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E-MailSonja Olhoft Rego is Professor of Accounting at Indiana University. This post is based on an article authored by Professor Rego, Alexander Edwards, Assistant Professor of Accounting at the University of Toronto; and Michelle Hutchens of the Department of Accounting at Indiana University.
A new structure for initial public offerings (IPOs), colloquially referred to as “supercharged IPOs,” has become increasingly popular in recent years. In our paper, Supercharged IPOs: Rent Extraction or Signal of Future Performance, which was recently made publicly available on SSRN, we examine the motivations and implications of this new IPO structure. In a traditional IPO, a private corporation “goes public” by issuing new shares of capital stock in exchange for cash from new investors on the open market. In a supercharged IPO, a series of transactions are typically performed as part of the IPO process, which generates new tax assets (e.g., larger future tax deductions) for the corporation but also creates a tax liability for the pre-IPO owners. The future tax benefits generated by the new tax assets are then split between the new IPO investors and the pre-IPO owners based on a contract, typically referred to as a “tax receivable agreement” (TRA). These arrangements allow pre-IPO owners to retain some portion of difficult-to-value assets (i.e., future tax benefits), which were created under their ownership and may otherwise be discounted by potential IPO investors.
There is debate about the relative costs and benefits of supercharged IPOs. Proponents have argued that supercharging an initial public offering creates benefits for both the new shareholders (through the creation of step-up in adjusted tax basis of firm assets and the associated future tax deductions) and pre-IPO owners (through the TRA). Critics have argued the complex transactions allow sophisticated pre-IPO owners and their advisors to take advantage of uninformed new investors during the IPO process. They also argue that supercharging an IPO obfuscates the economic details of the transaction. This obfuscation enables pre-IPO owners to unfairly benefit at the expense of the new investors in the IPO, since 85 to 90 percent of the newly created tax benefits are typically allocated to pre-IPO owners through the tax receivable agreement.
This study provides evidence on which parties benefit from the financial innovation of supercharged IPOs. Fleischer and Staudt (2014) argue that both the pre-IPO owners and the new investors who participate in supercharged IPOs benefit from this innovative deal structure and the only party potentially harmed is the tax collector. This conclusion is driven largely by the fact that supercharged IPOs provide a tax arbitrage opportunity. However, if there is differential initial pricing of supercharged IPOs as compared to traditional IPOs, then this scenario is incomplete. The net effect of a “supercharged” transaction to pre-IPO owners is the assumption of a tax liability in exchange for a contingent benefit (i.e., the TRA). For pre-IPO owners to realize a net benefit from supercharging the IPO, the firm must have sufficient future taxable income to realize the future tax benefits and make payments to the pre-IPO owners pursuant to the TRA. As a result, the decision to supercharge an IPO potentially provides a signal regarding the future prospects of the firm. If this signal is useful, we expect higher final offer prices for supercharged IPOs compared to traditional IPOs.
Our analyses reveal significantly higher offer prices for supercharged IPOs, consistent with TRAs providing a positive signal of future firm performance. We argue that the strength of the signal provided by supercharging an IPO should be strongest when the potential step-up in asset basis is largest. We test this argument by interacting the amount of pre-IPO deferred tax assets, our proxy for the potential step-up in tax basis in a tax receivable agreement, with a supercharged IPO indicator variable. Our results suggest that supercharged IPO firms with larger potential step-up in asset basis provide stronger signals of future firm performance.
These findings are consistent with pre-IPO owners possessing private information about future firm performance, which leads them to supercharge their IPOs. If this private information is correct and supercharging is not merely a means of rent extraction, the realized future performance of supercharged IPO firms will be superior to the realized future performance of traditional IPO firms. We empirically test this expectation and document higher future earnings, greater future cash flow from operations, and higher future return on assets for supercharged IPO firms relative to traditional IPO firms. We also find that supercharged IPO firms enjoy lower future effective tax rates (ETRs) than traditional IPO firms, which could be driven by supercharged IPO firms implementing more effective tax strategies than those at traditional IPO firms. In short, our findings provide evidence consistent with firms that undergo a supercharged IPO exhibiting superior financial performance in the post-IPO time period.
In our final set of analyses, we examine the impact of disclosure quality on the relations described above. Commentators have argued that supercharged IPOs obfuscate actual financial outcomes through a complex series of transactions, which allow sophisticated pre-IPO owners and their advisors to take advantage of uninformed new investors. We examine this conjecture by repeating our earlier tests and analyzing the effects for firms that provide higher vs. lower quality disclosure in the Form S-1 regarding the details of the tax receivable agreement. For the initial pricing, underpricing, and future performance tests, our evidence is consistent with tax receivable agreements providing a positive signal from pre-IPO owners regarding future firm prospects, and this signal is strongest when disclosure quality is high.
The full paper is available for download here.
