Understanding and Investing in Tax Receivable Agreements

What Are Tax Receivable Agreements?

Tax receivable agreements (TRAs) are contractual tax-sharing agreements that require buyers of a business to make additional purchase price payments to sellers when certain pre-closing tax attributes are used to shield post-closing taxable income. In the public markets, TRAs serve as the primary means of compensating pre-IPO owners for tax assets delivered to public vehicles on IPOs and de-SPAC business combinations. In private transactions, TRAs bridge valuation gaps with respect to tax assets delivered by sellers to buyers.

While TRAs allow for sponsors and founders to capture cash flows generated by tax assets at the exit of a business, TRAs present two potential issues to their holders: 1) TRAs are long-dated instruments with uncertain durations (in the case of sponsors, typically surviving the life of the fund in which they reside), and 2) the secondary market for TRAs is currently highly illiquid and opaque, with issuer buybacks and M&A representing the primary outlets for sale.

TRAs typically have contractual amortization periods of 15 years. However, the contractual amortization period represents the minimum payback period or “best-case scenario” payback. TRAs pay out cash flows as a corporate entity utilizes the underlying tax attribute to shield taxable income. There are several factors that may serve to extend or delay the TRA cash flows, which may include volatile/declining earnings at the corporate entity, subsequent seller (pre-IPO owner) share conversions in a market experiencing expanding multiples, and certain corporate decisions related to capital expenditures and acquisitions. Hence, it is not uncommon that 1) TRAs have expected lives greater than 20 years, which exceeds the lives of most funds by 10+ years; 2) holding a TRA may not be accretive to the internal rate of return of a fund; and 3) a TRA may not fit with a fund’s investment thesis despite representing incremental value.

Investing in Tax Receivable Agreements

Simultaneously, tax receivable agreements represent an attractive investment opportunity, as their unusual structure presents unique benefits. Because TRA payments are dependent on taxable income to utilize tax assets, their returns are not exposed to public market valuations, reducing mark-to-market volatility and correlation to public equity markets. TRAs also have positive exposure to tax rate increases and M&A transactions. This incongruence between TRAs represents a unique investment opportunity while often being poorly suited for the sponsor funds, indicating a need for a secondary market. 

Houlihan Lokey is actively conversing with investors, TRA holders, and industry stakeholders to develop a secondary market for these unique assets. We can advise you on the appropriate determination of value for the TRA as part of your transaction as well as provide independent advice and opinions of value to special committees, continuation vehicle transactions, and collateral value assessments. Houlihan Lokey can also provide compliance-driven valuations for financial and tax reporting purposes grounded in real market dynamics for TRAs. Our cross-functional team, with expertise spanning tax, special committee/board advisory, and complex illiquid financial instruments, can advise you on optimal TRA strategies, provide independent advice and opinions of value, and ultimately help you monetize your TRA.

Tax Receivable Agreements Market Update

Houlihan Lokey is pleased to present its Tax Receivable Agreements Market Update, which presents an overview of the market for both current and potential tax receivable agreement holders, investors, and industry stakeholders.