Accounting & Financial Reporting Throughout the Transaction Lifecycle
Accounting & Financial Reporting Throughout the Transaction Lifecycle
Stout’s Steve Hills and Simba Dutt-Mazumdar featured in PitchBook’s Q2 2022 US PE Breakdown Report.
This Q&A was published as part of PitchBook Q2 2022 US PE Breakdown sponsored by Stout.
How do you expect current economic conditions to impact transaction volume and execution?
Steve: As it relates to M&A activity, we’re not observing any slowdown. Transactions overall do not seem to be significantly challenged in terms of velocity and volume. What we are seeing is a shift in the distribution of transactions. For example, the SPAC market has all but dried up, and recent stock market volatility has stalled the IPO market. However, many of our clients continue to move forward with their IPO preparation efforts in order to be ready when the IPO “window” reopens.
Any commentary around future M&A or IPO transaction activity is speculative. What we do know is (a) there is still a substantial amount of dry powder within the private equity (PE) ecosystem, and (b) our PE clients continue to maintain robust M&A pipelines. We’re actively factoring this into our efforts to manage capacity for services that support M&A activity, particularly in the areas of accounting, financial reporting, and post-merger integration.
Simba: PE-driven activity continues unabated, specifically with respect to PE-backed companies that are approaching or have exceeded their hold period. We are seeing PE firms announcing their intent to sell portfolio companies or begin preparation, driving continued demand for financial statement preparation, sell-side due diligence, and other transaction-readiness type of activities.
How does accounting & reporting advisory fit into the M&A transaction lifecycle?
Steve: We recommend approaching a transaction with a holistic suite of accounting and finance services that are applicable throughout the deal lifecycle. Historically, accounting advisory firms focused on M&A-related compliance matters—for example, accounting for the acquisition under US GAAP, accounting for complex earnouts, or accounting for stock-based compensation awards. Our experience has shown that leveraging a mix of traditional accounting advisory professionals, as well as management consulting practitioners experienced in finance-focused process improvement and transformation, can help ease the integration experience post-close and potentially even accelerate the return on investment of a transaction.
Simba: Combining technical accounting and finance process expertise can help solve for any number of challenges that the accounting and finance departments might face in the throes of an M&A transaction across reporting, compliance, technology, service delivery model, and sub-processes.
What are the most important accounting issues for companies to consider toward the end of their hold periods and as they prepare for a sale transaction?
Simba: Being prepared for a full commercial diligence process is a key predictor of ultimate deal success. Additionally, sell-side preparedness, particularly with respect to earnings before interest, taxes, depreciation, and amortization (EBITDA) and net working capital positions sellers to effectively drive negotiations and avoid unexpected purchase price adjustments during the diligence process. Many companies engage a sell-side diligence provider to prepare a proactive Quality of Earnings analysis. The sell-side provider prepares management for the tough questions from the buyer and their representatives. In addition, sell-side diligence identifies issues that can be mitigated or resolved. If issues are uncovered that may be viewed as unfavorable, the diligence readiness process allows management to embrace first mover advantage in terms of setting the parameters of discussion when issues are surfaced by the buyer. In some cases, it can make sense for the company to introduce those issues during the commencement of diligence to build trust and reduce churn in the negotiation process.
Steve: Some accounting issues that commonly cause issues during the sale process include contingent or unrecorded liabilities, revenue recognition, inventory and accounts receivable reserves, and capitalized costs. As relates to the deal structure, certain items can cause additional accounting complexity, including earn-outs, exchange of stock-based compensation awards, and equity-denominated purchase consideration.
Are there specific deal structure items that can cause accounting surprises?
Steve: Yes, there are a number of common deal structure items that can result in non-intuitive accounting treatment. In my experience, first on that list is earn-outs. Earn-outs are commonly used to mitigate deal risk and align future incentives between buyer and seller. These mechanisms can also serve as a bridge between disparate buyer and seller valuations. While they are often a practical solution, earnouts can create significant accounting complexity, both with regard to purchase and post-transaction accounting. Depending on how they are structured, earn-outs may be treated as additional purchase consideration, post-combination compensation expense, or a combination of both. Earn-outs treated as post-combination compensation expense will impact future EBITDA and may need to be considered in deal models.
Another area that can cause accounting complexity is debt raised to finance a transaction. Often times, transaction debt is complex, with various embedded features, including conversion and redemption options. These features may need to be accounted for separately of the debt, potentially on a fair value basis. In addition, transaction debt often includes discounts and deferred financing costs that must be accounted for as effective interest over the term of the instrument.
Finally, I’d point to stock-based compensation awards that are modified or exchanged for new awards tied to acquirer equity as part of the transaction. Depending on the specific fact pattern, modification or exchange of stock-based compensation awards can impact predecessor expense, purchase price, and/or post-combination expense.
Once a transaction closes, what are some of the most common challenges companies face when integrating back-office finance and accounting functions?
Simba: Within middle-market PE, portfolio companies typically reflect a platform company purchased at a relatively high EBITDA multiple with bolt-on and tuck-in acquisitions added at comparatively lower multiples. These platforms generally struggle with producing financial data for decision support on a timely basis and capturing synergies across the back office. This is driven by the presence of fractional fulltime equivalents across administrative functions, multiple ERPs or general ledger systems, and back-office staff with varying levels of competency and capacity. These bolt-on organizations are rarely poised to meet the incremental challenges of being part of a larger concern.
Planning for day one readiness upon execution of either a letter of intent or binding purchase agreement can go a long way toward mitigating these issues and ensuring a more productive integration path.
Traditionally, PE has not established a true Integration Management Office (IMO) to manage incoming businesses. However, in an era where bolt-on and tuck-in acquisitions are standard practice, the traditional PE integration playbook is no longer sufficient.
Realizing the above, PE companies continue to embrace establishing an IMO that is a mix of PE, platform, and external professionals.