Parallaxes Capital’s General Counsel Saish Setty joined Nick Mazing on the Signals podcast to talk about Tax Receivable Agreements (TRAs) as an emerging asset class. In this episode, Saish and Nick explore the similarities between TRAs and music royalties and how Parallaxes Capital is leading the charge in bringing TRAs to the mainstream. Saish also provides insights on the potential benefits of TRAs within an ESG framework.
Dive into the world of TRAs by checking out the full episode:
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See below for a full transcript of the podcast:
[00:00:00] Saish Setty: Really, tax is one of the most powerful incentives that a government has to incentivize good behavior to dissent bad behavior. And similarly, it’s a powerful tool to affect ESG goals and we believe that TRAs themselves further these goals.
[00:00:31] Nick Mazing: Hello and welcome. You listen to Signals by AlphaSense, and I’m your host, Nick Mazing. Today, we’re going to talk about tax receivable agreements or TRAs for short as an emerging asset class. There are transferrable corporate tax assets that historically have had little secondary market liquidity. They found the category of esoteric asset classes like art, like music, royalties, like wine.
[00:00:58] But what’s interesting is that often what is an esoteric asset class today becomes mainstream over time. The prime example being securitizations. At one time, securitization had been novel and now not only do you have mortgage securitizations, but you have, other securitizations like cellphone tower rents, like aircraft, engine lease payments, like franchise as Domino Pizzas does those.
[00:01:23] And, the filings are actually public on Edgar. Today’s guest, Saish Setty is the General Counsel at Parallaxes Capital. An alternative asset manager investing in TRA. Saish, welcome. And can you tell us a little bit more about you and about your fund?
[00:01:42] Saish Setty: Thanks, Nick. So to take a step back, let’s think about tax generally. This is probably the largest asset class in the world that no one has ever really heard of or thought of as an asset class, even in the fabric of our daily lives. Two things are unavoidable, death and taxes. And honestly, at our lives, the Parallaxes probably tax receivable agreements as well.
[00:02:09] So tax receivable agreements, TRAs, they’re a sub-segment of this larger opportunity set, and we view them as the tip of the spear to unlocking the rest of the universe in this asset class. For TRAs themselves, we estimate that almost 10% of domestic IPOs in recent years have included A TRA. So for example, in the last few TRA, last few years, TRAs were included in the IPOs of TPG chips and Rocket mortgage.
[00:02:45] And now a little bit about ourselves at pers. Parallaxes Capital is an investment manager, entirely focused on TRAs, and our portfolio includes the Includes names like Planet Fitness, Funko, shake Shack, and Remax. So a lot of household names that we’re dealing with. And we were founded in 2017 and since that time we’ve deployed over 250 million to the opportunity.
[00:03:17] As for myself, I joined the team after, since at Wael and Paul Weiss, and I also act as the firm’s general counsel. And really what we offer, we offer our LPs the opportunity to invest in an uncorrelated and cash yielding asset class. That’s a greenfield opportunity. We don’t think there’s anyone else doing what we are doing.
[00:03:43] And also our strategy is probably one of the only strategies that we’re aware of that benefits from higher tax rates. So in some ways we’re effectively a call option for an increase in tax rates. And really when you bring up music royalties, that’s a great parallel. We don’t think we’re all that different from the pharma or music royalty space.
[00:04:08] Unfortunately, what we do isn’t ever going to be as sexy as I say Taylor Swift or Justin Bieber’s music catalogs, but still pharma music royalties. They’re both relatively new asset classes. That there are a lot of similarities to TRAs. They’re long dated annuity like cash flow streams that are generally uncorrelated to broader market performance, and we expect and hope that the TRA industry will follow the explosive path that we’ve seen take over those royalty spaces in the past few years.
[00:04:45] Nick Mazing: So let’s start with the basics. What are TRAs? And to be clear, when people talk about tax assets, most tend to think about net operating losses, or NOLs and TRAs are not ls. they don’t have like the anti-trafficking restrictions in the internal revenue code. And, they’re really corporate obligations, so to speak, closer to bonds.
[00:05:05] So what are TRAs, how do they arise?
[00:05:08] Saish Setty: Sure. So at its core, a TRA is just a contract. It’s a contract where one party agrees to pay out the benefits it realizes from tax assets like a depreciation deduction or an N O L to a third party as and when they realize those economic benefits. So because of this structure, They are debt like instruments, and more importantly, the underlying tax assets themselves aren’t being transferred here.
[00:05:41] So like you mentioned, the anti-tax loss trafficking rules, they’re just not implicated in this context and TRAs themselves. They can be broadly applied to many contexts, really anything where there’s an underlying tax benefit. So for example, let’s take a private M&A transaction. If the buyer and seller disagree on the value of a Target’s tax assets, they can actually use a TRA and the TRA here would allow the seller to keep the economic benefits of those tax assets.
[00:06:17] The seller can then hold onto the TRA assets or sell it to a third party like, like ourselves, that they believe more appropriately values the assets. Now one of the most common situations where you have a TRA is in an IPO, and for a little bit of background, when companies go public, they generally need to be structured as a C corp.
[00:06:42] Now you have exceptions like REITs or NOPs, but that’s, let’s put that to the side for now. So if you have a company that’s a partnership or an llc, It can still go public, but it’ll probably structure its IPO in what’s called an up C structure. One of the first up seas was actually for barnesandnoble.com in 1999.
