Unlocking Value & Navigating Conflicts in Tax-Receivable Agreements

Chris (00:02): 

You are listening to Solomon Connects, our podcast covering the latest trends and insights in dealmaking today. I’m Chris Moynihan, a director in our M&A group, and I’m joined here today by Matt Cornish, a managing director in our Financial Institutions Group (FIG). Matt, welcome to the podcast.

Matt (00:17): 

Thanks for having me, Chris. It’s great to be here.

Chris (00:19): 

So, we’ve interviewed other members of the FIG team, but maybe you could just start by giving us a little bit of a sense of what you cover, specifically, and then how your time has been with the FIG team so far.

Matt (00:29): 

Sure. So, I’m a managing director here at Solomon Partners focused on two key areas: One is traditional sell-side M&A for insurance services companies; the other, which is the topic of the conversation, is illiquid financial-asset monetization. Illiquid financial-asset spans a wide universe of all shapes and sizes of pools of assets. They can be pools like non-performing loans, tax-receivable agreements, life settlements — and it’s something that we’ve developed a good buyer’s universe in the esoteric asset space to help find liquidity for these illiquid investments.

Chris (01:04): 

So, maybe we dive into tax-receivable agreements. It’s an illiquid asset, as you mentioned, and it’s a bit more nuanced than a typical M&A transaction, but do you want to talk first, specifically, for our listeners, about what a tax-receivable agreement is?

Matt (01:18): 

Sure. A tax-receivable agreement (TRA) generally is created in a public company IPO. It happens when there is an Up-C structure, where a private partnership converts into a C Corp during the IPO and there’s a step-up in tax basis of the assets. That step-up in basis has been given to the pre-IPO equity holders. So, a tax-receivable agreement is created between the new PubCo and the prior shareholders so that when they convert their shares into the public company interests, they receive the benefit of that step-up in basis in future years as the company uses it as a tax shield.

Chris (01:56): 

We’re seeing a lot of market activity, specifically in TRAs. Can you talk about a little bit of what you’re seeing over the last year and how it’s picked up?

Matt (02:05): 

Sure. There’s been a lot of publicity and news articles around TRAs, which is helping to build investor interest in the asset class — which was exciting for me, being in the industry — but most people said, what is this? Is this investible? And we see a lot of the large-asset managers with multiclass pockets of capital start to say: Yes, hey, TRAs are interesting; it’s an asset we can invest in. And it’s created a robust buyer universe for something that used to be thinly traded.

Chris (02:35): 

So, there’s about 150 public companies that have these agreements in place today. Why do you think there’s been this sort of increase over the last three, four years in the number of tax receivable-agreements at companies?

Matt (02:48): 

Great question. It’s a newer concept. So, IPO boom between 2016 and 2021 is when this really became commonplace and it continues to be so today. It’s that for that step-up in basis, this document’s created, and it’s something that is becoming more traditional, wherein most Up-C IPOs, a tax-receivable agreement now exists. And as you mentioned, from the public perspective, there’s 150 in place on the balance sheet of those companies that we can track. But a lot of people don’t know this is actually something that could be done in private transactions. If you’re in a private M&A situation and there’s a disagreement on how to treat a step-up in tax basis, you can create a private TRA to handle that issue of value when you can’t agree on purchase price today you can defer payments on that tax step-up, where the selling party receives the benefit.

Chris (03:42): 

And I think that’s one of the interesting things about this type of an asset. There’s a real market behind it, right? You’ve had experience selling these types of assets, but there’s willing investors that are interested in this asset class.

Matt (03:53): 

There is. So, a key clause of the tax-receivable agreement is it’s portable, meaning it’s transferable to a new owner and it cannot be held up for anything except for good cause. So, in most cases, if you find a reputable buyer, it’s transferable to that buyer. So, there is a market of alternative credit and special situation investors that like cashflow return, that can price this and hold it as a new owner, if you need liquidity in something which is a long-dated asset.

Chris (04:24): 

And for our conversations with boards, it’s been a great starting point because having a market out there that can actually price these assets efficiently at least gives them a sense of where they can buy them back. And we talk a lot that often they’re the preferred buyer because it’s easy to deal directly with a company but knowing that there’s a credible third party behind them can help a little bit with the price discovery when you’re having that process.

Matt (04:46): 

It always helps to have multiple market reads as to where an asset should trade. And now that there is a more robust private market for tax-receivable agreements, it does give a good benchmark for boards to understand where this would trade in a third-party arm’s length transaction versus what it’s worth to them, where they actually have synergies to retire it.

