Parallaxes Featured on the Capital Allocators Podcast
Parallaxes Capital CIO Andy Lee joined Ted Seides on the Capital Allocators Podcast to discuss his background and path to the hidden gem of TRAs. Andy covers the basics of a TRA, rationale for their use, and drivers of return and risks. He also provides insight on Parallaxes Capital’s investment process, team, the future of the organization.
My guest on today’s sponsored insight is Andy Lee, the Founder and CIO of Parallaxes Capital. Andy spun out of Lone Star in 2017 to focus on the niche opportunity to invest in Tax Receivable Agreements or TRAs.
Our conversation covers Andy’s background and path to the hidden gem of TRAs. We cover the basics of a TRA, rationale for their use, drivers of return, and risks. We then discuss Parallaxes’ investment process, team, the future of the organization.
Hello, I’m Ted Seides and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at capitalallocators.com.
All opinions expressed by Ted and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions in securities discussed on this podcast.
In our continuing series of Empty Rooms, opportunities ignored by most investors because they either don’t want to or can’t participate. My guest on today’s sponsored insight is Andy Lee, the founder and chief investment officer of Parallaxes Capital. Andy spun out of Lone Star in 2017 to focus on the niche opportunity to invest in tax receivable agreements or TRAs.
Our conversation covers Andy’s background and path to the hidden gem of TRAs. We cover the basics of a TRA, rationale for their use, drivers of return, and risks. We then discuss Parallaxes’ investment process, team, and the future of the organization. Please enjoy my conversation with Andy Lee. Andy, great to be with you.
I’m from the middle of nowhere, Champaign, Illinois. I had the opportunity to go to college a little early. I went to college at 15 and I wanted to be an archeologist. Being Asian, Papa Lee wasn’t having any of that. And so, I ended up doing finance and accounting. When I graduated, I was a little too young to move to New York. At which point of time, I did a master’s in accounting with a focus on taxation, which really leads us to when I finally got to New York.
I was at Citi in M&A, and there I had the opportunity to work on a TRA. Primarily, because the head of the group basically came out of the office and said, “Don’t you have a master’s in tax?” I was like, “It’s not quite worth the paper it’s printed on,” but I ended up working on it. It was a transaction between Rio Tinto and Cloud Peak, a coal producer.
I found it fascinating and I said to myself that someone should provide third-party liquidity for it. Post-M&A, I went down to Lone Star Funds down in Dallas, Texas and there I was basically told, “The only way you get promoted here is for you to create something.” And so, there were a number of items that I looked at in earnest, but the one that really got us off the ground was in the creation of two TRAs in our portfolio.
After the creation of them, the firm asked me, “How much can you deploy annually into an opportunity set like this?” I said, “Annually, $150 million,” to the firm that was incredibly small. The partners basically said, “Andy, why don’t we give you some money? And if it doesn’t work out, come back in two years.” I left in 2017 pursuing a rather esoteric opportunity set, monetizing tax receivables.
It was interesting in many regards, insofar that when you’re a freshman, no one ever asked you how old you are. The common ages would be 17, 18, 19. And so, it was a challenge fitting in, but my sister had also gone to college relatively early at 15. I basically followed in her footsteps. That dynamic definitely did create some interesting stories.
My sophomore year, I was a resident advisor for a senior-heavy dorm. On the campus of Illinois, we have a tradition for St. Patrick’s, known as Unofficial. As you could probably tell from the name, it was a day where the campus basically goes buck wild. My job as a resident advisor was to police the halls and ensure that nothing got out of hand. You can probably appreciate my amusement being a 17-year-old resident advisor taking care of otherwise 21, 22-year-old residents who are of legal age and confiscating their alcohol and having to pour it all down the drain.