[00:07:08] You probably guessed the year from the.com appendage there. And since then, the structure has become more common. So recent up seas include names like tpg, Dutch Brothers Bumble. So this is hardly an industry specific type of structure. Now the up sea IPO, the structure itself basically generates tax benefits for the public company.
[00:07:38] These tax benefits are then shared with the company’s pre IPO owners through the TRA. And again, in terms of history, the first TRA was in the early 1990s. And they’ve gradually become more and more common again. We estimate that almost 10% of domestic IPOs in recent, in some recent years have included a TRA.
[00:08:04] And to put a little bit of context around those numbers, in the 2021 IPO boom, there were over 75 TRAs created, and that’s in comparison to only about 15 in 2015, and even in 2022, where you had very muted IPOs, SPAC activity, there were still about 20 new TRAs created. And so over the last five years, we believe the TRA market has grown to encompass now more than 30 billion of expected payments.
[00:08:39] So the growth in the space has just been truly exciting.
[00:08:44] Nick Mazing: So these are obviously very interesting assets, but why is the TRA structure. In place to begin with.
[00:08:55] Saish Setty: Yeah, so that’s that. That’s a great question and one that we often get. Academic theory suggests that TRAs do not negatively impact a company’s equity valuation when an IPOs. And TRAs are extensively disclosed in a company’s public filings, so it’s not as though they’re hidden from view. Looking back at my example of the TPG IPO, for example, when you look at their S one, they mentioned their TRA over a hundred times.
[00:09:30] Including in a number of risk factors. So then I think the natural question is, well, why doesn’t A TRA impact a company’s valuation? It is cash that they’re paying out to a third party. And there are a few theories there. One is just that they are difficult to value. The valuation difficulty stems from the fact that you need to estimate their co.
[00:09:54] You need to estimate a company’s future taxable income. You have to have a deep understanding of the relevant tax assets and Parallaxes. Maybe this is a dynamic or an explanation that we are a little partial to since it helps us build our competitive mode. But another common justification is that, Public market investors are just simply more focused on metrics that don’t incorporate tax.
[00:10:23] So if you’re valuing a company based on EBITDA or revenue multiple, then whether or not the company keeps these tax assets to themselves. It’s basically irrelevant. And really the other day I picked up one of those old investment banking guides. I hand on hand and before I get criticized, forgive me, I’m still a lawyer by trade.
[00:10:44] I need to refer to those things every now and then. But when you look at the DCF section, they have about 60 pages there. And off those pages, there were about four or five sentences on how to back out the impact of tax into the cash flows. So in an IPO, it’s, it’s just not surprising that these tax assets are disregarded or overly simplified in the valuation process. So at its core, pre IPO owners are incentivized to include a TRA in their structure. Because public market investors just don’t compensate them for the value of these assets. In an IPO,
[00:11:30] Nick Mazing: So w, you know, we discussed how they arise in different situations and you know, it’s an obligation between the corporation and its P owners looking to exit former P owners, whatever you wanna call them. Now, you acquired a TRAs from these. P funds. Why would a P fund actually look to exit the TRA?
[00:11:52] Saish Setty: So for a P sponsor or really any fund, you can find yourself near the end of a fund’s life and you’re still holding on to these TRA assets. In that situation, you’re almost a forced seller and for others, the TRA asset, it just might be too small to be a focus. It’s an asset that they don’t understand.
[00:12:19] It’s also something that pays out over a long duration, so people just don’t want to, or in some cases aren’t able to hold it to maturity, and this is funny, but in some cases it may not even be something that the holder knows they have. It’s hard for me to personally imagine this, but it’s not just theoretical.
[00:12:42] A few weeks ago, we were actually sourcing a potential investment. And speaking to a massive VC VC shop. It’s one that we’ve all heard of, and we were prepared for the conversation. We had our decks ready, our models ready. Now, what we weren’t prepared for Nick was them claiming that they didn’t even own a TRA.
[00:13:04] We have to pull up the Edgar filings off the s e C website and point out where they actually signed the TRA. And this is an asset that was valued in the tens of millions of dollars. So in some ways, you’ll always find holders that are thrilled to find value that they just didn’t know existed. And to them it’s almost fi, it’s almost found money.
[00:13:30] Nick Mazing: And, there is another angle that when we were talking be, before the recording and that is, an ESG angle, which I thought was interesting. So how do you think about it In, in, through kind of a ESG lenses?
[00:13:43] Saish Setty: Yeah, so this is actually something we’ve been spending a lot of time on as an institution, and let’s face it, tax related strategies can inherently just be a dirty word. Really, tax is one of the most powerful incentives that a government has to incentivize good behavior to dissent bad behavior. And similarly, it’s a powerful tool to affect ESG goals and we believe that TRAs themselves, Further these goals.
[00:14:18] So so much of ESG is focused on the E, let’s be honest, less so on the S N G, but the SNG, that’s where TRAs really shine. So for example, on the social aspect, there’s been a lot of thought and a lot of discourse on how companies should support tax policies that support long-term value creation.
[00:14:45] Versus just say tax minimization, but really like how realistic of a goal is that when almost every stakeholder in a company benefits from lower corporate tax rates, equity holders, benefit employees, management debt holders, arguably everybody benefits from a company having increased cash flows because it has a lower corporate tax rate.
[00:15:15] But TRA holders are a little different. We actually benefit from a higher tax rate, and that’s because our expected payments, the expected benefits under the TRA increase if you have a higher tax rate. So with a TRA in place, at least there’s one stakeholder with a competing interest here, and again, on the social front.
