Parallaxes Featured on the Reorg Podcast

Parallaxes Capital CIO Andy Lee and General Counsel Saish Setty joined Peter Washkowitz to discuss Carvana’s potential bankruptcy saga, the implications of Carvana’s Tax Receivable Agreement (“TRA”), and who at Carvana might benefit from the $1.6bn TRA liability.

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See below for a full transcript of their interview:

Peter (starting at 11:26)Joining me today from Parallaxes Capital are Andy Lee, founder and Chief Investment Officer, and Saish Setty, General Counsel. For those of you who are thinking that the name Saish Setty sounds familiar, that’s because, on the Mount Rushmore of Reorg covenant analyst, Saish Setty has a prominent place as he was the first rear covenant analyst. They’re here today to discuss a very esoteric portion of the covenant world, which itself is an esoteric portion of the universe. That is the tax receivable agreement.   Our guests today are from Parallaxes Capital and are here to shed some light on an interesting portion of Carvana’s Capital structure, its tax receivable agreement. Before we get started, could you guys give us some background on Parallaxes?
AndyThanks for having us, Peter. Parallaxes was founded in 2017 and is a leading investment manager focused on corporate tax as an asset class, specifically tax receivable agreements. We are unlocking liquidity for an otherwise niche asset class where there are often unnatural holders given their expertise, size, and durations of these underlying cash flows. Since 2017, we have raised and deployed more than 200 million dollars across our four flagship funds.
PeterAlright, and you know, I mean, I kind of pride myself on knowing a lot about covenants, but I gotta tell you, I don’t know the first thing about a tax receivable agreement. So, would you mind actually just kind of giving a general overview on what they are?
SaishYeah, and Peter, when you’ve examined a lot of these covenants, you might have actually seen the occasional carve out for distribution on account of tax receivable agreements and, in short, tax receivable agreements or TRAs are contractual arrangements where a company agrees to share the economic benefits from certain tax savings with another party, typically its pre-IPO owners. Now, these contractual arrangements are evidence through sharing arrangements, which are the TRAs themselves, and TRAs are most commonly found in IPOs that are structured as Up-Cs, and without really getting into the nitty gritty of it, an Up-C IPO is designed to generate basis step-ups, and these are what create valuable tax deductions for a company, and the TRA would typically provide pre-IPO owners with 85% of the tax savings generated by these basis step-ups.
PeterYeah, I mean, I’ve seen them in credit agreements before. I mean, but are they common, or are they kind of really just for IPO entities?
SaishYeah, so these will come up in entities that have IPO, and they’re growing increasingly common as the market has become more comfortable with the structure. So, there were over 75 TRAs in connection with IPOs that were created in 2021, and that’s compared to fewer than 15 in 2015. And then naturally 2022 was a slower year for IPOs all in, but there was still about 20 TRAs created in the market and a TRA was actually included in one of the largest 2022 IPOs, the one for TPG.
PeterI got it. And so obviously, you know that we’re gonna focus on Carvana today. So, I imagine that they have a tax receivable agreement, right?
AndyThat’s right. Carvana is a prime example of an Up-C structure that included a TRA. The company’s public filings note that the total TRA liabilities is in the 1.6-billiondollar zip code. So, the substantial portion of their liabilities, you might not see it today on their balance sheet, but it’s publicly disclosed in their underlying footnotes, as it pertains to other liabilities that are unrecorded on their balance sheet.
PeterAnd who stands to benefit from that 1.6 billion?
AndyThat would really be the TRA rights that are held by pre-IPO owners, and in this case, that would really be the Garcia’s who controlled the TRA.
PeterAnd so Carvana announced the tax preservation plan, two weeks ago or so, in order to preserve its NOLs in the case of an ownership change. So, is that related to the TRA?
AndyIn this specific example, the TRA was focused on the sharing of benefits from amortization deductions, which to Saish’s point stemmed from basis step-ups. TRAs can cover net operating losses, but those were not covered or contemplated as part of the Carvana TRA. In this instance, the Carvana TRA is entirely focused on basis step-ups. I would note, some of the unused abductions have since been converted to net-operating losses that may continue to be subject to the TRA, so a portion of the TRA is part of the NOL, but I would say by and large, this tax preservation plan is little bit of a red herring in our point of view.