I think it’s a combination of being semi-intelligent, but also more importantly hyperactive. My mom and dad were always at a loss as to what to do with me when I was growing up. I don’t know if this necessarily was foresight, but they found that the avenue through which they could satiate my appetite and intellectual curiosity was to put me in classes that were several grades ahead of me. I kind of think of that as babysitting. For all intents and purposes.
The simplest way to think about it is a tax receivable is merely a contract between a oftentimes public company with a pre-IPO holder. Names in our portfolio that some might recognize include the likes of a RE/MAX, a Shake Shack, a Duff & Phelps. Large-scaled businesses. What it is, is the contract effectively refunds the holder for the cash tax savings a corporation may receive.
Tax assets that one might recognize or be familiar with include the likes of a net operating loss. These net operating losses will be realized over time and generate cash tax savings, which will be valuable to both the corporation and the pre-IPO holder. The reason this option set even exists today is primarily a function of the fact that public equity investors oftentimes don’t ascribe much of any value to tax assets.
If you think about a business, they might look at it on a revenue growth basis or an EBITDA multiple, both of which don’t capture the inherent value that tax assets deliver to a corporation. Knowing as such, pre-IPO holders, might that be leveraged buyout firms, co-investors, or management team members, are attracting it for themselves through the utilization of a tax receivable agreement.
Let me take that example of a net operating loss. You have a business that’s lost money in the past. You then are saying that in the future, if they make money, they won’t pay taxes. Therefore, there’s some tax savings each year. Are you effectively securitizing that stream of future cash flows into a vehicle?
That’s effectively been already done through the creation of the TRA contract. We are merely secondary buyers of it, and so we’re stepping into the shoes of the previous owner of the contract and buying their rights to those cash flows. Longer- term, our goal is to become a primary originator of the opportunity. But today, we are secondary monetization of these.
It’s primarily done by private equity firms in the context of their portfolio companies. And it runs the gamut of industries from the likes of Bumble to GoDaddy, all the way to Shake Shack, my personal favorite. I admit that it’s somewhat odd, whenever I sit down at Madison Square Park to enjoy a Shack Stack, to think about what this all meant from an IPO, M&A structuring perspective.
The transaction that creates it is known as the Up-C, which is effectively for all intents and purposes just a step-up transaction. This technology really came from the real estate world from the UPREIT. The first UPREIT was created in the 1980s via Taubman Shopping Centers, and subsequent to that, TRAs inherited that technology when corporations started going public.
The new ones and why this is necessary is because in order to be a public company today here in the US, you need to be a C- corp. And so, clever tax structuring lawyers decided to utilize the same technology utilized in the REIT world for corporations.
Absolutely. It’s a step-up which is relative to cost basis of the original founders. It allows the public company to receive a full step-up. The full step-up effectively is the price at which the founder is selling his stock for, thereby delivering a large step- up, which over time is amortizable for tax purposes and delivers a large tax asset.
I think that’s most prevalent in the REIT and MLP world, where they are purchased by buyers who are focused on a cash flow yield. As I mentioned earlier, many public investors are focused on revenue growth, EBITDA multiples, perhaps a P/E multiple.
They don’t model down to free cash flow or can’t do that accurately. And so, as part of that, MLPs trade at such a premium because of the valuation metric that they are oriented towards. The creation of a TRA would actually be an obstruction to the realization of that overall value.
Those are incredibly challenging. Yes. They could definitely create a TRA. Venture capitalists who back these companies oftentimes don’t fully appreciate the value of tax assets, because many of the corporations are not oriented to being profitable. They’re more oriented towards growth and as such, the adoption in the venture capital community has been relatively slow.
That said, as a result of the flurry of both IPOs as well as SPACs in ’21 and ’22, there was a significant uplift in terms of number of TRAs created that were shared by both growth equity firms as well as venture capital firms. Many of them are now trying to understand what they even own. And so, we’ve been at the forefront of trying to educate them as to the value of those latent tax assets that they have today, but also what they could create across their portfolio in time.
