Niche Assets: Tax Receivable Agreements feat. Andy Lee

Hello, future billionaires. Welcome back to a new episode of the Invest Like a Billionaire podcast. Have a fun interview for you today with a gentleman named Andy Lee of Parallaxus Capital and very, very fun discussion all around one particular asset class that you've probably never heard of called TRAs, tax receivable agreements, and really cool background. He tells a story of why he got a master's in taxation, really is way to appease his dad and just not have to do a lot of work. But it actually ended up really working in his favor, finding a very unique asset class of C-corps that kind of creating these receivables and it gets all into it. Really, really cool stuff. But again, with our goal here, Investing Like a Billionaire, we like to do a lot of different things. One of them being educating around unique, interesting asset classes that you maybe never heard of and things that are very interesting and happening in the alternative finance space. So got to give the caveat as you do with any a body coming to the podcast that is potentially raising capital. I've not done any due diligence. I've brought them on to our podcast purely out of curiosity, just wanted to understand what they're doing. So we didn't really get into any of the specifics. You know, if you have interest, you can do your own due diligence, reach out to them and check it out. But just want to be clear, we've not done any due diligence, and this is purely out of curiosity, uh, to bring them on to talk about something very interesting. With that, if you are enjoying the show and you're not already subscribed, please do so. And if you can leave us a review, that really helps us get the word out, get on bigger guests onto the show so we can keep adding more value-packed content. And I hope you enjoy this show. Thanks. This is the Invest Like a Billionaire podcast where we uncover the alternative investments and strategies that billionaires use to grow wealth. The tools and tactics you'll learn from this podcast will make you a better investor and help you build legacy wealth. Join us as we dive into the world of alternative investments uncover strategies of the ultra-wealthy, discuss economics, and interview successful investors. Looking for passive investments done for you? With Aspen Funds, we help accredited investors that are looking for higher yields and diversification from the stock market. As a passive investor, we do all the work for you, making sure your money is working hard for you in alternative investments. In fact, our team invests alongside you in every deal, so our interests are aligned. We focus on macro-driven alternative investments, so your portfolio is best positioned for this economic environment. Get started and download your free economic report today. Welcome back to another episode of the Invest Like a Billionaire podcast. I'm your host, Ben Frazier, and I'm joined by my friend Andy Lee of Parallaxus Capital. Very excited for this conversation. So Andy's team reached out and said, hey, we had him talk about TRAs. And I first thought, well, what the heck is a TRA? And then second, no, we haven't. So I'm excited to bring Andy on. He is the founder of Parallax Capital. He was previously with Lone Star Funds and spent his career early on at Citigroup, you know, lives in New York in the heart of finance and doing a really cool thing in this space called TRAs or tax receivable agreements. And I think you said it before on our other call that you focus on esoteric financial instruments or something like that. And so this is something that's very different, right? Very unique in the— even within the alternative space, but something that is, well, not well understood but has some really unique, cool dynamics that I'm excited to dive into. So Andy, give us a little bit of background on you and kind of how you found your way into the world.

Absolutely. And thank you for having me. So, look, I'm from the middle of nowhere, not too far from you. I'm from Champaign, Illinois, and I had the option to go to college a little early. I went to college when I was 15. When I graduated, I was too young to sign a lease in New York City. And so my dad refused to let me go and really wanted me to pursue a PhD. I refused. I didn't want to join the family business in that regard, but he had obviously dominion over me at that point of time. And so I was forced into a compromise. And I, so I did instead of a PhD, I did a master's and I did a master's in taxation. The reason for which frankly was twofold. One, it had a no coursework participation grading, whereby you didn't need to go to class to get an A, and two, it had an open book exam at the end of the year. So for someone who didn't really want to go to class, it was an absolute godsend. I did that. I started my career off at Citigroup. In there, I advised between two companies who were undertaking a transaction to resolve their TRA. Cloud Peak, a coal mining business, and Rio Tinto, a major miner. And in that regard, I was like, this is a fascinating opportunity set and an interesting instrument. Someone should provide third-party liquidity for the opportunity. Went down to a firm called Lone Star Funds down in Dallas, Texas, and they said, the only way you get promoted here is for you to create something. And so there are a number of things that we ideated around. The one that got heard us and off us off the ground was in monetizing tax receivable agreements. And what I do today. And the firm said, this is a fascinating concept. How much can you deploy annually? I said $100 million thinking that was a large number. And they said, you're missing several zeros around that. The firm is, call it, in the $100 billion zip code from an asset management perspective. And so partners basically said, Andy, why don't you go do this? We'll give you money to go do it. And if it doesn't work, come back in 2 years. That was 2017. We've raised a number of vehicles since and built a team around the opportunity set, but it's a labor of love and a lot of growing pains.

