Article:

What do new accounting standards mean for private equity deal prices?

17 May 2018

Justin Hallett , Executive Director |

IFRS 15 and 16 deal with revenue from contracts with customers and leases – and most private equity funds have no revenue or leases. However, they should be paying attention to these standards.

The most significant number on a PE fund’s balance sheet relates to investments and their valuation. Valuations make use of key performance data of the investee entity such as earnings before interest, tax, depreciation and amortisation, net debt and revenue.  

In theory, the new accounting standards should not impact valuations.  IFRS 13, which covers fair value measurement, has not changed so the multiples being used should adjust.

However, a number of key factors challenge the theory:-

  • There will be substantial judgement in applying these standards. Differences in judgement could reduce comparability between available financial data year-on-year.
  • Different entities can also choose from various permitted transitional methods, which will affect comparability in the year of initial application.
  • Without appropriate financial data adjustment, a company under UK GAAP is potentially no longer comparable going forward.
  • Private company valuations are often based on comparable listed company multiples which could be affected by the timing of their adoption of these standards and results release.
  • Net debt may increase making deals look less attractive, subjecting them to downward price pressure.
  • Earn out clauses prepared under previous standards could be impacted meaning currently non-performing earn out clauses may now be in the money and vice versa without contract revisions.
  • The impact to any new earn out clauses should be considered to ensure they operate in the future as intended.
  • Compensation, performance bonuses and other incentives of the management of the investee entity may need amending.

IFRS 15

Badged ‘the revenue recognition standard’, it applies to accounting periods commencing on or after 1 January 2018. It identifies one standard model for how revenue is recognised through customer contracts by:

  • Identifying the contract(s) with a customer;
  • Identifying the separate performance obligations in the contract;
  • Determining transaction price;
  • Allocating transaction price to the separate performance obligations;
  • Recognising revenue when the entity satisfies a performance obligation.

IFRS 15 applies to all contracts with customers across all industries, with two methods of transition:

  • Full retrospective method where comparatives are fully revised as if the standard had been applied historically.
  • Modified retrospective method where comparatives are not revised.

Depending on transition method adopted, results may not necessarily be comparable historically year-on-year nor with previously comparable companies.

The standard may significantly impact revenue, profitability, net debt and other key performance indicators.

Judgement will be required in applying the standard, for example, recognition of revenue on long-term contracts should be a focus of discussions in any deal to understand how the new standard has been adopted and its potential valuation impact.

IFRS 15 will change revenue recognition. In theory, assuming a constant valuation, if revenue is accelerated and EBITDA increased, this should see comparable multiples reduce. Without a full understanding of the comparable and entity in question, a lower multiple versus historic transactions may put sellers off such a deal. Conversely, buyers would prefer the lower multiple.

Likewise, delaying revenue and decreasing EBITDA should increase comparable multiples –and potential for over-paying if not correctly factored in.

IFRS 16

Effective from 1 January 2019, it sets out a model for identification and treatment of lease arrangements. It removes the distinction between ‘off-balance sheet operating leases and ‘on balance sheet’ finance leases for lessees. Subject to a few exceptions, all leases become ‘on balance sheet’ - potentially impacting valuations:

  • EBITDA will increase. Operating lease rentals previously included within administrative costs will be replaced with a depreciation charge in respect of the leased asset together with a finance cost – with both outside of EBITDA.
  • Net debt will increase due to lease liability becoming on balance sheet. Comparable EBITDA multiples will need to change / restate.

In theory, the company’s enterprise value will increase as EBITDA increases and multiples restate. This should be exactly offset by an increase in net debt. In reality, pre and post valuation will not be the same – which goes against logic given it is the same entity. Hence the risk to the deal price without appropriate adjustments.

An advantage of IFRS 16 is consistent treatment of owned or leases assets, improving comparability.

However, from a valuation perspective there is a potential lack of comparability in the net debt position between entities as the net debt only represents the remaining lease period.

Consider two companies identical in all respects, apart from company one having 10 years left on its lease. Company two has one year remaining. Assuming all other things being equal, company one will have a net debt 10 times that of company two.

Without appropriate adjustment for the net debt (or benefit of a longer remaining life of the assets) in cases of materially different leasing profiles, company two would be more expensive – despite essentially being the same entity as company one. After all, company two soon needs a new lease.

Conclusion

Generally, accounting for PE funds should not be impacted, however valuations and deal prices could be. Deeper knowledge of these standards is essential, with care needed when pricing transactions from the buy and sell side.

Ultimately, the business being valued hasn’t changed so valuation shouldn’t change. However, these new operational challenges must be worked through by PE houses.

This article originally appeared in The Guernsey Press.