How external auditors help PE-backed firms navigate complexity

Geopolitical risks, ongoing tariff changes, and macroeconomic uncertainty have impacted the PE landscape and dampened dealmaking momentum. Deals continue to happen, despite the challenges, but when windows of opportunity open, PE firms must act quickly.  

The private equity life cycle is complex. PE-backed businesses often operate with financial structures that have nuanced characteristics and arrangements that mean they are often unintentionally caught by requirements of applicable UK financial reporting frameworks; namely UK Generally Accepted Accounting Principles (UK GAAP) and International Financial Reporting Standards (IFRS). 

Common examples of such arrangements include:  

• Preference shares
• Shareholder loans
• Exit fees
• Arrangements subject to ‘leaver’ terms, including ‘sweet equity’ and share options 

In addition, the accounting in highly transactional businesses can add complexities regarding recognition and measurement, such as the identification and valuation of intangible assets and purchase price allocation. These issues can lead to unintended consequences of technical interpretation, judgement and estimation. Meanwhile, the complexity of the calculations and impact on the presentation of the financial performance or position, may result in difficulty understanding the actual picture. 

When management of these businesses prepare financial statements or come to transact, such as a disposal or IPO, further challenges can arise because of these reporting areas. That’s where a skilled and experienced external auditor and financial reporting specialist become indispensable. They build buyer confidence by navigating complexities to prevent costly errors, speed up deal timelines, improve valuation, as well as reduce the risk of issues arising in diligence and post-deal disputes.

Bridging the gap between UK GAAP and PE transactions 

The applicable UK financial reporting frameworks weren’t written with the highly transactional PE markets in mind. Here, funding structures are often complex, blending debt and equity arrangements as well as contingencies linked to continued employment. Some commentators argue that the current presentation of primary financial statements, which report on period performance and balance sheet position, do not help readers to understand the success of the value creation activities being executed by management. 

Consequently, we often see earnings before interest, taxes, depreciation and amortisation (EBITDA) or adjusted EBITDA used as an alternative performance measure (APM). While greater consistency in the APMs used would be helpful, it does at least provide:  

• Useful clarity on the operational performance of the business
• Simplified analysis and greater comparability – by removing the impact of many of the more complex, non-cashflow-impacting requirements of the accounting and reporting standards
• Use in valuing the business and the success of the value creation activities management and their investors are pursuing.   

Because these arrangements are often entered into with specific commercial and other value driven objectives in mind, rather than with a view for the specific effect of application of financial reporting frameworks applicable in the UK, there can be considerable ambiguity, complexity, inconsistency and judgement involved in concluding how to report such transactions. The result is greater potential for misinterpretation, error, difficulties in comparability, and lengthier reporting processes and increased compliance costs.  

What is the strategic impact of an external auditor’s role? 

Management teams need auditors who really understand these intricate issues and bring invaluable insight and perspective. They provide critical support in the following ways: 

• Interpreting standards – challenging management on the correct treatment of complex instruments, such as preference shares and management equity
• Alternative performance measures – ensuring the performance of the business is clearly understood, using consistent comparative benchmarks such as EBITDA, together with useful narrative commentary in Strategic and Directors reports
• Reviewing group structures – ensuring acquisitions, disposals, reorganisations and other critical transactions are accurately reflected in financial statements
• Ensuring accounting policies align with the nature of the business operations and comply with UK GAAP or relevant accounting standards
• Preparing for sale – validating financial disclosures to ensure they present a true and fair view, reducing buyer risk
• Auditing completion accounts – offering assurance over sale price adjustments such as working capital and net debt, including whether the assessment of debt is basic or non-basic
• Managing tax and dividends – supporting correct reporting of distributions, shareholder transactions, loan interest, and tax positions and exposures   
• Strengthening governance – identifying financial risks and control gaps that could arise on diligence and impact deal execution 
• Introducing specialists with relevant experience of similar transactions where the need arises. 

Using financial reporting specialists to complement management

From our experience, using independent financial reporting specialists and engaging external support is most valuable when you need to address the following complex judgements:   

• Classification of financial instruments basic or non-basic under UK GAAP
• Identification of, and accounting complications associated with, embedded derivatives under IFRS, for example, where debt agreements contain prepayment options
• Accounting for the implications of ‘leaver clauses’ where instruments are issued to employees. For example, an employee holding instrument’s ability to participate in the full value of the instrument is restricted if they cease employment before the next transaction.

In addition, support can be useful in post-deal impairment reviews. This is when businesses have been acquired on high multiples but are struggling to achieve the forecasts they've been acquired on. Management will often opt to produce a ‘value in use’ model which tends to be complex to prepare. Independent specialists will be able to support the preparation of the model, but also share insights on deal valuation and market conditions to support a credible fair value less cost to sell calculation.    

Will PE reporting metrics become standardised? 

The applicable UK financial reporting frameworks are unlikely to be re-written anytime soon to accommodate the nuances of private equity funds and their portfolio of investments. But there's a strong case and growing support for developing and agreeing a framework of consistent and tailored APMs to improve transparency and standardisation. 

Organisations such as the Private Equity Industry Guidelines Group (PEIGG) and the Institutional Limited Partners Association (ILPA) are working towards standardising performance metrics that provide better transparency and comparability among funds.   

For their portfolio investments, the advocacy is less developed, but this is where much of the challenge lies. There's a strong argument to be made for information that provides a comprehensive view beyond traditional ‘statutory’ financial reporting metrics. The obvious ones are operational and cashflow metrics, such as EBITDA, margins, revenue growth and liquidity. However, advocates also make a case for including industry-specific benchmarks, stakeholder impact, integrated ESG and long-term value creation metrics, such as strategic growth, innovation and competitive positioning.   

Preparing for success: How we can help 

The challenges of PE reporting will persist, but businesses can mitigate risk by partnering with auditors who understand the terrain. From managing technical judgements to aligning policies and preparing for sale, auditors provide the expertise needed to navigate complexity confidently. 

Early engagement is the key to unlocking opportunity and delivering long-term value. Engaging with an auditor ahead of a sale is a critical step for PE-backed businesses. Proper preparation ensures technical accuracy, regulatory compliance, and smoother transaction execution. 

Grant Thornton is a global leader working as advisors and auditors across the PE landscape. We audit over 500 funds and portfolio investments across a range of sectors in the UK. Our teams of dedicated specialists have the depth of knowledge to confidently chart the course you need through the complexities.      

For further insight and guidance, contact Norman Armstrong and Paul Bamber.