Man, that's a great story. So you kind of fell into it by, by accident, looking for the shortcut to get out of school and learned really, I'm sure, a lot of things that help you in your, your business today. So talk a little bit about what is a TRA, right? I mean, this, you know, I had a little more, you know, context, more conversation to kind of get the base, you know, understanding of it. But it is a little complicated. So let's, you know, explain it, explain it to the very high level, just kind of key parties involved, why it's created and kind of how it works. So just kind of set the stage for us here.

So in terms of what a TRE is and relative to some of the analogies that you likely have brought onto your show over the course of the last year or so, there are— it reminds many of what pharmaceutical royalties were in the 2000s and what musical royalties were in the 2010s. So long-dated annuity-like cash flows that are uncorrelated to broader markets. And so that's at least what we do. In terms of the asset itself and the opportunity set, let's call it a $30 billion opportunity and growing with increased adoption. We like to say as a firm that not only is there riches in the niches, but it is also the largest opportunity set that people have just never heard of. Tax. So across a number of things, think about us almost buying the standard deduction, a concept that many are probably familiar with, but for corporations. Names in our portfolio that we've transacted with include the likes of a RE/MAX, a Shake Shack, a Duff Phelps. So public issuers that people have seen, understand their propositions. They're not small businesses, they're relatively large and they're public companies in nature. In terms of the product, it is a long-dated annuity stream that is, one, uncorrelated, two, cash yielding, and three, serves as a call option on higher corporate tax rates. Those are attributes that are interesting to many, and it's created by just a misunderstanding of tax more broadly. Primarily on the front of, I mean, how often do you look forward to going to your dentist?

Not very often, we'll say that.

In the same way, most people run away from tax season. And that's like one of the misunderstandings driven by the fact that most people don't want to have to deal with much in the way of tax. And tax professionals, unfortunately for my brethren in this space, rarely if ever speak English. And that creates an incredible challenge, but also an opportunity for us to bring light to this overall opportunity set.

Yeah, no, so interesting. And what I love about this whole world of alternative investments, right, is as we kind of see these new things start to percolate over time, like you mentioned, you know, music royalties, you know, I've seen other things as, you know, Unique is investing in distilleries and, you know, casks for wine or you know, Harder Liquors. I've seen, you know, buying fractional shares of horse, you know, racing horses. And I mean, it's really creating liquidity, creating markets around assets that have different characteristics, but being able to bring it to a different audience to where maybe there was no market, right? And in this case, you're kind of one of the first in creating a market to transact on these assets that are created that the companies that have on the balance sheet don't really want to hold because it's not, you know, very advantageous to them from an allocation of capital or resources standpoint. And, you know, there's not a whole lot of buyers out there, I'm assuming. We've talked a little bit about just what you have to do to go to drum up these types of assets. It's difficult to find and explain all that. And so you've kind of created this, this very unique niche that is totally uncorrelated to, you know, the markets. It has some other unique aspects. So let's kind of give a— give an example here of how this is created and who the kind of key parties are in, you know, what the transaction might look like just at a high level. So use some kind of just more of a case study, but just use simple numbers so we can kind of get a sense of how this— how this works.