Chris (05:05): 

And I think what’s been great is, as you’ve joined the platform with this knowledge of how the market works and how to price these assets, we found an interesting synergy with our longstanding special committee advisory group, which is focused on public company M&A and navigating conflicts. And one of the things that we see with TRAs is they often pose a conflict between the shareholders, the holders of the TRA and then ultimately the board of directors who’s actually representing the shareholders. And what we’re seeing increasingly, and where you’ve been helpful, is we’ve had conversations with companies, and often this conflict exists and they want to deal with it, but there’s never a great time to deal with a liability like this on your balance sheet. You’re trying to figure out is it an appropriate use of capital — should the cash be going to retire this liability versus doing more productive things on an ROI basis and looking at the different investment opportunities you have available? And so, one of the interesting use cases is combining your expertise and then figuring out and advising companies as to what’s the best way to retire it. And one of the ways that’s emerged is pursuing a buyback in what we call a clear day settlement; so, doing it outside the context of M&A. Do you want to talk a little bit about how that process works and how board should think about it?

Matt (06:20): 

Sure. So, tax-receivable agreements, in nature, are conflicted, and that’s because generally the pre-IPO holders of the shares are the C-suite of the company that’s IPO-ing, and they generally remain in management post IPO. So, given that, board members, CEOs, CFOs, and the others that control decision-making own the TRA, it’s a natural conflict of interest if you’re thinking about retiring the liability, because in order to retire the liability, there’s going to be a cash payment made or a stock payment made, and that’s going to go to some of your C-suite members of the firm. That creates a situation where it’s mandatory that you create a special committee that’s not conflicted and not biased to execute in the best interest of shareholders and execute that fiduciary responsibility.

Chris (07:11): 

And I think one of the interesting things we’re seeing in market is, earlier on there were some cases and litigations where the GoDaddy, for example, where there was a lot of scrutiny as to how the company and more the board handled the TRA negotiation and settlement. Now I think we’re seeing companies engage early, form the special committee like you said, and actually take the conflict seriously, all the way up to providing a fairness opinion, if warranted, for the shareholders to show we understand that this is a conflict, we’re going to find the best way to actually deal with it and make sure that all is above board, hire real advisor so that they can deal with it appropriately. Now, we know that not all these TRA settlements are paid at full value or the nominal value of what the TRA is. Can you talk a little bit about, marketwise, what you’re seeing in terms of settlements or where the discounts are pricing out depending on what the TRA is and the attributes of it?

Matt (08:06): 

Sure. In a clear day buyback or retirement of the TRA liability by the corporate, they are generally priced via a discounted cashflow model where you estimate the future cash payments that are due on that TRA and discount it back at a discount rate that’s at a slight premium to the weighted average cost of capital for the specific company. Now, that innately will be at a discount to the carrying value of the liability based on the way it’s held according to GAAP, and it creates an incentive for the company to potentially clean that liability up. It’s also complicated financial reporting. There’s a lot of time and energy spent by the C-suite managing this due to the number of payers and differences in the schedules that’s owed to each individual person that’s converted shares at what time. And there’s some risks to M&A holdup value. In the event of a take-private, there are acceleration clauses in the TRA, where if there was M&A at the corporate level and a take-private, the full TRA comes due. So, sometimes it makes sense to clean that up so that you don’t have a potential poison pill in an M&A deal, where a TRA holder can block the transaction.

Chris (09:17): 

And I feel like that’s why we’re seeing boards engage now, because with the market where it is in performance on stock price, a lot of these companies might be thinking: Either, I’m going to go out and do an acquisition, or more likely at some point I might get taken private, or my stock price is low and I have to value out alternatives. And the last thing you want is a liability dictating the outcome of what that strategic alternatives process could be. So, handling it appropriately ahead of time can actually be a good use of capital. And on top of that, I think we’ve seen in the recent examples that Wall Street has been relatively favorable — at least the equity research reports that we’re reading based off of the retired TRA liabilities and whether or not the stock price is reflected — at least the analyst community seems to think that it was a good idea to retire that liability.

Matt (10:07): 

Yeah, I think the trends and views of TRA buybacks is starting to shift similar to a world I used to cover around continuation vehicles (CV). It used to be a huge negative to put an asset into a CV. Now it means it’s one of your best assets. So, trends change around certain transactions. We’re starting to see the same things around TRAs is, buybacks are no longer viewed as something negative, conflicted, and a poor use of capital. It’s actually something that’s enhancing shareholder value, because your earnings per share — post a discount takeout of a TRA liability — increases in the future and you get credit for it.

Chris (10:44): 

Since we’re winding down the episode, any advice you’d give to companies that have a TRA that are dealing with this liability right now?

Matt (10:53): 

Sure. I think boards and the C-suite should be proactive. Just like anything else that they do in their normal course, it’s prudent to analyze the TRA to ensure that you’re treating it properly in the best interest of shareholder value. And that could mean leaving it outstanding or considering a buyback of the liability in retirement. And that all comes down to looking at the cash payments, looking at the forecast, assessing the best use of cash today for the company to achieve the best returns on capital.

Chris (11:22): 

Great points. Enjoyed the very productive discussion on tax-receivable agreements. I know it’s complicated, but we appreciate your knowledge on these illiquid financial assets. It’s great having you here today, Matt, and thank you for coming on the podcast.

Matt: 

Thanks for having me, Chris.

Chris: 

To our listeners, thank you for tuning in. For more M&A insights, check out solomonpartners.com.