Man. This market has grown like weeds. In 2017, the market opportunity was, call it, $7 billion on the back of euphoric equity markets, and more importantly, adoption by private equity sponsors. That number is now closer to $30 billion. It runs the gamut from the likes of TPG to a European Wax Center or even a Portillo’s in the more recent vintages.
On a annual basis, there are, call it, 25 to 40 IPOs with TRAs. Depending on the IPO market. Just to frame it, in 2021, there was 75 that went public with a TRA. So there was a huge upgrowth in the opportunity set.
What we seek to deliver to our investors is an uncorrelated cash-yielding investment that serves as really a call option on corporate tax rates on a go forward basis. Those attributes are incredibly valuable to us in many regards, because it reminds many of what pharmaceutical royalties were in the early 2000s, but we’re also where musical royalties were in the 2010s. Long- dated annuity-like cash flow streams.
Think about net operating loss. Think about that as the volume equation. Think about the tax rate as your price. Let’s say the net operating loss is $100, the tax rate is 25%. The multiplication of the two would result in a total cash savings of $25. Should tax rates go up to 40% from where they were, we would get $40. 100 by 40. In the same way, if tax rates went down to 15%, it’ll be 100 by 15 or $15.
There are two other risks, the first of which is bankruptcy risk. As mentioned, they are an unsecured obligation. And so, a lot of our work relates to the credit worthiness of these companies. I think the item across the industry that is not well understood is that they are oftentimes IG or near-IG names.
They oftentimes are large-scale and with access to public markets. And so, on average, we see the industry being approximately 400-plus of EBITDA, less than two times leverage or less than a billion of indebtedness, and they oftentimes have a market cap in the $5 to $10 billion zip code. And so, the LTVs across the opportunities are relatively low.
That sounds more like a step-up type business than a business with an NOL. When you look at those two different investment opportunities, how do you assess the pluses and minuses of those two different types of TRAs?
Net-operating losses are incredibly challenging for us to underwrite, because our entire value prop to many of our investments who are endowments and foundations is that we seek to deliver an uncorrelated return. A net operating loss TRA is incredibly correlated to the economic performance of a company. I would also articulate that oftentimes there is a bid/ask between us as well as the sellers, insofar that they have a more bullish view of when a company would utilize its NOL versus relative to what we might be willing to underwrite.
Where we are more focused on is the step-up tier. Primarily, because for many of the names that we are underwriting, they can see almost a 60% to 80% drop, their earnings metrics might not be an EBITDA-oriented metric, and see no changes to their overall payment. Often the one thing that people fail to understand is you never lose a tax asset, you merely defer it, which has the impact on your IRR, but not necessarily changing your MOIC on an opportunity.
The company would file its corporate tax filing, if and when they file their taxes, and they are able to utilize the deductions that a TRA’s assets are able to deliver them. They would then pay 85% of those savings to the holder of the TRA. Should the likes of a Blackstone save $100 million on that tax return, they would then pay $85 million to the likes of a Steve Schwarzman, who might be the holder of that TRA, and then keep 15% for themselves.
Many of these are large-scaled businesses. One of the things that they don’t want to do is to publicly announce that they are undertaking an IRS audit. Among the other things that a TRA holder has is information rights as to understanding how the company filed its taxes, the accounting policies, as well as practices that they necessarily utilize in the filing process.
And that allows us to monitor, as a TRA holder with information rights, how the company was undertaking it. These large public companies do not want to be perceived as having been too aggressive in the view that, should they undertake an IRS audit, it would be something that would have a negative implication onto their public stock.
It’s a lot of brain damage. I would say there are no intermediaries in the space that we deal in, as a function of a number of things. Domain expertise as well as the size of each underlying opportunity prevents many intermediaries from engaging in earnest on this space. As we think about it, these are large public companies who oftentimes file among other things the overall TRA document or the underlying LLC. Should they not, there is some grunt work that is undertaken to understand who the pre-IPO holders are.
