Lynnley Browning has an interesting article in DealBook about "supercharged IPOs" today. The gist is that some private equity portfolio companies go public, but keep in place agreements requiring them to pay over 85% of certain tax benefits that they receive to their former IPO owners. This, or so the argument goes, is both unfairsies - why do private equity firms get that money rather than the current shareholders? - and also, y'know, opaque secretive financial engineering etc. Viz.:
Now, buyout specialists are increasingly collecting continuing payouts from their former portfolio companies. The strategy, known as an income tax receivable agreement, has been quietly employed in dozens of recent offerings backed by private equity ...
While relatively rare, the strategy, referred to as a supercharged I.P.O., has proved to be controversial. To some tax experts, the technique amounts to financial engineering, depriving the companies of cash. Berry Plastics, for example, has to make payments to its one-time private equity owners, Apollo Global Management and Graham Partners, through 2016.
“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 who coined the term “supercharged I.P.O.” ...
Another potential issue is that sophisticated investors do not necessarily understand the deals, either. The agreements typically warrant just a few paragraphs in a company’s I.P.O. filings.
So that last part, meh. The prospectus for Berry Plastics - the main example DealBook cites - describes its income tax receivable agreement in several places and pretty clearly. It explains what's going on - "we're funneling 85% of our tax savings from current NOLs to our pre-IPO shareholders" - and even gives some numbers, estimating that the payments will total $310 to $350 million and mostly be paid by 2016.1 It's not really all that tricky.
Is it "depriving companies of cash"? Well, sure. But it's like:
- There's a company owned by a private equity sponsor.
- That company has assets, which are "probable future economic beneﬁts obtained or controlled by a particular entity as a result of past transactions or events."
- The sponsor sells that company - and its assets - to the public in an IPO, in exchange for money.
- The public pays a price for that company equal to (its estimate of) the present value of those future economic benefits.
- Now the sponsor has the money, and the new shareholders don't.
Any money that goes to the sponsor is money that doesn't "benefit all the [post-IPO, public] shareholders." That's how it works. If you're a private equity firm, your job is (1) to buy assets when you think they'll provide more profit than the public markets think, and (2) to sell (IPO) them when you think they'll provide less profit than the public markets think. That's kind of it. Also leverage.
That model is perpetually subject to criticism, because if you're doing your job right you're sort of always ripping off public shareholders, for some loose value of "ripping off."
The interesting thing in supercharged IPOs is not that private equity firms get money that would otherwise benefit public shareholders - that's true of any private equity deal - or that they're particularly opaque and shady. The opposite, in fact. Normally in an LBO a private equity firm is offering to buy a company for a fixed price but not revealing its (higher) "true" valuation of the company; in an IPO, conversely, the sponsor is offering to sell a company for whatever the market will bear but not revealing its own (presumably lower) reservation price. Here, those tax assets are pretty easy to value, and Apollo's and Berry's tax experts valued them, and there it is, right in the prospectus: they're worth $310 to $350 million.2
The interesting thing is rather that the supercharged IPO disaggregates one sort of asset - tax assets - from the rest of the assets - y'know, the company. Presumably if it had sold all of them together, it could get a higher price in the IPO - but instead it accepted a lower up-front price in exchange for hanging on to those tax assets and realizing them over time. Apollo effectively sold Berry's plastic-making machines and client relationships and future operating revenues and so forth, but kept (85% of its) tax assets.
Why would it do that?
The obvious answer is "because the market wants those plastic-making revenues more than Apollo does, but it wants the tax assets less than Apollo does." The prospectus effectively says "we're pretty sure these NOLs are worth somewhere between $310mm and $350mm, but we're also pretty sure you'll value them at much less than that, so we're gonna keep them." If the market would pay $310mm for them, you can be pretty sure Apollo would sell them: why hang on to a tail of risk in Berry Plastics - that they'll go bankrupt or defer payments,3 or that the tax laws will change - when you can get paid now?4
Browning cites this article by Victor Fleischer and Nancy Staudt about supercharged IPOs, which is worth reading particularly on the history of their development. They started out as essentially tax engineering: the sponsors would create tax benefits by selling the company's assets to an IPO newco just before it goes public, so that the company would have a high basis and lots of goodwill etc. to amortize. But this created a tax event for the sponsors, which they'd need to get repaid for somehow:
[W]hy would Founders Co. [i.e. the sponsors] agree to pay tax on the sale of stock simply to provide Public Co. (and its new outside investors) with valuable tax assets? The answer is simple: Public Co. will compensate Founders Co. for the tax costs that it will incur. One possible, and very simple, compensatory plan would involve charging the new shareholder-investors a higher price per share at the time of the IPO — this would reimburse the Founders Co. for its tax costs and still enable investors to enjoy the benefits of the newly-created tax assets. ... The parties, however, ... adopted a far more complicated plan. Founders Co. and Public Co. supercharge the deal by executing a TRA [tax receivables agreement] that requires Public Co. to pay a portion of the value of the tax asset to Founders Co. in the post-IPO period. ...