Absolutely. So the— there is a fundamental tax transaction that occurs whenever a company goes public. Many businesses here in the US are formed in several formats, that being pass-through entities. Might that be a limited liability corporation, a partnership, or an S corporation? And so whenever you go public here in the US, unless you are electing for an MLP or a REIT designation for tax purposes, you ultimately have to become a C corp. As a result, you undertake a tax transformation and there is a taxable transaction known as an up-C transaction that occurs. That transaction results in the pre-IPO shareholders paying a large tax liability and as a result, also creating and delivering to the newly public company a large tax asset for which they share it via a tax receivable agreement. So the key stakeholders in this transaction are, one, the public company which receives a large tax asset, and two, the pre-IPO shareholder who not only paid a large tax liability but also received a large tax asset in the transaction. Many of these are private equity funds. So think about them as having many portfolio companies that they take public on a regular basis. And for private equity funds, they have 10-year fund lives. They may take a company public in year 6 of their fund, and over time as the company grows and they sell down their exposure, they then are at the tail end of their funds and these tax assets might survive 10 years after that. And so some of the holders that we've transacted with, they run the gamut from management team, co-investors, private equity funds, and they're just looking to wrap up finite fund life vehicles. So in that sense, we are almost helping them provide liquidity for a somewhat misunderstood asset. In order for them to deliver proceeds back to their investors, one, and to reduce the administrative burden with closing down a fund.

Right. Okay. So let's break it down a little bit further because there's a lot of, lot of information there. So what you're saying is on these companies that are going IPO, they go onto an exchange, become publicly traded. To do so, you have to change the structural ownership of your firm, right? And most stocks and companies that are traded on exchanges are C-corps. That's a requirement unless you have an exemption, either being an MLP, master limited partnership, or a REIT. But most of them are C-corps, right? So when you, when you go public, you have to convert the structure. But you've had your legacy structure, which most people, you know, when they're building businesses that are private and not publicly traded, they're usually using limited liability companies, LLCs, limited partnerships, other types of partnerships or S-corps like you said. 'Cause you're not generally gonna start with a C-corp unless you have to, right? That's kind of the idea.

Unless you have a successful S-corp.

Yeah, there are reasons, there are times when it makes sense. But as you're kind of making this transition, what you're saying is you kind of have this, you said tax transformation, that is creating this transaction that, you know, between the new publicly traded company and the older company or the old shareholders. So talk a little bit about that. So basically, the shareholders of the pre-IPO company, they have a receivable from the new publicly traded company. Is that correct?

That's right.

So what they're doing is they now have an agreement between these two parties where they're going to be receiving X amount of you know, cash per year over a set period of time. Well, what you were just saying at the end there is a lot of these shareholders of these pre-IPO companies, they're funds and they have, you know, designated fund terms. And if they're liquidating these assets through, you know, the IPO, they're getting a nice big, you know, you know, the capital event in the fund, they now are kind of winding it down potentially and they don't want to have to hold on to this kind of probably small asset as a percent of the overall fund that now is a receivable over a long period of time. And there's an administrative burden. It's just, you know, you have to send K-1s for the next 10 years to your investor. So it creates kind of this annoying, you know, kind of pebble in the shoe that they don't want to deal with. And so they're willing to sell this asset at potentially a discount. Am I right so far?

Absolutely. So you are 100%. We're a secondary market purchaser of these assets.

So up to this point, there hasn't really been a market for these assets, right? I mean, talk a little bit about what does the market look like? Has there been a market? I mean, if there has been, I'm sure it's you know, been very, you know, haphazard or idiosyncratic.

Absolutely. So it's been a large growing opportunity set, even though these assets have been around for almost 30+ years. They are just relatively to many market participants novel, despite their age. And most people don't quite understand the opportunity set. And there are several reasons why. So the first of which is the domain expertise necessary to underwrite the opportunity. And we talked a little bit about that where my brethren have not done a good job of translating tax into English. So one, helping people understand the value of these assets. Two is around duration, whereby The market hasn't formed around that primarily because private capital vehicles are many times ETFs and whatnot where money comes in and out very quickly. In order to hold this piece of paper, you need to have 10+ year capital where you have locked up vehicles. Most private credit funds have 4 to 6 year paper. They can't hold that. The third reason is, and is around return expectations. If you're doing private credit, for which you've interviewed others, like they're delivering consistently 12 to 14%. You don't— it's a well-understood market. It's not terrible amount of brain damage. Very liquid, relatively liquid. You all of a sudden look at that and you're like, if I want, I can do something simple and get a 14%, do I? And I have to undertake all sorts of brain damage to do this, like, I want to get paid more. And so there's been a big bid-ask spread between sellers and potential buyers on the opportunity set. And so the overall opportunity as a result makes it incredibly challenging to drive capital formation, primarily because you need someone who came from the deal world, who also understands tax and is relatively commercial to bring it all together. And that hasn't quite existed in the same body for a very long time. And so for our many sellers who are looking for liquidity, who are just finding a void in the space, and that's really where we step in.

