Supercharged IPOs Draw Attention
In an initial public offering (IPO), a private company issues shares to public investors in exchange for cash. Companies benefit through IPOs because the infusion of cash from investors allows them to expand operations, pay off expensive debt, or make acquisitions. IPOs do not result in the private company owners, the public investors, or the company itself incurring any federal income tax liability.
In 2007, private equity giant the Blackstone Group went public in a complex variation of the IPO that has become known as the “supercharged IPO” (although Blackstone was not the first to do it). In a supercharged IPO, the private owners of the company, pursuant to an agreement called a tax receivables agreement (TRA), receive a stream of tax benefits from the private company after it becomes public. The payment streams from the post-IPO public corporation to the private company’s former owners set forth in some TRAs are eye-popping: $200 million is not an uncommon figure.
TRAs are common in the business world; they often deal with how parties to a deal share tax credits and deductions such as depreciation and net operating losses. But TRAs in the context of supercharged IPOs are unique in that they deal with the allocation of a tax benefit that is created as a result of the IPO. The following is a simplified description of how a supercharged IPO works (all Section references are to the Internal Revenue Code):
A private company operating as a pass-through entity such as a partnership or LLC (it could also be a corporation, although that is less common) wishes to go public in an IPO. The owners of the private company contribute their partnership or LLC interests to a newly-formed public corporation. Although this transaction can be structured as tax-free under Section 351, the private company’s owners and the public corporation intentionally structure the deal to be taxable. As part of the deal, shares in the public corporation will later be made available to public investors as well. The transaction is structured to be taxable so that the public corporation can take a “stepped up” basis in the private company’s assets, including intangible assets such as goodwill. In the transaction, the private company’s owners will recognize gain equal to the excess of the value of the public company stock (or cash) they receive over their basis in the private company. The public company recognizes no gain when it receives property in exchange for its stock, pursuant to Section 1032. But crucially, under Section 362, the public corporation takes a basis in the private company that is equal to the gain recognized by the private company owners. In contrast, if the exchange had been structured to be tax-free, the public corporation’s basis in the private company would have been zero. As things stand after the exchange, the private company’s (former) owners owe tax, and the public company has a basis equal to that tax due which can be depreciated and used to offset future income taxes.
Why would the private company’s owners ever agree to a supercharged IPO if all they get is a tax bill, when they could have done a traditional IPO and deferred any tax? The answer lies in (a) the way the private company’s goodwill is treated for tax purposes and (b) some basic tax arbitrage. As a general rule, a company is not allowed to amortize its self-created goodwill. This is a significant provision in the tax law because goodwill is often one of the most valuable assets of a company. However, the purchaser of a company thereby acquires its goodwill, and the purchaser is allowed to amortize (essentially, to depreciate and claim deductions) the cost of the goodwill over 15 years pursuant to Section 197. When the public corporation acquires the private company in a taxable exchange, it takes a stepped up basis in the private company’s assets, including goodwill. The public corporation can then depreciate over 15 years the amount allocable to goodwill.
What happens in the supercharged IPO is that the public corporation gains a tax asset– basis in the private company giving it the right to depreciate goodwill over 15 years– that would not have existed but for the taxable transaction. As mentioned above, the “cost” of creating this asset is that the private company’s owners have to pay an immediate tax bill. But this unpleasant result is offset by the TRA; the TRA provides, that for each of the next 15 years, the public corporation will give the private company’s former owners cash equal to a certain percentage (perhaps 85 percent) of the public company’s depreciation deductions attributable to goodwill. And tax arbitrage comes into play here. The private company’s former owners generally pay long term capital gains rates on the sale of their partnership or LLC interests to the public corporation. These gains are subject to a federal income tax rate of 20 percent (plus 3.8 percent under the Obama administration’s health care law). But the deductions the public company claims with respect to goodwill offset a corporate tax rate of 35 percent. The private company’s former owners are happy to take the short-term pain of an immediate tax hit (at a tax rate of 23.8 percent, although prior to 2013 the tax rate was 15 percent) if they are guaranteed to receive cash equal to the value of deductions against a 35 percent tax rate.
A simple hypothetical illustrates the benefits of a supercharged IPO. A private company operating as a partnership is worth $10 million. The partners have a zero basis in the company. For the sake of simplicity, the only asset the partnership owns is goodwill. The private company decides to go public. The partners form a new public corporation and contribute their partnership assets (i.e., the private company) to the corporation in exchange for stock valued at $10 million. The transaction is structured to be taxable, so the partners pay tax on the $10 million gain. The tax is $2.38 million (i.e., $10 million * .238). The partners now have a $10 million basis in their stock, which they can sell to public investors if they so desire. The public corporation has acquired goodwill worth $10 million that it amortizes over 15 years at the rate of $666,667 a year. If the public corporation is taxed at the highest corporate tax rate of 35 percent, a $666,667 deduction is worth $233,333 to it. If the partners and public corporation agree to a TRA which gives partners 85 percent of the value of the amortization, the partners receive a cash payment of $198,333 each year, which is almost $3 million over the course of 15 years. If that $3 million figure is translated to present value terms, it is a smaller amount, but it is still sufficient to offset a very large percentage of the partners’ $2.38 million tax bill. The results can be even more favorable depending on the numbers in a specific case; in the Bloomberg Group’s 2007 IPO, the private company’s former owners were entitled to receive payments for tax assets equal to $864 million, which was more than enough to pay their tax due on the transaction.
Although supercharged IPOs make up only a small percentage of IPOs, they have drawn increasing attention. The New York Times recently ran an article on them, and law professors Victor Fleischer and Nancy Staudt have an article on the subject that is scheduled to be published in the Vanderbilt Law Review. After the Bloomberg Group’s supercharged IPO, Congress considered a bill that would target such transactions, but ultimately took no action on the matter. Congressional scrutiny aside, some commentators believe that private equity is taking unfair advantage of public investors who buy into an IPO without understanding that the private company’s former owners have a claim against the post-IPO public company’s future cash flows.