and a company is forced to pay its former PE owners a large lump sum based on assumed, future tax savings that may never actually be realized.
Flaherman closes by saying that he has more coming on TRAs. Let’s hope he sheds some light on the pressing issue of “Who really gets the money?”
* TRAs may not always be that rich. For instance, the latest earnings announcement for Berry Plastics suggests that its TRA payment was only 10% of free cash flow But free cash flow is generally greater than pre-tax earnings (remember, depreciation gets added back in), plus as you will see, the TRA payment is a function of how much income the company has and what its marginal tax rate is, so actual TRA payments seldom match what the model said they would be. But since the company pays interest on the balance of the TRA liability still owed, the TRA beneficiaries don’t lose out if they have to wait.
** Even this characterization is charitable. Despite popular perceptions otherwise, once you exclude the general partner and its affiliates, wealthy individuals in the US contribute relatively little of the total dollars invested in private equity.