PeterWell, I mean, you know, it definitely got market participants concerned about a potential bankruptcy filing. So, I mean, what would happen to the TRA, were Carvana to file?
SaishYeah, so there really haven’t been that many bankruptcy filings that involve a TRA claim, but we’ve seen this happen in both the bankruptcies of Rosehill Resources and J.G. Wentworth. In those cases, TRA holders were able to receive a portion of the equity in their recovery. And in terms of how this works structurally, a bankruptcy would generally trigger the acceleration of all obligations under the TRA. And as you might have guessed from the way this was described before, TRA benefits are generally paid out over time as and when a company realizes cash tax savings. So, these payments can occur over a 10, 15-year period, but in a bankruptcy, you would accelerate all those payments.   And so, in Carvana’s case, based on the company’s filings, this could result in a claim that’s well over a billion dollars. In terms of where the claim would sit, the claim would be subordinated to the company’s debt, but senior to their equity. And this is because the TRA itself includes explicit subordination provisions within it. And again, as we kind of touched on before, much of the benefit of this claim would accrue to the Garcia’s themselves. And I think this is where it creates some interesting nuances because the TRA could provide the Garcia’s with additional ammunition in a bankruptcy, and depending on where recoveries lie, the additional claim could provide them with more avenues to exert influence over a bankruptcy proceeding and improve their recoveries.
PeterAnd so, I mean, this might be a silly question. But if the payments under these agreements are kind of, you know, spread out over, you know, many, many years, and if the company were to file, they obviously have not received any of the cash payments or benefits. So, any claims on this, and let’s say that it was fully paid out, it’s cash that Carvana doesn’t actually have today and maybe would’ve gotten in the future, but it becomes a cash obligation in the present, even though none of those future flows have been received, right?
SaishThat’s right. So, when you accelerate this payment stream, you do it on a number of assumptions, and one of those assumptions is that you assume that the company would’ve been able to fully utilize these tax deductions when they became available. So even though these are occurring in the future and haven’t yet happened, when you accelerate, you assume that they will happen. And that’s how you calculate this claim.
PeterAnd, I mean…so, do you see that, you know, the instances of tax receivable claims and bankruptcy becoming a bigger kind of issue, or, I mean, are there a lot of precedents for how these kinds of claims are handled in bankruptcy?
SaishSo, there aren’t a ton of precedents out there. The ones where we’ve seen recovery so far are in Rosehill, JG Wentworth. That said, TRAs have become increasingly common in the market. And so I would expect that as a product of that in the next few years, we’ll see these playing out in bankruptcies more often just by virtue of their prevalence.
AndyJust one thing that I might note is that it is an incremental form of currency. We would note that in 2017, as part of the TXU restructuring, the emerging company, Viscera, came out with a large tax receivable agreement. And so it’s an incremental form of currency as creditors think about increasing their recoveries in time.
PeterOh, so, well, that’s right. I was actually gonna ask that. So, you know, obviously Carvana’s been in the news a lot and, you know, you see kind of the, you know, their debt holders, you know, kind of coming to some agreement about how to, you know, strategies going forward. So, but given that the TRA claims are subordinated, will it affect their recoveries or, I mean, will part of their recovery potentially be a portion of, you know, a future tax receivable agreement?
SaishYeah, so for existing debt holders, because of these subordination provisions, the TRA should come after them in a bankruptcy proceeding. But the Garcia’s, in this instance, would have control over an entirely different claim in the proceeding, and that’s where they could start exerting additional influence.
PeterAlright. Well, that’s all really interesting. Again, this is something that I have never kind of thought about before, but it seems, you know, all things Carvana are interesting and this is actually a really interest in kind of, you know, all the coverage that, you know, we’ve seen. So, I appreciate you guys kind of giving us an overview of this and, you know, it’d be interesting to see how it plays out.
SaishYeah, definitely. Thanks for the time, Peter.
PeterAll right. Take care guys.