Once we have a list of those names, it’s a matter of enhancing that underlying information, and then seeking to get either warm introductions or seeking to cold email them as part of the overall sourcing process. Our job is that oftentimes we are the educator of the holder of the asset fresh off the IPO. A lot of what we do is getting in front and staying in front of these holders, educating them about the TRA, the value that it can deliver them over time, but also providing them the option to sell the TRA should they ever want liquidity.
As you think about some of these holders that run the gamut from a sponsor, a downtown management team member, they may for different reasons want liquidity. Might that be finite fund life, considerations, or just a desire and an opportunity cost conversation. Our job is to serve as the educator to them as to what their options are as it pertains to, for many of them, what is a latent and stranded tax asset.
You can imagine a situation where the seller of a business going into an IPO has a lot going on. How have you gone about engaging these people who are super busy about this asset that they have, that they may not value, that they may not care about?
We run the gamut from seeking to engage with these holders. A low cost avenue that we seek to leave an impression on them is doing things such as promotions on LinkedIn, where we seek to put ads specifically targeting them and their TRA. All the way to the other side of the equation, where we seek to get in front of them, and in-person doing an educational seminar or topic.
We also have done things such as cameos, where we have sought to understand who are their favorite sports team. Might that be college or pro. And by doing so, picking their favorite athlete and sending them a personalized cameo with that athlete suggesting that they engage with us in a potential sale. That has included the likes of a Jay Williams, a LaVar Ball. All the way to college sports teams members like the head coach of Indiana or Baylor.
My favorite sourcing story is clearly not very scalable. We were looking to get in touch with the CEO of a company with a large TRA. Let’s call him Noah. Noah was the chairman of a not-for- profit with an upcoming 5K. As part of trying to bump into him, we decided to participate. While I completed and achieved my personal best, I definitely looked like a fool zigging and zagging through that race as Noah was nowhere to be found.
We look and feel almost like a CLO manager. Many CLO managers undertake within their strike zone to underwrite as many of the underlying names that may issue broadly syndicated loans or bonds. For us, for the entire opportunity set of, call it, 200 in changed names, we have sought to underwrite the entire opportunity from a credit, legal, and tax perspective. And that’s required a ton of spade work, but it allows us and our team to start from the 80-yard line versus starting from the one-yard line whenever an opportunity arises.
call it, 200 in changed names, we have sought to underwrite the entire opportunity from a credit, legal, and tax perspective. And that’s required a ton of spade work, but it allows us and our team to start from the 80-yard line versus starting from the one-yard line whenever an opportunity arises.
It also allows us to pre-identify opportunities that may have challenges to executing a transaction. Take for instance, if there is a ROFR in the opportunity with the company, that would be challenging for us as a firm to engage with. There are TRAs with significant international tax assets. Tax is a very local domain of expertise. It’s incredibly challenging for someone like myself, who studied primarily federal tax, to understand anything about state tax. Let alone international tax in Canada or Mexico.
Our credit underwriting is non-differentiated relative to what a credit manager in direct lending or in the distressed world might undertake. What we’re looking to do is understand, A, is the business going to remain a growing concern? Because B, we have a different lens as to the world that we live in. Primarily, because we’re not originating seven-year pieces of paper, where we believe that our takeout is a refinancing via that data.
For us, seven years is oftentimes the window through which we receive the majority of our cash flows. But in order for us to make not just a return of capital, but a return on capital, we really need the Year Eight through 15 cash flows to have a profit. We have to underwrite, “Do we believe this business is going to remain outstanding for 15 years?” Though it’s a lazy underwrite, which makes it challenging for certain businesses that some may view to be fads or where they have fewer products among others. Those can be incredibly challenging to underwrite.
One of my favorite stories from underwriting is when we were seeking to better understand the realtor market, as part of understanding a RE/MAX. As part of that, we sought to have one of our team members take the New York Realtor Examination. Sadly, I would share that I was the one volunteer. The one thing that I would say positively is that I actually passed. One of my colleagues has made it his life mission to eat at every Shake Shack in Manhattan.
