Up-C IPOs Quietly Gaining Traction During Market Lull

Before the initial public offerings market slipped into its recent funk, a small subset of offerings known as Up-C structured IPOs picked up steam as investors became more familiar with the complex arrangements that provide tax advantages to public-bound partnerships.

While no Up-Cs have debuted in 2016 — the entire market has produced only four IPOs amid a volatile global equities environment — attorneys expect select companies will continue pursuing the alternate-style offerings when markets recover, noting that plenty of prospects are in the hopper.

“There is not an IPO we do for a company, where it’s a partnership pre-IPO, where we don’t think about whether an Up-C makes sense,” Kirkland & Ellis LLP partner Joshua Korff said. “Everyone is considering it. Whether they do it or not depends on whether it makes sense from a tax perspective.”

Up-C IPOs remain relatively rare because they apply only to partnerships — corporations are ineligible — willing to undertake the complexities to realize potentially millions of dollars in tax savings.

But the structure, which allows founding partners to preserve the partnership's pass-through tax status while taking the business public through a separate corporate entity, has gained traction within that small segment in recent years, representing between 5 and 6 percent of IPOs from 2012 to 2015, according to Dealogic. Up-C offerings peaked at 15 on an aggregate basis in 2014 — a robust year for IPOs overall — before slipping to 10 in 2015 as the wider market softened.

“You’ll see a bunch more, too,” said Latham & Watkins LLP partner Ian Schuman, whose firm handled last year’s Up-C IPO from restaurant chain Shake Shack Inc., declining to identify candidates for confidentiality reasons. “They are on the runway.”

Keeping the Taxman In Check

Deciding whether an Up-C makes sense boils down to analyzing costs and benefits. Though execution can get complex, the benefit of an Up-C is relatively simple. The structure allows a partnership to take its business public while retaining its flow-through tax status, meaning unit holders are taxed only at the individual level, reducing tax liability.

The Up-C avoids the double taxation associated with a standard C corporation, which is taxed at the corporate level and again at the shareholder level when individuals collect dividends or sell investments. The partnership preserves its single-tax advantage through an Up-C by forming a separate C corporation, which becomes the company’s publicly traded vehicle and invests proceeds back into the partnership in exchange for interests in the partnership.

An additional tax benefit is established through what is known as a tax receivable agreement, in which the pre-IPO owners and the public company agree to divide among themselves cash savings that can result from a step-up in the structure's tax basis. Accounting firm PricewaterhouseCoopers has estimated that the TRA can result in additional consideration to the selling partners of up to 30 to 40 percent compared with a traditional IPO.

“Pretty much any company currently organized in the U.S. as a pass-through for tax purposes that is considering an IPO should consider the use of this structure,” said Joshua Bonnie, a Simpson Thacher & Bartlett LLP partner. Last year that firm handled building materials company Summit Materials Inc.'s $460 million IPO, which used the Up-C structure.

“There really is no reason not to at least think about it," Bonnie said.

Inviting Complexity

In determining whether the Up-C is appropriate, attorneys say, companies have to consider whether they are prepared to deal with additional complexity that comes with creating a business with corporate and partnership entities.

The multilayered structure of an Up-C increases compliance costs, requires more sophisticated accounting to track the TRA, and adds complexity to shareholder liquidity matters. Companies also need to be ready to explain their elaborate setup when dealing with banks and landlords, making borrowing money and signing leases more complicated.

While none of these additional obligations is trivial, they are generally not a deterrent if a thorough tax analysis has otherwise concluded that the Up-C structure makes business sense for the company, according to attorneys.

"There are incremental costs on an ongoing basis associated with the complexity,” Bonnie said. “I don’t find any of those costs to be particularly insurmountable in any way. None of them are deal breakers."

Attorneys note that the added expenses can weigh more heavily on smaller companies, which already find it harder to go public than larger businesses because small firms have less capacity to absorb the greater costs of becoming a full reporting company with the U.S. Securities and Exchange Commission.

"If you are too small, you can indeed face a situation where those fixed costs can outweigh the benefits that could be achieved from a Up-C structure,” said Remmelt Reigersman, a partner in Morrison & Foerster LLP’s tax division. “In that case, one might decide not to do it.”

Korff said that the larger the anticipated tax benefit, the easier it is to weigh the comparative cost.

“It's not going to be worth it if you are going to generate half a million dollars of tax savings,” Korff said. “If you're going to generate a hundred million dollars of savings, it becomes very much something people think is worth it.”

Raising Capital

Early-stage businesses often convert to corporations to attract more investment from venture capital firms, a group historically known to prefer investing in the simpler and more familiar corporate entities.

Attorneys point out that venture firms also tend to steer clear of investing in partnerships because it can complicate the firms' own tax reporting. If a company chooses to become a corporation to secure more capital, attorneys say, it can foreclose the opportunity to revert to a partnership, which can be costly and impractical.

Aside from private venture funding, according to experts, the broader public markets have become more comfortable with Up-C offerings, which began in 1999 as a variant of the UPREIT structure used in the real estate industry.

Whereas a decade ago, the idea required considerable energy and patience to explain, the distinct qualities of an Up-C are less an issue, now that the market is better educated about the structure, according to Bonnie. The execution of high-profile IPOs last year like Shake Shack's and website domain register GoDaddy Inc.'s, the latter guided by Wilson Sonsini Goodrich & Rosati PC, further eased uncertainties, attorneys say.

“Once you can point to X number of prior deals, people then tend to become more comfortable with the notion of the next one," Reigersman said.

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