Got it. Yeah. So you're basically trading with the pre-IPO shareholders, hey, I'll pay you a lump sum at a discount to hit kind of our turn threshold that I want to hit. and you don't have to deal with the kind of tail of this annuity-like payment stream, right? And so they can, you know, take a one-time payment and be done with it, close the fund, move on. And you can underwrite this asset and purchase it and receive the kind of payment stream over, over a set period of time. And so what you're really doing, I mean, in the most simplest form is you're buying a receivable from a publicly traded company. So you're really underwriting the creditworthiness of the payee, right? In this case, like you said, RE/MAX and Duff Phelps and others. And so talk about kind of the process when you got to, you know, get the parties to agree what the asset is, the value of it is, and you get them to transact. But then you also got to do the underwriting and make sure you know, it's a, it's a risk-reward profile that makes sense for investors. So what kind of discounts are you generally purchasing these, you know, TRAs at from the shareholders?

So we typically pay between 25 to 40 cents on the dollar, which translates into an annual return in the mid to high teens from a target perspective. And so that to many is attractive primarily because the comparable debt that one of these holders, one of these obligors might have, a RE/MAX or Shake Shack, is in the 6 to 8% zip code. And so like earning 1,000 points on top of that, they find to be very compelling. So they look at these businesses, they say they're public, they are investment grade, near investment grade, And I have the potential to capture 1,000 points of spread on an uncorrelated asset relative to the overall performance. Because if I buy the stock, I'm very earnings sensitive. Here we can see a significant deterioration relative to the earnings power of a business before we experience any deterioration. And so they find that to be a compelling sale in that regard. And so that's at least how we think about our opportunity set. There are fundamentally 3 risks that we underwrite. The first that you mentioned, bankruptcy risk, which is the company remaining a going concern. And so for us, obviously the attributes being IG or near investment grade are very valuable. The second risk is around corporate tax rates. So if we have a linear relationship with tax rates. If hedge were to go down, we have our— we see a downward, um, movement in our returns. Correspondingly, on the way up, we have an upward movement to our returns. So that's inverse to almost every asset class. So some of our investors view us as a tail risk hedge to the rest of their portfolio. The final risk is deferment extension, what I might describe as you never lose a tax asset, you merely defer it. So if you can't use it in a certain year, you get to use it whenever you are profitable again. So think about it as your MOIC or your cash on cash remaining constant, your IRR just deteriorating as a result of being a time-weighted measure.

Got it. So in this case, using just names to make it easier, RE/MAX, they have maybe not a good year. Hey, interest rates are up, transaction volumes are down, we have a net loss. So we are choosing to defer, you know, paying this because it's not, you know, accretive to the bottom line and you don't have a whole lot of ability to force them to pay. Obviously you'll get paid at some point, but either that, that's what you're talking about. Is that accurate?

That's right.

Okay.

So they don't really have a choice insofar that obviously penalties associated with such a deferral. But for many of them, they are repatriating part of the benefit that they receive from the IRS. And so like for them, it's just a transfer of value away from what they might otherwise have paid.

Okay. Okay. So you have an agreement that's already in place and there's penalties if they don't pay, but that penalty might be less than what they're going to get, you know, from a tax loss and not having to pay the IRS. So they might choose to, to have that penalty incur, be incurred and, and not pay it out. But it's still— they're not— they still have to pay it back at a certain point. So it's not a matter of if, it's just more of a matter of when. And then you go back to— because you mentioned at the very beginning that this is a call option on corporate tax rates, right? And so what you're saying is you have a positive correlation to tax rates. And so if tax rates go up, you know, that increases your returns, and if they go down, it decreases them. And so a lot of investors use this as kind of a tax hedge because most investments would perform inversely to the tax rates. Right. So that makes sense. And what has been the trend on tax rates?

You know, we are at the lower limits in a corporate tax rate perspective here in the US. So Um, we are at 21% federally today. Um, in the past, obviously before, as a result of the Trump tax cuts prior to that, it was 35%. And then it's been as high as in the '90s, um, dating back to early in the century. And so in the US, in the US, um, which is out of curiosity, what do you think the corporate, um, pay in terms of the overall US federal budget revenues?