[00:15:39] One metric to determine a company’s social contributions is frankly, it’s total tax contributions, but this is extremely difficult, if not impossible to glean from a company’s public disclosures. This needs transparency, and honestly, that transparency is provided to TRA holders. Holders often receive a company’s tax returns themselves, or at the very least, they’re receiving detailed information on how the company is calculating its taxes.
[00:16:13] And then on the governance front, on the G. TRAs, promote better reporting and communication with stakeholders. You also need better process controls to ensure compliance with your TRA obligations. And TRAs themselves. They’re also a really useful part of a compensation package to management members. You have payments here that are actually tied to a very concrete metric.
[00:16:41] They’re tied to taxable income, and they’re isolated from the market euphoria that can really distort something like stock-based compensation. But similar to stock-based compensation, TRAs pay out over a long time period. And that alone can help eliminate some of the tendencies to short-termism and again, TRAs.
[00:17:06] They aren’t designed to have these benefits. This is just part of their very nature. And if anything, that’s why we believe there are very powerful tools on the ESG framework.
[00:17:18] Nick Mazing: On, on your end, obviously you are investors, you’re on your fourth fund now. How do you analyze these at the individual and the at the portfolio level? They’re obviously interesting as an asset class, but what really goes on in the kitchen?
[00:17:32] Saish Setty: So maybe I’ll oversimplify it a bit with the statement, but at its core what we’re doing is we are offering existing TRAs a factoring solution. They hold a long dated asset that pays out over time. We take an N P V of that and we come to a view on price. That said, the devil is always in the details. We have three main considerations when valuing A TRA.
[00:18:05] The first is that we have to understand the tax collateral itself. So by that I mean the underlying tax deductions or tax assets subject to the TRA. The second is that you have to come to a forecast of taxable income. And then the third point is, well, once you have those two items, you still need to construct a discount rate.
[00:18:29] So on the first part, the tax collateral. Here you need a very deep understanding of the tax benefits or assets that are subject to the TRA. This requires tremendous knowledge of the tax code. Our CIO actually has a master’s in tax and that is certainly a massive help on that front. And really that’s a pretty unique combination that you har, that you very rarely see amongst deal professionals.
[00:18:59] I think. Most deal professionals, when they hear the word tax, they kind of want to take off in the other direction, and that is absolutely not something that we can do. But again, sorry. The second point though is forecasting taxable income. So once you have an understanding of the tax benefits, you have an understanding and a forecast of taxable income, you overlay those two items and you come to a stream of assumed cash flows under the TRA.
[00:19:28] Once you have that, then you come to the last step that’s constructing a discount rate, which is always a bit more art than science. And in our view, we are aggregating perceived risks from credit risk. From a duration risk perspective, and by duration risk, this is really the idea that payments under the TRA may be stretched out over a longer period than we expect them to be.
[00:19:57] And so that’s a risk that we incorporate into our discount rate. And we also include things like illiquidity risk since we might, and we expect to hold these items to maturity. And then finally even legislative risk that’s factored in since, as we mentioned, tax rate changes will impact our payments. So putting all that together, we’re able to figure out a price that we’re willing to pay for any given TRA asset.
[00:20:27] Nick Mazing: So what would you say is your edge here? What’s, what gives you the an advantage in, in this marketplace?
[00:20:35] Saish Setty: Yeah, I mean, at this point in time, I think our strategy benefits from a number of market inefficiencies. One framework for how to think about this that I find useful at least, was put out by Blue Mountain a few years ago. This is the bait framework, so you’re looking for B, behavioral, A analytical, I informational, and T technical inefficiencies on the behavioral front.
[00:21:06] Really, investors typically have a tendency to move as a flock. Parallaxes has a first mover advantage here. We’re operating in a complex asset class that has many modes to entry, and there really just aren’t any other dedicated players in the space right now. On the analytical side of things, we have an edge from operating on a very different timeframe.
[00:21:33] And we also weigh information differently. So we have a very different view on duration as we expect to be able to hold these assets for a long time, and we structure ourselves in a manner that allows us to do so, and we’re also able to weigh information differently. Since tax disclosures and public filings can be meaningless to a lot of analysts without deep tax knowledge.
[00:22:02] And similarly on the informational side, we again have an edge due to our domain expertise. We’re focused on information that might just be noise to other parties. As we mentioned, tax assets, the related information, they arguably don’t even affect equity valuations. So in a lot of cases, we might just be looking where others aren’t looking at all.
[00:22:29] And then finally you have technical inefficiencies. These are where market participants have to say, buy or sell assets for reasons that are completely unrelated to fundamental concerns. And again, this is a dynamic that we can take advantage of at Parallaxes. As we touched on before, we frequently encounter counterparties that are selling due to something like an end of life consideration,
[00:22:56] end of fun life consideration. Meanwhile, the transaction size, that just might not be practical for a lot of participants and other market participants. They might just not even have the mandate or the expertise to engage with these types of assets. So when you take all those factors together, I think we’re building ourselves a pretty difficult moat for other people.
[00:23:20] Nick Mazing: So let’s dig in the details a little deeper so everyone who has ever read bond covenants knows that they can be very unstandardized. There’s absolute nightmare in some cases, especially in distress situations. You have and you have a great white paper that our listeners to reviewers can request from your website that details a lot of technical aspects that are involved.