When you’ve gone through the process of educating a company about the value of this asset, then I imagine you have to go through a negotiation to try to figure out the price. Because you’re not just highlighting the asset, you’re trying to buy it at a discount to what it’s worth. How does that process play out?
We’re pretty upfront about our cost of capital and how we think about it. And that’s a function of a number of items. Might that be the underlying credit risk of the business … But also, when we believe that we’re actually going to get paid, and we share that oftentimes from a qualification of a seller perspective, many of them don’t want to engage at that price level.
And that’s fine. Our job is to educate them as to what we can get done. And it’s important for us to know if there’s a transaction to be done or not for us to cut bait on a opportunity that may not exist, because we have different price expectations of what makes sense.
There are a number of avenues. Obviously, this is annuity and self-amortizing. First and foremost, is the inherent cash yield that we get on an annual basis. Look, we are pursuing a path similar to the leaders in the pharma royalty space as well as the musical royalty space, who have undertaken the process of consolidating their holdings and ultimately listed them.
Our goal is to undertake a similar process. We did that in 2021 and are in the process of a completing our second merger. But on a go forward basis, our goal is to originate these assets, and subsequent to that, contribute them into our overall portfolios with the long-term exit strategy of potentially going public.
It’s more so a lack of competitors. There are really five rationales as to why that is. I think the first that I alluded to is the domain expertise or requisite to underwrite the opportunity set. Most deal professionals hear the word, “Tax,” and they just run away. The second rationale is around the return expectations. The third rationale is around the fact that the duration of the opportunity oftentimes makes it incredibly challenging for people to clear committees. Insofar that if you were a hedge fund with one-year locks and you had a one-year asset, everyone could do it.
If you said that you need to have eight to 10-year funds, that starts becoming incredibly challenging for many of the more credit-oriented firms who have six to eight-year vehicles to originate the opportunity. The fourth reason is around the sourcing of the opportunity and the size of each opportunity. The average opportunity is between $15 to $20 million. If you are a large-scale manager with several billion dollars to deploy, that can be challenging to spend a significant amount of time to deploy $15 to $20 million for each check.
The fifth reason and final reason is we’re trying to make it challenging to compete against us. Several of the things that we’ve done to do that includes the likes of pre-underwriting the opportunity set, to the extent that we can deliver our sellers speed and certainty as and when they ever want to transact. We are not only getting in front of them whenever they want to sell, we’re staying in front of them and trying to add value to them on a regular basis.
Our biggest competition that has always been there, it’s not a third party. It’s really the company itself. They have not only the lower cost of capital, they also have asymmetric information even relative to us, as it pertains to what they view their tax assets to be worth and when they will realize it. And so, the company is oftentimes our single largest competitor.
I think many who are facile with tax would look at our portfolio and say all we are is factoring items that have existed in tax code for almost 100 years and are protected by lobbies. Including the real estate lobby. We fundamentally followed the same principles that many of these that have been well-honed in tax code … There are many other asset classes that would hurt in earnest prior to it really affecting us.
That is something that we spend a lot of time thinking about, but is a macro factor that we candidly have no control over or ability to influence in earnest. We actually tried to hire an advisor who had previously been a former IRS commissioner.
There are six of us today. I’ve always sought to build relatively small and tight-knit teams. I recognize that one of the things that many institutional investors want to see is a institutionalized-oriented organization. I think that’s a tad challenging for a relatively new asset class. Primarily, because there are many items and many problems that a private equity firm may encounter that aren’t necessarily relevant to us.
And so, one of the things that we’ve been very focused on is avoiding technical debt that we may incur as a result of taking on some of the legacy systems that make sense for private equity, but less so for us.
