I.P.O./Offerings | Private Equity

Squeezing Out Cash Long After the I.P.O.

By
Minh Uong

When the Berry Plastics Group, a container and packaging company, went public last October, it generated up to $350 million in tax savings. But the company won’t collect the bulk of the benefits. Rather, Berry Plastics will hand over 85 percent of the savings, in cash, to its former private equity owners.

The obscure tax strategy is the latest technique that private equity firms are using to extract money from their companies, in this case long after the initial public offering.

In a typical buyout, the owners make money by sprucing up the operations and selling the business to another company or public investors. Private equity firms have also found ways to profit before the so-called exit with special one-time dividends and annual management fees.

Now, buyout specialists are increasingly collecting continuing payouts from their former portfolio companies. The strategy, known as an income tax receivable agreement, has been quietly employed in dozens of recent offerings backed by private equity, including those involving PBF Energy, Vantiv and Dynavox.

While relatively rare, the strategy, referred to as a supercharged I.P.O., has proved to be controversial. To some tax experts, the technique amounts to financial engineering, depriving the companies of cash. Berry Plastics, for example, has to make payments to its one-time private equity owners, Apollo Global Management and Graham Partners, through 2016.

“It drains money out of the company that could be used for purposes that benefit all the shareholders,” said Robert Willens, a corporate tax and accounting expert in New York who coined the term “supercharged I.P.O.”

Eva Schmitz, a spokeswoman for Berry Plastics, declined to comment, as did Charles Zehren, a spokesman for Apollo. Graham Partners did not return multiple calls for comment.

A form of the strategy, known as a tax-sharing agreement, has been around for decades. Through such deals, a parent company and its subsidiary agree to share any losses that could lower their tax bills.

Private equity firms started to take notice of the technique in 2007 after the $3.7 billion I.P.O. of the Blackstone Group. Before the offering, the private equity firm used complex partnership structures to create large deductions for good will, a type of intangible asset. Blackstone’s partners then got to keep 85 percent of the deductions, or $864 million, securities filings show.

Private equity firms are now applying the strategy to their own investments. Income tax receivable agreements account for only about one in 50 I.P.O.’s backed by private equity, according to some estimates, but industry experts say they are on the rise.

“The investment banks are spending a lot of time on models for these deals,” said Eric Sloan, a principal in merger-and-acquisition services at the accounting firm Deloitte. “We are going to see more of these deals,” he said, adding that “it brings new value to the table.”

Under the typical agreement, the private equity portfolio company transfers partnership interests to a newly formed entity. The transfers bolster the market value of certain items, like tax credits, operating losses, good will, amortization and property depreciation. In doing so, the related entity captures the tax savings on those items.

“It’s meant to extricate cash value from taxes,” said Warren P. Kean, a tax lawyer focused on partnerships at K&L Gates in Charlotte, N.C. “Private equity firms have realized that there’s a benefit here in unlocking the tax value associated with portfolio companies.”

Private equity firms view the deals as the “pearl in the oyster shell,” because the strategy generates valuable tax assets that did not exist or were not usable and converts them into cash.

As part of the deal, companies sign a long-term contract with the private equity owners to hand over 85 percent of their current and future tax savings. The newly public companies keep the remaining 15 percent, providing it with deductions that they otherwise would not have had.

It’s lucrative for the private equity firms. The payments, which can last as long as 15 years, create a tidy income stream, typically taxed at the lower capital gains rate. The Graham Packaging Company, a maker of plastic containers, expects to pay its former owners $200 million, according to securities filings; Emdeon, a billing company, $151 million; and National CineMedia, a cinema advertiser, more than $196 million.

But some tax experts take issue with the strategy.

“They involve millions, often billions, of dollars in cash transfers from newly public companies to a small group of pre-I.P.O. owners,” Victor Fleischer, a tax professor at the University of Colorado, and Nancy Staudt, a public policy professor at the University of Southern California, wrote in a 2013 study. (Mr. Fleischer is a contributor to DealBook.) The study said the primary reason for the deals was tax arbitrage.

Another potential issue is that sophisticated investors do not necessarily understand the deals, either. The agreements typically warrant just a few paragraphs in a company’s I.P.O. filings.

And the companies are generally on the hook for the cash payments, even if their profits deteriorate. Berry Plastics lost $10 million in the last quarter and already carries a costly debt load of $4.6 billion. In its I.P.O. filing, the company cautioned that the tax deal could affect its liquidity.

A version of this article appears in print on 03/14/2013, on page B9 of the NewYork edition with the headline: Private Equity Squeezes Out Cash Long After Its Exit.