[00:23:42] I read the white paper with great interest and you know, there’s, and, and these are things like, you know, minority holders, like obligations of the corporation itself in that’s essentially an external transaction and so on. So can you give us some of the highlights on, on these topics?
[00:23:57] Saish Setty: Yeah, I mean, TRAs, they are a newer instrument, so when you look back 10 years, you often find TRAs that aren’t well drafted, they’re sloppier. They don’t include the provisions you see in a newer TRA. That said, we have seen TRAs become a bit more standardized in recent years, and this is a process that we hope to continue to drive with our white papers because even though they’ve become more standardized, they’re still not at the level of a bond indenture or credit agreements. And in terms of specific provisions, unsurprisingly, one of the biggest points we care about is transferability. So again, one of the most common assignment formulations makes it so that TRAs are freely transferrable. That’s basically what we wanna see. That’s about one out of every three TRAs. The rest can really, really vary.
[00:25:01] In some, you need company consent, and this can take many forms and it can also really be a massive roadblock to a transaction. And to make it more concrete, a few months ago we were working with a firm on a TRA sale. We had fully negotiated the documentation, agreed on price, the works. The last step naturally was just obtaining company consent to the transaction that a lot of us took as something for granted here.
[00:25:32] Lo and behold, the company refused consent and really that’s just a terrible outcome. Sure, you can have a blacklist and a credit agreement, but in the debt world, flat consent writes like that. Are more or less unheard of. And these are the types of things that we hope to move the market on. And TRAs, they’re, they’re drafted by the best law firms in the world for the most part, but they’re often not drafted with transfers in mind.
[00:26:06] And that’s something in particular that we wanna change. And there are other provisions too that impede transferability or disadvantaged holders. So for example, in the bond and loan market, you’ll often see strong protections against adverse amendments. And even with that, there’s still been an onslaught of lender on lender violence that you alluded to with coercive exchanges and the like.
[00:26:34] But even in that context, bonds loans, they will have sacred rights, things that are untouchable. You can’t just go out and amend down the principle and a bond without getting everybody’s consent. And these are the types of protections that we want to see more explicitly built into TRAs. And again, these aren’t just selfish considerations.
[00:27:02] Realize the focus on assignments might sound a little selfish, but we want TRAs to flourish in the market. And one item of focus for companies is potentially the operational burden up a TRA. So sometimes tax benefits under the TRA, they’re going to be created when you have equity holders that exchange subsidiary units.
[00:27:29] For corporate stock and the frequency of these exchanges can create a ton of administrative burden for companies. So that, for example, is something that they might want to limit. And there was one asset manager in particular that had an earlier TRA and they had a ton of partners that were party to the TRA and these partners, they’re all sophisticated, they’re exchanging units on a daily, weekly cadence.
[00:27:58] Everybody doing it at a different time. This is just a huge burden on the company. Each exchange can create a new work stream and limiting things like that, limiting that flexibility, all of those can help reduce the operational hassle for a company and hopefully incentivize more TRAs on the market.
[00:28:19] Nick Mazing: Another thing that was interesting in, in your white paper is how many household names, so to speak, famous, famous companies are involved in TRAs and in some cases, TRAs are a factor in special situations like takeover proposals in some cases around distress. So can you share with us some of those situations and what’s going on there?
[00:28:42] Saish Setty: Yeah, so definitely in one situation in particular, There was a mattress company with a TRA and for a little bit of background, usually when a company that’s issued a TRA is acquired, you would accelerate all the obligations under the TRA and it’s paid out to holders, so it’s effectively a make call.
[00:29:05] Now when this mattress company received a takeover proposal, this was in the fall of 22, it was actually conditioned on the company just waving or obtaining a waiver of these change of control acceleration provisions. And ultimately this proposal was rejected. The acquirer launched a campaign to nominate board members.
[00:29:29] The company old playbook put a poison pill in place, and this was actually all Brazil, earlier in April, the poison pill was removed. The company made concessions on its board nominees. But it was super interesting to see the TRA actually be a central part of the acquisition negotiations here and another recent acquisition.
[00:29:56] This one was with a financial advisory firm, and the acquirer was a sponsor, a private equity sponsor. They actually structured the deal to provide TRA holders with a promissory note instead of an accelerated payout. So again, I mean, TRAs, they’re generally newer instruments. So it’s, I at least find it fascinating.
[00:30:19] Maybe that paints me as a bit of a dork, but I find it fascinating to see how they’re playing out in the acquisition context. And then on the distress side as well, one situation that we’re focused closely on is a car is a car retailer. They’re in a distressed situation and under the company’s t TRA a bankruptcy, like a change of control results in an acceleration of the entire TRA.
[00:30:48] And the company here is actually controlled by a single family and their TRA holding will actually provide them with another avenue to influence a ba, bankruptcy proceeding if and when the company files. And I find at least a lot of commentary here, people are so focused. On the family’s equity stake, but it’s the TRA that actually provides them a more senior means to influence the bankruptcy proceeding.
[00:31:20] And we’ll see what happens here. But again, it’s extremely exciting to be on the forefront of a new market and to watch it develop in all of these different contexts.
[00:31:32] Nick Mazing: Thank you for joining us today.
[00:31:34] Saish Setty: Great. Thank you, Nick. It was always a pleasure.
[00:31:36] Nick Mazing: This was a great overview of TRAs as an emerging asset class with Saish Setty of Parallaxes Capital. We learned about how TRAs actually arise, how to think of them as an investible asset class, and what his fund actually does. We have all the relevant links in the show notes. This was another episode of Signals by AlphaSense.