Corporate pay? What do you mean by that?

What percentage of the US federal revenues do you think corporates contribute?

Oh, good question. Um, let's say 25%.

I might shock you by sharing that it's closer to 6% and going down. Okay. The vast majority of taxes are borne by Social Security, individual and personal taxes, among others.

Interesting, interesting. So, so hey, we're running deficits that—

yeah, we're still going down, right? Uh, right. But there is a chance that in the world that we live in, and based on where we are in society, and we might see potential changes in corporate tax rates to the upside as well.

Yeah, interesting. Are you, are you seeing, uh, the bid-ask spread, you know, widen or contract based on kind of political regime? Like, we're in a political, you know, year in 2024 here, and you could have some things that are going on. Does that impact kind of the price discovery of when you're transacting these assets or not?

We always joke that we originate as Republicans and we asset manage as Democrats. The elements there, like we can't price a change in corporate taxes. That's fundamentally also a risk that our investors want that exposure to. So let's say like someone that we were buying from, like yourself, Ben, you might be like, here, let's have a sharing arrangement. If tax rates were to move up, then I capture X value. but if I did that, then my investors wouldn't get the benefit of that outcome, right? Which is the hedge that they're looking for, for their broader portfolio. And so in that context, it's hard for us to give up that change in value in order to meet a bid ask. And so it's an education sharing how we think about that with the seller to arrive at a transaction. But you're not wrong. There are many transactions that may get held up as a result.

Yeah. Interesting. When you're trying to create opportunities from a deal standpoint, yeah, I mean, there's a lot of chicken and eggs, right? Because you're kind of buying these as one-offs or maybe you have a fund. I think you have a fund, you know. So do you have capital kind of at the ready to go buy these or, you know, is it kind of deal-specific as you you know, get to a deal that you can raise the capital for? Is it a little bit of both?

So we have 4 flagship funds with an access of $300 million of capital under management. Think about them primarily from leading endowments and foundations. And so what we're looking to do is we have committed capital vehicles that we can deploy capital out of immediately and/or if, if should the opportunity arise. So that enables us to be relatively nimble versus what some might know as the independent sponsor model, where they're going out to raise capital against an opportunity. So ours is more so in a committed fund structure.

Okay, got it. And then when you're reaching out to these companies to, you know, try to transact on their TRAs, you know, I think you showed me a screenshot of someone you reached out to like I don't even know what that is. You're probably talking to the wrong guy, right? So what's that process like? I mean, I know there's a lot of education involved, but what's— I mean, how difficult is it to kind of unearth a good deal that you can actually transact on at a good, good basis?

So I think it's more so, to your point, a big educational element as to what we do. And that's a function of the tenacity of our opportunity set in the minds of capital market participants. And so a big part of, as we engage with holders like that, our job is to demonstrate to them that they have it, one. Two, to give them a compelling offer for them to pay attention. So for many of them, when we say we're willing to give you $10 million sight unseen, they're like, okay, Well, sorry, I didn't even know, like, evidently I have a valuable asset. So what is it? How do I assess if it's a $10 million, it's a good amount? And at which point of time we go down the rabbit hole with them, helping them uncover the value of their asset. And for many of them, they're incredibly thankful 'cause they're like, this is almost found money for us, and in many regards. And so that element is a big educational push. Whereby we have these over hundreds of conversations and, and they might not sell today, but over time they may have considerations as it pertains to selling. Might that be the finite fund life consideration, but also for many holders, it's complexity and estate issues where similar to like a mineral royalty, like you might not want to distribute your mineral royalty to your 4 kids. For many of them, they're like, we just want to distribute cash to our kids. Let's just sell this to you and move on. Or they might have an even more compelling opportunity. We spoke with the former CEO of a large business and they were like, I am about to invest and be CEO of a new concept that I'm incredibly excited about and I want to invest personally a ton of money. So you're telling me that you're going to earn pay me 25, 40 cents on the dollar for this asset, if I'm going to make 100 times my money on this, I, I'll do that each and every day. And so it's an opportunity cost that he is weighing in his situation. And so it's a little bit unique to each underlying pattern that we are engaged with. But our job is to help grow the market longer term and, you know, when it's time for us, we hope to be able to be the liquidity provider of choice whenever someone finally desires liquidity.

