There are potential accounting and financial reporting complexities when it comes to private equity (PE) transactions. Jennifer Ilsley and Pinkesh Patel outline what you need to know.
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In the first half of 2023 private equity deal volumes in the UK mid-market were down 35% on H1 2022 and 51% down on H1 2021, according to our research (using PitchBook Data, Inc). While deal volumes have stagnated, record amounts of dry powder still exist in the private equity markets, creating a very competitive landscape for high-quality businesses.

Such transactions are rarely simple, however, and often create accounting complexities. Generally speaking, the accounting under FRS 102 and IFRS is aligned but there are also some key differences to consider between the two reporting frameworks, and we've noted these where relevant. 

 

Overview of PE-backed transactions

Most typically, to facilitate a PE-backed acquisition of a business, a new legal corporate structure is created. This involves the incorporation of what is known as 'stack entities' – a chain of holding companies – and the company at the bottom of this stack usually acquires the target company. This group of entities almost always consists of a variation of a 'Bidco', 'Midco' and 'Topco'.

The acquirer (via this stack of entities) typically issues financial instruments, such as series shares, preference shares and loan notes to the PE house, and often members of its own management team, equivalent to the equity value of the acquiree. These instruments can be complex and challenging to account for and value, for accounting purposes, depending on the terms of the instrument.

The PE house collaborates with the management team to drive growth and generate value for the stakeholders. The aim is to exit after a certain period and for all investors to receive the planned return in the exit 'waterfall'.

So what does this mean for the investee?

 

Stack entity accounting

As mentioned, in almost all PE-backed acquisitions funds flow through the stack of entities (typically a Topco, Midco and Bidco) to the acquirer (usually Bidco) and different entities in the stack may issue different instruments. For example, loan notes may be issued by Bidco, whereas shares are issued by the Topco.

More often than not, cash is received by way of intercompany loans issued down the structure to buy out the outgoing business owners’ interest. Members of management then re-invest, creating a circular transaction. Management teams need to consider how funds flow through the entities in the stack, and which entity is issuing each financial instrument.

Once this is established, the next thing to determine is the value at which you bring these instruments on to the balance sheet. Depending on the terms of the instrument, this value may not equate to the cash paid – for example, if an element of the instrument is actually an employee benefit. Employee benefit elements will need to be separated from the underlying instrument (more on this later).

 

Consideration paid and links to employment

Another complexity we see time and again within the framework of PE-backed investments is transactions entered into between the investee and members of management where there are individuals who remain employed by the entity after the PE transaction.

If there's any link between a shareholder being able to participate in share rights, or the holding of such shares, and their continuing employment, it's highly likely that a share-based payment arrangement exists. For accounting purposes a share-based payment arrangement wouldn't form part of the consideration paid to acquire the business, but would instead be treated as an ongoing transaction with employees.

Furthermore, the accounting treatment and disclosures required for such arrangements differs significantly from those related to the issue of 'vanilla' equity instruments. Recording and measuring share issues to employees can be complicated if, for example, there are settlement or redemption options at the discretion of either the employee, or the company, or both.

Similarly, if a member of management holds a debt instrument contingent upon their continued employment by the business, it's highly likely that they're receiving some sort of employee benefit. A quantification exercise may be needed to establish the portion of the instrument that constitutes a loan, and the portion of the employee benefit – again giving rise to accounting complexities.

And if there's contingent consideration, such consideration may be payable so long as individuals remain employed within the business. This needs to be assessed to understand whether it should be accounted for as part of the cost of the business combination, or as an employee benefit – the accounting treatment differing significantly depending on the substance of the transaction.

In all of these instances, complexities can arise in relation to which company within the group incurs the related charge, ie, which company receives the benefit of the employee service.

These flowcharts set out the decision process and accounting outcome, when contingent consideration could be part of the cost of the business combination, or if it should actually be accounted for as remuneration, depending on the reporting framework.

 

Debt versus equity

A common feature of a PE transaction is to issue preference shares, or instruments that contain redemption clauses, listing provisions, or monetary consequences of an exit event. Finance teams need to analyse contract clauses to check for any mandatory cash payments embedded within these agreements, as unavoidable payments usually mean the instrument will need to be accounted for as debt rather than equity. There may even be an interplay between two or more instruments that need to be assessed together in order to conclude on the correct accounting treatment.