[00:31:56] My name is Nick Mazing, and you can find us on all the major platforms. Thank you for watching or listening.
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See below for a full transcript of the podcast:
[00:00:00] Saish Setty: Really, tax is one of the most powerful incentives that a government has to incentivize good behavior to dissent bad behavior. And similarly, it’s a powerful tool to affect ESG goals and we believe that TRAs themselves further these goals.
[00:00:31] Nick Mazing: Hello and welcome. You listen to Signals by AlphaSense, and I’m your host, Nick Mazing. Today, we’re going to talk about tax receivable agreements or TRAs for short as an emerging asset class. There are transferrable corporate tax assets that historically have had little secondary market liquidity. They found the category of esoteric asset classes like art, like music, royalties, like wine.
[00:00:58] But what’s interesting is that often what is an esoteric asset class today becomes mainstream over time. The prime example being securitizations. At one time, securitization had been novel and now not only do you have mortgage securitizations, but you have, other securitizations like cellphone tower rents, like aircraft, engine lease payments, like franchise as Domino Pizzas does those.
[00:01:23] And, the filings are actually public on Edgar. Today’s guest, Saish Setty is the General Counsel at Parallaxes Capital. An alternative asset manager investing in TRA. Saish, welcome. And can you tell us a little bit more about you and about your fund?
[00:01:42] Saish Setty: Thanks, Nick. So to take a step back, let’s think about tax generally. This is probably the largest asset class in the world that no one has ever really heard of or thought of as an asset class, even in the fabric of our daily lives. Two things are unavoidable, death and taxes. And honestly, at our lives, the Parallaxes probably tax receivable agreements as well.
[00:02:09] So tax receivable agreements, TRAs, they’re a sub-segment of this larger opportunity set, and we view them as the tip of the spear to unlocking the rest of the universe in this asset class. For TRAs themselves, we estimate that almost 10% of domestic IPOs in recent years have included A TRA. So for example, in the last few TRA, last few years, TRAs were included in the IPOs of TPG chips and Rocket mortgage.
[00:02:45] And now a little bit about ourselves at pers. Parallaxes Capital is an investment manager, entirely focused on TRAs, and our portfolio includes the Includes names like Planet Fitness, Funko, shake Shack, and Remax. So a lot of household names that we’re dealing with. And we were founded in 2017 and since that time we’ve deployed over 250 million to the opportunity.
[00:03:17] As for myself, I joined the team after, since at Wael and Paul Weiss, and I also act as the firm’s general counsel. And really what we offer, we offer our LPs the opportunity to invest in an uncorrelated and cash yielding asset class. That’s a greenfield opportunity. We don’t think there’s anyone else doing what we are doing.
[00:03:43] And also our strategy is probably one of the only strategies that we’re aware of that benefits from higher tax rates. So in some ways we’re effectively a call option for an increase in tax rates. And really when you bring up music royalties, that’s a great parallel. We don’t think we’re all that different from the pharma or music royalty space.
[00:04:08] Unfortunately, what we do isn’t ever going to be as sexy as I say Taylor Swift or Justin Bieber’s music catalogs, but still pharma music royalties. They’re both relatively new asset classes. That there are a lot of similarities to TRAs. They’re long dated annuity like cash flow streams that are generally uncorrelated to broader market performance, and we expect and hope that the TRA industry will follow the explosive path that we’ve seen take over those royalty spaces in the past few years.
[00:04:45] Nick Mazing: So let’s start with the basics. What are TRAs? And to be clear, when people talk about tax assets, most tend to think about net operating losses, or NOLs and TRAs are not ls. they don’t have like the anti-trafficking restrictions in the internal revenue code. And, they’re really corporate obligations, so to speak, closer to bonds.
[00:05:05] So what are TRAs, how do they arise?
[00:05:08] Saish Setty: Sure. So at its core, a TRA is just a contract. It’s a contract where one party agrees to pay out the benefits it realizes from tax assets like a depreciation deduction or an N O L to a third party as and when they realize those economic benefits. So because of this structure, They are debt like instruments, and more importantly, the underlying tax assets themselves aren’t being transferred here.
[00:05:41] So like you mentioned, the anti-tax loss trafficking rules, they’re just not implicated in this context and TRAs themselves. They can be broadly applied to many contexts, really anything where there’s an underlying tax benefit. So for example, let’s take a private M&A transaction. If the buyer and seller disagree on the value of a Target’s tax assets, they can actually use a TRA and the TRA here would allow the seller to keep the economic benefits of those tax assets.
[00:06:17] The seller can then hold onto the TRA assets or sell it to a third party like, like ourselves, that they believe more appropriately values the assets. Now one of the most common situations where you have a TRA is in an IPO, and for a little bit of background, when companies go public, they generally need to be structured as a C corp.
[00:06:42] Now you have exceptions like REITs or NOPs, but that’s, let’s put that to the side for now. So if you have a company that’s a partnership or an llc, It can still go public, but it’ll probably structure its IPO in what’s called an up C structure. One of the first up seas was actually for barnesandnoble.com in 1999.
[00:07:08] You probably guessed the year from the.com appendage there. And since then, the structure has become more common. So recent up seas include names like tpg, Dutch Brothers Bumble. So this is hardly an industry specific type of structure. Now the up sea IPO, the structure itself basically generates tax benefits for the public company.