Got it. Very cool, Andy. Well, this is a very unique asset that I hadn't even heard of until you reached out to me. And not to say that, you know, I'm aware of everything out there, but it's definitely cool to see an interesting asset class that you're providing liquidity to that is a pretty big market and growing. And you're still able to purchase a pretty significant discount. So very, very cool. And it sounds like you raise a lot of money from institutional investors. Do you work with kind of more high net worth retail investors as well?

Absolutely. So we've worked with a number of top investors, especially many stakeholders in our space. What is actually shocking is that there have been a bunch of holders of these shares who have actually sold us their GRA and subsequent to that, given us money in our funds because they're like, what you do is so unique and so cool. Like, I just want to be part of your story. And so that's been an incredible point of validation. But we also produce for many of these smaller investors like an income stream, like the cash yielding nature of our product that's uncorrelated. They find it to be incredibly valuable. And from a tax characteristic, from a tax perspective, it's tax-deferred and we pay out long-term cap gains. And so they're like, okay, so it's an income-like product that's primarily capital gains. That is incredibly valuable to many holders like that. And so that's a big part of what we seek to do. And it's a big part of market adoption. In order for us to create longer-term, more TRAs, we need people to be educated about the opportunity. A great way to educate them about the option is to get them invested, put money in their pockets, and they then say like, hey, how do I make— I've invested in several private equity portfolio companies. How do we bring this to them whenever they go public?

Yeah, makes sense. What do you see as the market maybe matures, becomes a little more efficient? Like right now you have the advantage of major lack of education. There is no liquidity, but liquidity and a more efficient market drives down returns generally, right? So what do you kind of expect the lifecycle of this to be? Is this an opportunity set that's going to be available for the next decade because it's just so difficult to transact in? Or do you kind of see we have a short window here to buy as much as you can at the, at the, the basis that you're talking about before things become a little more efficient?

Competition is not a if, it's a when. Just like in every asset class, niches end up getting exploited. What I might articulate is some niches are harder to exploit than others. So I'll give the instance. One avenue that many within the tax realm are relatively familiar with is, do you know that H&R Block is the largest factor rate of tax receivables associated with your tax refunds. So you file very high.

Yeah.

You, the IRS, I pay you in 30 days. H&R Block has a billion-dollar, multi-billion-dollar business lending people money or giving you that money now in return for more money in the future. Yeah. Not many people have tried to disrupt that because they're like, it's—

They're just such a big, yeah, player in that space.

And like, I don't know when's the last time you went to Europe, but if you or your wife did any shopping, like oftentimes you'll be entitled to what is known as a value-added tax refund. And when you'll go to the airport, and instead of waiting for the money from the EU government, you would say, Global Blue, gimme 90 cents on the dollar for it. Same as what H&R Block basically does. And they do the exact same thing. Like, there's a large aspect people just have never thought of that just sits in plain sight. Like, it's just because the underlying product is relatively not the most interesting in the world. That's a fault of tech professionals. But the fact that it's just a very misunderstood opportunity. So yes, as the more intellectual capital, comes into our space that will be incremental competition. But it is such a large space that in every dollar that you make as a professional, the US under— the taxes are 40% of it. Whenever you sell your business, that's 25% of it. Whenever you sell a stock or anything like that, it is the largest opportunity set that people are just not thinking about. Relative to everything else. Musical royalties. Everyone can associate themselves with musical royalties. Not many people come out of college saying like, I want to be the master of the universe in the tax world. That's just not a thing.

Yeah, makes sense. Andy, this has been really, really fun. Thank you so much for helping just uncover this really unique asset class. And sounds like you guys are doing some cool stuff over there and hope the best for you. What's the best way for people to learn more about what you're doing?

Absolutely. And thank you for the time. Like, the best way to reach us is on LinkedIn, where people can reach out. We've been relatively active on that front, providing educational materials on our space because, look, as the market leader, it is incumbent upon us to educate the universe. And so a big part of what we do is trying to share what we do, how we go about doing it, and ultimately being a good steward for the industry.

Awesome. And what's your website again for those who want to check it out?

Parallaxus, which is plxcap.com.

Okay. Awesome. Andy, thanks so much for coming on. Appreciate it. Thank you for the time, sir.