Do IPOs of Companies with an Innovative “Up-C” Structure Harm Public Shareholders?

The umbrella partnership corporation (“Up-C”) IPO structure allows an entity taxed as a partnership to go public by creating a shell corporation that sits above, and whose sole asset is units of, the historic partnership.  Unlike a traditional IPO where all owners hold shares of the public corporation, in an Up-C structure, shares of the public shell corporation are sold to the public while the pre-IPO owners continue to own their economic interests directly in the historic partnership (see Shobe 2017, Supercharged IPOs and the Up-C, for an overview).  A primary benefit of the Up-C IPO structure is that, when the pre-IPO owners exchange their partnership units for shares of the public corporation in a taxable exchange, it creates valuable tax assets for the public corporation that would not be available in a traditional IPO structure.

IPOs with an Up-C structure have become increasingly popular in recent years.  Up-C IPOs account for 4 percent of all IPOs since 2004, but 9 percent of IPOs in 2019 made use of the Up-C structure, and Up-C companies account for between 5 percent and 23 percent of annual proceeds in IPOs since 2013.  Our article analyzes the effects of the Up-C structure on company performance and share price.

The Up-C structure has generated significant discussion and some controversy. Proponents of the Up-C deal structure claim that it is a driver of post-IPO value because it can create valuable tax assets that are unavailable in a traditional IPO. Our article shows that, unsurprisingly, the average Up-C creates tax assets of $92 million in the IPO year alone, which is significantly greater than the tax assets created in a traditional IPO.

Critics argue, however, that the Up-C structure allows pre-IPO owners, including founders and private equity sponsors, to siphon this value from public shareholders. Importantly, if public shareholders price in the Up-C’s widely touted tax benefits but underestimate its costs and how much of that value is shared with the pre-IPO owners, then the public shareholders may be harmed by the Up-C structure. Therefore, our study asks whether public shareholders overvalue the Up-C deal structure at the IPO.

We find that the Up-C structure increases IPO valuations, indicating that the tax-asset benefits of the Up-C structure are at least somewhat priced in by public investors.  However, our article also shows that Up-C companies’ stocks perform worse after their IPOs than comparable non-Up-C companies’ stocks do. The negative stock-return performance of Up-C IPOs indicates that public stockholders do not accurately price in the downsides associated with the Up-C structure. Therefore, despite the Up-C’s benefits, the article finds that IPO investors are ultimately harmed by the Up-C structure. Accordingly, our evidence suggests that there is merit to critics’ claims that the Up-C structure facilitates opportunism.

The article’s evidence suggests that the market underperformance of Up-C IPOs is not typically driven by disappointing post-IPO earnings, but is instead a manifestation of public shareholders’ dissatisfaction over how they share in the reported earnings. Our findings show that, although the Up-C deal structure predicts positive future operating performance, the negative stock returns concentrate in the subset of Up-C IPOs that generate positive net income. In other words, although the operating company in an Up-C structure outperforms non-Up-C companies, public shareholders receive less of that economic value than expected. It appears that the mispricing is often revealed to investors over time via wealth-transferring events that are unique to the Up-C.

The article explores many possibilities for Up-C return underperformance. One controversial feature that accompanies nearly all Up-C IPOs is the contractual agreement to return a large portion of the value created by the Up-C deal structure to pre-IPO owners. The contract, referred to as a tax receivable agreement (“TRA”), typically requires the company to pay its pre-IPO owners 85 percent of the value of tax assets created by the Up-C structure as the value of those tax assets is realized.  It is possible that investors do not fully understand the implications of TRAs at the time of an IPO, especially since, if TRAs were fully priced in at the IPO, then there would be no point in using them in the first place.

Even if the TRA and its payment structure are well-understood, IPO investors may not anticipate the myriad ways pre-IPO owners can exploit TRAs. Recent litigation relating to TRAs in M&A deals illustrates potential issues. For example, in the recent case of Pluralsight, public shareholders, as well as prominent proxy advisors ISS and Glass Lewis, voiced opposition to the acquisition of the company by Vista Equity Partners, in part due to special TRA payments to pre-IPO owners as part of the acquisition agreement. In response to scrutiny and the alleged self-interest of pre-IPO owners, Pluralsight and Vista amended the proposed merger agreement to waive TRA payments.

In addition, Up-C companies use a unique type of dual-class structure. Unlike traditional dual-class companies, where pre-IPO owners and public shareholders typically own different classes of common stock with different voting rights but hold their economic interests in the same entity, in an Up-C structure, pre-IPO owners and public shareholders hold their economic interests in different entities. The public shareholders own shares in the publicly traded corporation, while the pre-IPO owners own their economic interests directly in an operating partnership subsidiary, which creates unique opportunities for pre-IPO owners to receive disproportionate economic value from the Up-C structure. This type of risk is never present in a traditional dual-class company because all owners own their economic interests in the same entity, the public corporation.

Our findings also show that Up-C IPOs face a significantly higher rate of post-IPO litigation as compared with non-Up-C IPOs. Because IPO investors seemingly do not anticipate the myriad ways in which the Up-C deal structure might facilitate opportunism by pre-IPO owners, they appear to turn to litigation as an ex-post settling-up mechanism. Litigation relating to the Up-C illustrates how Up-C investors face the challenge of calibrating how much value remains with the post-IPO firm and how much value may be extracted by pre-IPO owners.

Our findings suggest that the distinct and complex organizational structure of Up-C IPOs, including the dual-class feature inherent in the choice of the Up-C structure, introduces both the motive and ability for pre-IPO owners to extract value from the public entity in ways that public shareholders do not anticipate when pricing the offering. Understanding the value of this structure to shareholders is critical to informing investors as they evaluate the Up-C structure and regulators charged with oversight of public company disclosure. Our findings are especially timely considering the recent rise in the number of Up-C IPOs, the increasing amount of capital being raised via the Up-C structure, and the potential for Up-Cs to account for an even greater portion of the IPO market going forward.

This post comes to us from Mary Brooke Billings and Kevin Hsueh at New York University, Melissa F. Lewis-Western at Brigham Young University’s Marriott School of Business, and Gladriel Shobe at Brigham Young University’s J. Reuben Clark Law School. It is based on their recent article, “Innovations in IPO Deal Structure: Do Up-C IPOs Harm Public Shareholders?” available here.

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