[00:07:38] These tax benefits are then shared with the company’s pre IPO owners through the TRA. And again, in terms of history, the first TRA was in the early 1990s. And they’ve gradually become more and more common again. We estimate that almost 10% of domestic IPOs in recent, in some recent years have included a TRA.
[00:08:04] And to put a little bit of context around those numbers, in the 2021 IPO boom, there were over 75 TRAs created, and that’s in comparison to only about 15 in 2015, and even in 2022, where you had very muted IPOs, SPAC activity, there were still about 20 new TRAs created. And so over the last five years, we believe the TRA market has grown to encompass now more than 30 billion of expected payments.
[00:08:39] So the growth in the space has just been truly exciting.
[00:08:44] Nick Mazing: So these are obviously very interesting assets, but why is the TRA structure. In place to begin with.
[00:08:55] Saish Setty: Yeah, so that’s that. That’s a great question and one that we often get. Academic theory suggests that TRAs do not negatively impact a company’s equity valuation when an IPOs. And TRAs are extensively disclosed in a company’s public filings, so it’s not as though they’re hidden from view. Looking back at my example of the TPG IPO, for example, when you look at their S one, they mentioned their TRA over a hundred times.
[00:09:30] Including in a number of risk factors. So then I think the natural question is, well, why doesn’t A TRA impact a company’s valuation? It is cash that they’re paying out to a third party. And there are a few theories there. One is just that they are difficult to value. The valuation difficulty stems from the fact that you need to estimate their co.
[00:09:54] You need to estimate a company’s future taxable income. You have to have a deep understanding of the relevant tax assets and Parallaxes. Maybe this is a dynamic or an explanation that we are a little partial to since it helps us build our competitive mode. But another common justification is that, Public market investors are just simply more focused on metrics that don’t incorporate tax.
[00:10:23] So if you’re valuing a company based on EBITDA or revenue multiple, then whether or not the company keeps these tax assets to themselves. It’s basically irrelevant. And really the other day I picked up one of those old investment banking guides. I hand on hand and before I get criticized, forgive me, I’m still a lawyer by trade.
[00:10:44] I need to refer to those things every now and then. But when you look at the DCF section, they have about 60 pages there. And off those pages, there were about four or five sentences on how to back out the impact of tax into the cash flows. So in an IPO, it’s, it’s just not surprising that these tax assets are disregarded or overly simplified in the valuation process. So at its core, pre IPO owners are incentivized to include a TRA in their structure. Because public market investors just don’t compensate them for the value of these assets. In an IPO,
[00:11:30] Nick Mazing: So w, you know, we discussed how they arise in different situations and you know, it’s an obligation between the corporation and its P owners looking to exit former P owners, whatever you wanna call them. Now, you acquired a TRAs from these. P funds. Why would a P fund actually look to exit the TRA?
[00:11:52] Saish Setty: So for a P sponsor or really any fund, you can find yourself near the end of a fund’s life and you’re still holding on to these TRA assets. In that situation, you’re almost a forced seller and for others, the TRA asset, it just might be too small to be a focus. It’s an asset that they don’t understand.
[00:12:19] It’s also something that pays out over a long duration, so people just don’t want to, or in some cases aren’t able to hold it to maturity, and this is funny, but in some cases it may not even be something that the holder knows they have. It’s hard for me to personally imagine this, but it’s not just theoretical.
[00:12:42] A few weeks ago, we were actually sourcing a potential investment. And speaking to a massive VC VC shop. It’s one that we’ve all heard of, and we were prepared for the conversation. We had our decks ready, our models ready. Now, what we weren’t prepared for Nick was them claiming that they didn’t even own a TRA.
[00:13:04] We have to pull up the Edgar filings off the s e C website and point out where they actually signed the TRA. And this is an asset that was valued in the tens of millions of dollars. So in some ways, you’ll always find holders that are thrilled to find value that they just didn’t know existed. And to them it’s almost fi, it’s almost found money.
[00:13:30] Nick Mazing: And, there is another angle that when we were talking be, before the recording and that is, an ESG angle, which I thought was interesting. So how do you think about it In, in, through kind of a ESG lenses?
[00:13:43] Saish Setty: Yeah, so this is actually something we’ve been spending a lot of time on as an institution, and let’s face it, tax related strategies can inherently just be a dirty word. Really, tax is one of the most powerful incentives that a government has to incentivize good behavior to dissent bad behavior. And similarly, it’s a powerful tool to affect ESG goals and we believe that TRAs themselves, Further these goals.
[00:14:18] So so much of ESG is focused on the E, let’s be honest, less so on the S N G, but the SNG, that’s where TRAs really shine. So for example, on the social aspect, there’s been a lot of thought and a lot of discourse on how companies should support tax policies that support long-term value creation.
[00:14:45] Versus just say tax minimization, but really like how realistic of a goal is that when almost every stakeholder in a company benefits from lower corporate tax rates, equity holders, benefit employees, management debt holders, arguably everybody benefits from a company having increased cash flows because it has a lower corporate tax rate.
[00:15:15] But TRA holders are a little different. We actually benefit from a higher tax rate, and that’s because our expected payments, the expected benefits under the TRA increase if you have a higher tax rate. So with a TRA in place, at least there’s one stakeholder with a competing interest here, and again, on the social front.