Examples of such arrangements are:

  • mandatory dividends
  • share conversions from one class to another in the event of a listing
  • mandatory repayments on an exit event
  • exit fees, set as a percentage of the ultimate sale price, which are unavoidable.

If a preference share contains these types of clauses, it's highly likely that the instrument will need to be accounted for as debt as opposed to an equity instrument.

 

Transaction costs

Unlike IFRS, where generally transaction costs need to be expensed, under FRS 102 certain transaction costs associated with a business combination can be capitalised as part of the cost of investment, as opposed to expensing these through profit or loss. As a general rule, if the transaction cost would have been avoided but for the transaction, it may be capitalised against the item it relates to.

Management needs to closely analyse transaction costs incurred as part of the investment to establish who incurred them, and how to account for them, including what happens on consolidation. Sometimes they're not obviously attributable to one particular instrument and a reasonable apportionment is needed to allocate them.

The flowchart below sets out the accounting requirements depending on which framework is applicable:

 

Note that in respect of transaction costs associated with issuing debt instruments, both IFRS and FRS 102 are generally aligned whereby direct costs of issuing the debt would be capitalised against the financial instrument (as opposed to expensed). Similarly, both reporting frameworks stipulate that equity instruments issued as part of the deal should be measured at their fair value, net of transaction costs (if these are directly attributable).

 

Consolidations

Due to the formation of a new legal corporate structure, there'll almost certainly be a requirement to consolidate the group at least at one level, if not more. Finance teams may need to implement controls and processes, or create capacity within the team to cope with these additional reporting requirements.

There are often potentially both financial and non-financial covenants attached to PE investment which require audited financial statements to be completed, often significantly earlier than usual Companies House filing deadlines. This can also place additional pressure on finance teams to produce consolidated (and audited) financial statements in the requisite timeframes.

Exemptions from consolidation are available, depending on the size of the group, and if the entities are included in a consolidation higher up in the chain of ownership. And if holding companies are incorporated in other jurisdictions, for example, the Channel Islands, consolidation and filing requirements may differ from those required by UK reporting frameworks and Company Law.

 

Acquisition accounting

The acquisition of the target entity, or entities, will be a business combination for accounting purposes, triggering the need for acquisition accounting in the consolidated financial statements of the group. This may be a new challenge for finance teams who don't usually deal with such transactions. Depending on the financial reporting framework, a purchase price allocation (PPA) exercise may be needed to allocate the price to the assets and liabilities acquired, including any separately identifiable intangible assets, which may not have been recognised previously in the target entity.

This usually involves valuation expertise and finance teams may need to engage with specialists to support them, particularly in valuing items such as customer contracts or brands.

Differences between reporting frameworks in relation to separately identifiable intangible assets:

 

Distributable reserves

As a result of the PE transaction, businesses often incur significant interest charges on the debt issued. If the company in question is simply a holding entity for the debt – in other words, it doesn't otherwise trade – this can put it into a loss-making position. The directors are ultimately responsible for the distributable reserves of the company incorporated in the UK and should therefore ensure they've considered the impact such transactions may have on future capital returns.

 

Other considerations

The Financial Reporting Council (FRC) published a Financial Reporting Exposure Draft (FRED 82) on 15 December 2022, which proposes a number of changes to FRS 102, following the second periodic review of FRS 102 and other financial reporting standards.

FRED 82 proposals include:

  • a new model of revenue recognition (for FRS 102 and FRS 105)
  • a new model of lease accounting (for FRS 102 only)
  • various other incremental improvements and clarifications.

The aim of this second periodic review was to produce amendments to FRS 102 to better align the standard to IFRS, incorporating the IASB’s latest proposed changes to the international financial reporting requirements. While the changes are not yet issued, they're designed to come into effect for periods beginning on or after 1 January 2026

The proposed changes will significantly impact earnings before interest, tax, depreciation and amortisation (EBITDA) and revenue recognition – two important metrics for PE houses. If this is likely to impact your business, you'll need to work with the PE house in order to understand the effect on your corporate reporting, management information and any covenants.

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Learn more about how our Financial accounting advisory services (FAAS) services can help you

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How we can support you

Our team has helped numerous clients navigate the challenges associated with accounting for private equity-backed transactions, including: accounting expertise, support with processes and controls, and placing extra finance team members to assist with pulling data and information.

If you're anticipating or have recently undergone a PE-backed transaction, get in touch with Jennifer Ilsley or Pinkesh Patel for further insight and guidance on these topics.

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