Why would the parties set up a complicated deal structure and execute a TRA, requiring Public Co. to share the benefits of any pre-existing tax assets when the IPO does not generate extra value for Public Co. (in the form of new tax assets) or increased costs on Founders Co. (in the form of a double tax)?
The answer is related to the obscure nature of tax assets and investors’ failure to understand or value them. Investors, it is widely believed, simply do not account for tax assets when purchasing stock.
So Apollo gets $310-$350mm over time instead of zero up-front. Good deal! But not all supercharged deals involve this sort of step-up transaction that creates new tax assets: Berry's tax receivables agreement, for instance, covers pre-existing net operating losses, not amortization benefits created by the IPO. The supercharging here is not about taking new tax benefits from the IRS: it's just about allocating them from a party that doesn't value them (public shareholders) to a party that does (private equity).
In other words: without this structure the public markets would be ripping off Apollo! Apollo would sell Berry Plastics, worth $X, plus a tax asset worth $310mm, for a total of $X. Public shareholders would get $310mm of value for nothing.
As a rule, Apollo doesn't get ripped off. Thus, supercharging.
That history is also interesting, I think, to answer another question: why just tax assets? Why don't private equity IPOs carve up future cash flows more generally, selling to public shareholders the cash flows that they (over)value and keeping for the sponsors the cash flows that the public undervalues? The tax supercharging suggests we're at a fairly early stage in that development: the tax receivables agreement made total sense in the case of tax assets that were created by the sponsor immediately before the IPO. Now it's been extended to other tax assets that weren't created by the sponsor but look sort of similar: they have similar asymmetric-valuation issues, and also are similarly tax-y. The next step, I suppose, is to extend it to other assets that the market values less than the sponsor but aren't tax-y: give public markets everything they'll overpay for, and nothing they won't. That would be supercharged.
1.Here's a sample (page 81):
Following our initial public offering, we expect to be able to utilize net operating losses that arose prior to the initial public offering and are therefore attributable to our existing stockholders, option holders and holders of stock appreciation rights (i.e., Apollo, management and other investors). ... We will enter into an income tax receivable agreement and thereby distribute to our existing stockholders, option holders and holders of our stock appreciation rights the right to receive payment by us of 85% of the amount of cash savings, if any, in U.S. federal, state, local, and foreign income tax that we and our subsidiaries actually realize (or are deemed to realize in the case of a change of control and certain subsidiary dispositions, as discussed below) as a result of the utilization of our and our subsidiaries’ net operating losses attributable to periods prior to this offering. ...
Assuming no material changes in the relevant tax law and that we and our subsidiaries earn sufficient taxable income to realize the full tax benefits subject to the income tax receivable agreement, we would expect that future payments under the income tax receivable agreement will aggregate to approximately $310 to $350 million. ... Based on our current taxable income estimates, we expect to repay the majority of this obligation by the end of our 2016 fiscal year.
2.Actually I guess 1/0.85 of that but whatever.
3.Which they can do, at L+500.
4.Also: why tell the market "the value of this asset is $310-$350mm" when you can avoid doing that? When you IPO a company you basically let investors put their own valuation on it, and whoever puts the highest valuation on it ends up buying the stock. Sort of by hypothesis their valuation is higher than yours. Here, on the other hand, the prospectus puts a dollar value on these tax assets. If Berry ends up paying Apollo, not $310mm or $350mm but $500mm under these tax agreements, you can bet that someone will sue. And they'll probably win, right? You basically have to be conservative here, if you're Apollo/Berry, meaning erring on the side of overstating rather than understating what Berry will end up paying its sponsors.