[00:15:39] One metric to determine a company’s social contributions is frankly, it’s total tax contributions, but this is extremely difficult, if not impossible to glean from a company’s public disclosures. This needs transparency, and honestly, that transparency is provided to TRA holders. Holders often receive a company’s tax returns themselves, or at the very least, they’re receiving detailed information on how the company is calculating its taxes.
[00:16:13] And then on the governance front, on the G. TRAs, promote better reporting and communication with stakeholders. You also need better process controls to ensure compliance with your TRA obligations. And TRAs themselves. They’re also a really useful part of a compensation package to management members. You have payments here that are actually tied to a very concrete metric.
[00:16:41] They’re tied to taxable income, and they’re isolated from the market euphoria that can really distort something like stock-based compensation. But similar to stock-based compensation, TRAs pay out over a long time period. And that alone can help eliminate some of the tendencies to short-termism and again, TRAs.
[00:17:06] They aren’t designed to have these benefits. This is just part of their very nature. And if anything, that’s why we believe there are very powerful tools on the ESG framework.
[00:17:18] Nick Mazing: On, on your end, obviously you are investors, you’re on your fourth fund now. How do you analyze these at the individual and the at the portfolio level? They’re obviously interesting as an asset class, but what really goes on in the kitchen?
[00:17:32] Saish Setty: So maybe I’ll oversimplify it a bit with the statement, but at its core what we’re doing is we are offering existing TRAs a factoring solution. They hold a long dated asset that pays out over time. We take an N P V of that and we come to a view on price. That said, the devil is always in the details. We have three main considerations when valuing A TRA.
[00:18:05] The first is that we have to understand the tax collateral itself. So by that I mean the underlying tax deductions or tax assets subject to the TRA. The second is that you have to come to a forecast of taxable income. And then the third point is, well, once you have those two items, you still need to construct a discount rate.
[00:18:29] So on the first part, the tax collateral. Here you need a very deep understanding of the tax benefits or assets that are subject to the TRA. This requires tremendous knowledge of the tax code. Our CIO actually has a master’s in tax and that is certainly a massive help on that front. And really that’s a pretty unique combination that you har, that you very rarely see amongst deal professionals.
[00:18:59] I think. Most deal professionals, when they hear the word tax, they kind of want to take off in the other direction, and that is absolutely not something that we can do. But again, sorry. The second point though is forecasting taxable income. So once you have an understanding of the tax benefits, you have an understanding and a forecast of taxable income, you overlay those two items and you come to a stream of assumed cash flows under the TRA.
[00:19:28] Once you have that, then you come to the last step that’s constructing a discount rate, which is always a bit more art than science. And in our view, we are aggregating perceived risks from credit risk. From a duration risk perspective, and by duration risk, this is really the idea that payments under the TRA may be stretched out over a longer period than we expect them to be.
[00:19:57] And so that’s a risk that we incorporate into our discount rate. And we also include things like illiquidity risk since we might, and we expect to hold these items to maturity. And then finally even legislative risk that’s factored in since, as we mentioned, tax rate changes will impact our payments. So putting all that together, we’re able to figure out a price that we’re willing to pay for any given TRA asset.
[00:20:27] Nick Mazing: So what would you say is your edge here? What’s, what gives you the an advantage in, in this marketplace?
[00:20:35] Saish Setty: Yeah, I mean, at this point in time, I think our strategy benefits from a number of market inefficiencies. One framework for how to think about this that I find useful at least, was put out by Blue Mountain a few years ago. This is the bait framework, so you’re looking for B, behavioral, A analytical, I informational, and T technical inefficiencies on the behavioral front.
[00:21:06] Really, investors typically have a tendency to move as a flock. Parallaxes has a first mover advantage here. We’re operating in a complex asset class that has many modes to entry, and there really just aren’t any other dedicated players in the space right now. On the analytical side of things, we have an edge from operating on a very different timeframe.
[00:21:33] And we also weigh information differently. So we have a very different view on duration as we expect to be able to hold these assets for a long time, and we structure ourselves in a manner that allows us to do so, and we’re also able to weigh information differently. Since tax disclosures and public filings can be meaningless to a lot of analysts without deep tax knowledge.
[00:22:02] And similarly on the informational side, we again have an edge due to our domain expertise. We’re focused on information that might just be noise to other parties. As we mentioned, tax assets, the related information, they arguably don’t even affect equity valuations. So in a lot of cases, we might just be looking where others aren’t looking at all.
[00:22:29] And then finally you have technical inefficiencies. These are where market participants have to say, buy or sell assets for reasons that are completely unrelated to fundamental concerns. And again, this is a dynamic that we can take advantage of at Parallaxes. As we touched on before, we frequently encounter counterparties that are selling due to something like an end of life consideration,
[00:22:56] end of fun life consideration. Meanwhile, the transaction size, that just might not be practical for a lot of participants and other market participants. They might just not even have the mandate or the expertise to engage with these types of assets. So when you take all those factors together, I think we’re building ourselves a pretty difficult moat for other people.
[00:23:20] Nick Mazing: So let’s dig in the details a little deeper so everyone who has ever read bond covenants knows that they can be very unstandardized. There’s absolute nightmare in some cases, especially in distress situations. You have and you have a great white paper that our listeners to reviewers can request from your website that details a lot of technical aspects that are involved.
[00:23:42] I read the white paper with great interest and you know, there’s, and, and these are things like, you know, minority holders, like obligations of the corporation itself in that’s essentially an external transaction and so on. So can you give us some of the highlights on, on these topics?