A lot of times when someone’s found a niche that is limited in size, they spend some time trying to figure out are there adjacencies and other opportunities so that they can expand their business. How have you thought about the future of your business as you look out a couple of years?
I think a lot of life is focus. There are many opportunities. Especially, in tax. It’s a really poorly understood world and opportunity set from a finance perspective. I don’t know if that’s my burden to carry, insofar that as I think about the opportunities that today that we have, it’s large, it’s growing in adoption. There are so many avenues through which we can express ourselves that to look further, I feel, may make it challenging for us to bring to bear the value propositions that we seek to deliver to our stakeholders.
I am absolutely obsessed with history. Learning about some of the victories as well as losses that historical figures have experienced has been incredibly fascinating to me, as I just think about our daily life and the work that we do. Might that be the lives of some of the Roman or Greek leaders and some of the battles. Might that be the Alexander the Great fight, which is taking the high ground in a battle.
What does that mean? How do you express that in the business world that we live every day? Or to the trials and tribulations of Hannibal as he crossed the Alps. For me, being a little country bumpkin coming from Champaign, Illinois, New York City is my Rome. And so, crossing the Alps and trying to find a way to win the Punic Wars is something that I somewhat romanticize to myself each and every night.
People who think in binary terms. That being good or bad. One of the meanings of Parallaxes is … Just for the word, a parallax is looking at an item from a different vantage point. Parallaxes is a plural of which you can look at a problem from multiple vantage points and arrive at a different solution set. And so, I really struggle with people who only see things through a single lens.
There are definitely two individuals who have made a significant impact. The first of which is Greg Beard. I still remember calling him … I struggled to break into investment banking coming out of Illinois. Primarily, because many of the investment bankers were seeking juniors and not a freshman or a sophomore.
And so, in that context, I was scratching my head as to how I could get an internship. I thought about, “Who is the stakeholder that an investment banker might care about?” And I realized it was something called private equity. I wasn’t quite sure what that was. I cold called a number of private equity individuals. One of them was Greg. He was at Riverstone and he said, “I actually also went to college at 15. You remind me of my story. And so, I’ll make a number of calls on your behalf.”
Ultimately, that ended up in a summer internship, but he’s been a mentor throughout my life. The second individual is Jamie Sholem. He’s also from Champaign, middle of nowhere, and has been a big brother for me throughout this process. Understanding how to navigate the institutional investor landscape, but also how to necessarily counter position and enable yourself to achieve something that a little country bumpkin might never have even imagined.
At the end of 2017, we had just raised our fund one when TJCA had just passed. I had just hired an individual who had worked for me at Lone Star, and we found a press release from a large- scaled manager that suggests that they had interest in the opportunity set that we are pursuing today.
I remember standing in the shower and literally saying to myself, “I convinced one of my best friends to leave a great job.” I just raised our fund one from investors on the premise that this was an untapped opportunity set, and here is someone who could easily blow us out the water. It’s been six years since. That did not come to pass. But I remember being incredibly challenged if we should give the capital back during that time.
As brilliant as Papa Lee is, I really learned this one from my mom. My dad did his PhD in artificial intelligence and is one of the brightest individuals in that space, but I learned this one from my mom. You have to learn to sell in the same way that you have to sell your future spouse on marrying you, your kids on eating vegetables.
You have to sell institutional investors as to why they should put you on their roster and why you will deliver for them a return that is outstanding. You have to sell employees on why they should join you on this journey and why you are going to be the winner in this overall opportunity set.
Life is actually fairly simple. It’s just not easy. What’s an example of that? Public speaking, as you can probably tell, is not my strong suit. But it’s one of the most powerful and important skillsets to develop in life. A simple thing that one could do is to participate in their local Toastmaster, performing in front of friendly faces prior to taking the next step onto the big stage. It’s a simple piece of advice. It’s just not easy to follow through on.
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About Parallaxes Capital
We are an alternative manager focused on tax receivable agreements and esoteric assets.