Accounting for a Private Equity-Backed Company (#388)
/Additional Accounting Duties
When a private equity firm takes over a business, the accounting department is no longer expected to focus on just the accounting basics, like issuing customer invoices and paying suppliers. Now it’s given some extra targets. The first set of targets is based on the new capital structure of the business. The new owners probably paid for the acquisition with some equity and a whole lot of debt. There could be multiple types of debt that were obtained from different lenders, and each one has different fees and repayment terms and covenants associated with it.
All of these new debt features may have their own accounting implications, including interest expense recognition, debt issuance costs, covenant tracking, and ongoing classifications between current and long-term obligations. Debt is probably now hogging the balance sheet, so getting the debt accounting right is critical.
This concern with debt also carries over into financial reporting – or, more specifically, covenant reporting. Lenders can get really, really twitchy when an acquired company with a big debt load starts to breach its covenants. This means that the accounting staff has to get into predictive accounting mode, and watch the covenants in advance to see if there are going to be any failures. If management is warned in time, maybe they can negotiate new covenants.
A further issue here is that the definitions of performance metrics used in covenant agreements might not be the same as what’s defined in the accounting standards. That means the accounting staff has to conform to the definitions being used by the lenders.
Another issue involves investors. Private equity people do not just want the basic set of financial statements. They’re trying to build the value of the business as quickly as possible, so that they can sell out for a whopping profit. To do that, they’re going to want a lot from the accounting department.
Above all else, they want to know if the company can make its scheduled debt payments. To do that, the accounting staff has to prepare detailed cash flow forecasts – possibly every single day. For this type of investor, life revolves around the cash flow forecast. The owners will want to know about debt service coverage, and how much excess liquidity the company still has – if any. This is especially important if the company doesn’t have consistent sales; if there’s a drop in revenue, maybe due to seasonal or business cycle factors, then the owners will want to see how that impacts the latest cash flow projections.
Financial Statement Acceleration
The next change is that the new investors are going to demand financial statements as soon after the end of the month as humanly possible, so they can spot issues and correct them. So if you haven’t implemented fast close procedures before, then expect to now. The new owners are going to want results within a couple of days of month-end. And on top of that, they may demand financials on a more frequent basis – maybe some sort of a soft close at the end of each week, where you skip doing any accruals. This is going to put a lot of pressure on the accounting staff, so you’ll need to be as efficient as possible. That means using lots of closing checklists, and accrual templates, and setting up automated processes wherever you can.
Variance Analyses
A new issuance that goes along with those financial statements will probably be detailed explanations for negative variances. Private equity people set difficult goals, so it’s entirely possible that the business is going to have lots of variances – of the bad kind. If so, the accounting staff will be expected to track down the causes of those variances, so that the new owners can take action. This can be fiendishly time-consuming, since the accounting staff may have to go all over the business, trying to track down variance issues.
Accounting Policy Standardization
Here's another item. A private equity company probably handles its portfolio of businesses in a standardized manner. For example, it might impose a standard set of accounting policies that cover things like revenue recognition, capitalization policies, and expense classifications to be used. These new policies might differ from the ones that the accounting department was already using. If so, this will change the accounting for some transactions, and also might make it difficult to compare current period performance to what was reported in prior periods. As a very simple example, a new accounting policy might decrease the capitalization limit from $10,000 to $1,000. If so, a lot more expenditures will have to be classified as fixed assets, which is going to boost the reported amount of depreciation expense.
Use of Non-GAAP Measurements
Another issue will be the use of measurements that don’t align with anything authorized by an accounting framework. A prime example is adjusted EBITDA, which lots of private equity firms like to use. EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and each firm has its own set of adjustments to modify it even further. The accounting staff will have to reconcile the differences between adjusted EBITDA and either GAAP or IFRS reporting, depending on what you’re using.
A variation on adjusted EBITDA is key performance indicators, or KPIs. Private equity people evaluate the company’s progress with KPIs. The exact metrics used will vary by industry, but they normally include revenue growth, gross margin, EBITDA margin, working capital efficiency, and one or more leverage ratios. The accounting department is responsible for ensuring that the data used to create these KPIs is accurate. And on top of that, the owners might expect KPI updates a lot more frequently than once a month. This is not a minor task. When it comes to importance, meeting your KPI targets is right up there with the cash forecast.
Exit Planning Documentation
And then we have exit planning. A private buyer very likely comes into its new acquisition on the first day with a plan for how it wants to exit the business. Maybe they plan to flip it to a strategic buyer, or maybe they want to take it public. Either way, they’re going to impose very high reporting standards on the accounting staff, so the financials they produce will be acceptable to buyers, or detailed enough to support going public.
Not only does this require more financial reporting, but also lots and lots of detailed supporting documentation, so there won’t be any questions about whether reported numbers are correct. As an example of this extra reporting, let’s say that the plan is to take the company public in a few years. If so, the accounting staff has to get started with segment reporting right now, so that it can produce historical segment reports when the IPO eventually happens.
Or, as another example, what if the plan is to spin off part of the business? If so, you’ll need to prepare financials for just that part of the business that’s going to be spun off, and may also have to go back in time to create the same reports for the past couple of years.
In short, accounting represents the reporting and feedback loop for private equity buyers. It’s expected to collect specific types of information and churn out reports on a very frequent basis. This can cause a lot of stress within the department, so some pushback is required.
If you’re the company controller, you should demand extra staff to support the additional work, and ask for investments in automation, if that will support what the private equity folks are demanding.