[00:23:57] Saish Setty: Yeah, I mean, TRAs, they are a newer instrument, so when you look back 10 years, you often find TRAs that aren’t well drafted, they’re sloppier. They don’t include the provisions you see in a newer TRA. That said, we have seen TRAs become a bit more standardized in recent years, and this is a process that we hope to continue to drive with our white papers because even though they’ve become more standardized, they’re still not at the level of a bond indenture or credit agreements. And in terms of specific provisions, unsurprisingly, one of the biggest points we care about is transferability. So again, one of the most common assignment formulations makes it so that TRAs are freely transferrable. That’s basically what we wanna see. That’s about one out of every three TRAs. The rest can really, really vary.
[00:25:01] In some, you need company consent, and this can take many forms and it can also really be a massive roadblock to a transaction. And to make it more concrete, a few months ago we were working with a firm on a TRA sale. We had fully negotiated the documentation, agreed on price, the works. The last step naturally was just obtaining company consent to the transaction that a lot of us took as something for granted here.
[00:25:32] Lo and behold, the company refused consent and really that’s just a terrible outcome. Sure, you can have a blacklist and a credit agreement, but in the debt world, flat consent writes like that. Are more or less unheard of. And these are the types of things that we hope to move the market on. And TRAs, they’re, they’re drafted by the best law firms in the world for the most part, but they’re often not drafted with transfers in mind.
[00:26:06] And that’s something in particular that we wanna change. And there are other provisions too that impede transferability or disadvantaged holders. So for example, in the bond and loan market, you’ll often see strong protections against adverse amendments. And even with that, there’s still been an onslaught of lender on lender violence that you alluded to with coercive exchanges and the like.
[00:26:34] But even in that context, bonds loans, they will have sacred rights, things that are untouchable. You can’t just go out and amend down the principle and a bond without getting everybody’s consent. And these are the types of protections that we want to see more explicitly built into TRAs. And again, these aren’t just selfish considerations.
[00:27:02] Realize the focus on assignments might sound a little selfish, but we want TRAs to flourish in the market. And one item of focus for companies is potentially the operational burden up a TRA. So sometimes tax benefits under the TRA, they’re going to be created when you have equity holders that exchange subsidiary units.
[00:27:29] For corporate stock and the frequency of these exchanges can create a ton of administrative burden for companies. So that, for example, is something that they might want to limit. And there was one asset manager in particular that had an earlier TRA and they had a ton of partners that were party to the TRA and these partners, they’re all sophisticated, they’re exchanging units on a daily, weekly cadence.
[00:27:58] Everybody doing it at a different time. This is just a huge burden on the company. Each exchange can create a new work stream and limiting things like that, limiting that flexibility, all of those can help reduce the operational hassle for a company and hopefully incentivize more TRAs on the market.
[00:28:19] Nick Mazing: Another thing that was interesting in, in your white paper is how many household names, so to speak, famous, famous companies are involved in TRAs and in some cases, TRAs are a factor in special situations like takeover proposals in some cases around distress. So can you share with us some of those situations and what’s going on there?
[00:28:42] Saish Setty: Yeah, so definitely in one situation in particular, There was a mattress company with a TRA and for a little bit of background, usually when a company that’s issued a TRA is acquired, you would accelerate all the obligations under the TRA and it’s paid out to holders, so it’s effectively a make call.
[00:29:05] Now when this mattress company received a takeover proposal, this was in the fall of 22, it was actually conditioned on the company just waving or obtaining a waiver of these change of control acceleration provisions. And ultimately this proposal was rejected. The acquirer launched a campaign to nominate board members.
[00:29:29] The company old playbook put a poison pill in place, and this was actually all Brazil, earlier in April, the poison pill was removed. The company made concessions on its board nominees. But it was super interesting to see the TRA actually be a central part of the acquisition negotiations here and another recent acquisition.
[00:29:56] This one was with a financial advisory firm, and the acquirer was a sponsor, a private equity sponsor. They actually structured the deal to provide TRA holders with a promissory note instead of an accelerated payout. So again, I mean, TRAs, they’re generally newer instruments. So it’s, I at least find it fascinating.
[00:30:19] Maybe that paints me as a bit of a dork, but I find it fascinating to see how they’re playing out in the acquisition context. And then on the distress side as well, one situation that we’re focused closely on is a car is a car retailer. They’re in a distressed situation and under the company’s t TRA a bankruptcy, like a change of control results in an acceleration of the entire TRA.
[00:30:48] And the company here is actually controlled by a single family and their TRA holding will actually provide them with another avenue to influence a ba, bankruptcy proceeding if and when the company files. And I find at least a lot of commentary here, people are so focused. On the family’s equity stake, but it’s the TRA that actually provides them a more senior means to influence the bankruptcy proceeding.
[00:31:20] And we’ll see what happens here. But again, it’s extremely exciting to be on the forefront of a new market and to watch it develop in all of these different contexts.
[00:31:32] Nick Mazing: Thank you for joining us today.
[00:31:34] Saish Setty: Great. Thank you, Nick. It was always a pleasure.
[00:31:36] Nick Mazing: This was a great overview of TRAs as an emerging asset class with Saish Setty of Parallaxes Capital. We learned about how TRAs actually arise, how to think of them as an investible asset class, and what his fund actually does. We have all the relevant links in the show notes. This was another episode of Signals by AlphaSense.
[00:31:56] My name is Nick Mazing, and you can find us on all the major platforms. Thank you for watching or listening.