Okay, this is my 2nd accounting question today, but I have a superday next Friday and accounting is my weak point.
In my last superday, I had a question about how the statements are affected when you go from equity to debt, like in an LBO. I didn't know the answer and I've searched on here but have seen a few different answers to this question. Does anyone know the correct answer to this one?
Any other accounting questions regarding the effect on the statements that I should be prepared for?
There are several ways an LBO can impact a company's financials, although most of the adjustments occur on the balance sheet. Below is one simplified example (although there are a number of different ways this can actually work):
Any preexisting cash and debt of the company are assumed by the former owners, and as such get swept off the balance sheet. On the L / OE side of the BS, debt increases by the amount of total leverage on the deal, while the balance of the purchase price (including deal fees) gets be classified as common and / or preferred equity.
On the asset side of the BS, goodwill increases by the purchase price (excluding deal fees) less the pre-deal book value of assets (excluding any cash that was swept), while deferred financing costs are increased by the amount of total deal fees and expenses for the buyer.
This is for a standard LBO.
B/S
Liability Side Old debt remains about the same although technically old debt is typically refinanced with new debt due to change of control put provisions in the bonds/loans which call for retirement of the bonds at 101% of par when a 3rd party acquires a certain stake, or when there is a change of control. Since the targets risk profile/capital structure has changed, the rates on old debt aren't reflective of this new risk profile and capital sructure resulting from the LBO, so old debt (especially bonds) are usually redeemed. Redemption ultimately depends on the covenant in the notes.
New LBO debt For LBOs new debt is added onto B/S - junk paper, secured debt, etc.
SH Equity Since all the stock is effectively redeemed, and replaced with sponsor equity, just plug in the value of the equity investment. But for a leveraged recap of a public company this is not the case, as you can actually have -VE SH equity, but we can save this for another day....
Asset Side Tangible/Intangible Items Not to bog you down with details, but for GAAP and even for the 1060 allocation on the tax side PPA, you will fair value all the identifiable tangibles and intangibles, so there may be a step up/step down. This is called a 141 allocation of purchase price, which is very very important to the sponsor since he can get some tax shields if its a taxable step up transaction.
Regardless of whether the deal is structured as a stock or an asset purchase, for GAAP, the 141 PPA is typically done so that when the target goes public again, or at least if it gets sold to a public strategic buyer, you at least have a credible B/S to work with.
But for tax, depending on whether it is structured as an asset purchase or a stock purchase, there may or may not be a step-up/step-down. We can save this for another day, as I don't foresee this coming up in an interview....
Transaction costs Advisory fees, legal/accounting fees are just indefinite-life intangibles, so these don't amortize but sit on B/S like Goodwill.
Loan financing costs Capitalized debt issuance costs must now amortize along the life of their respective liabilities - bonds, loans, etc., and as such are fully tax deductible, just like OID's in zero coupon bonds.
Goodwill Any excess over the aggregate FV of tangibles and intangibles is allocated to goodwill. Again for tax, depending on whether the deal is structured as a tax free stock swap deal, or a taxable asset purchase, goodwill may or may not be amortizable, or even recognized...
Most LBOs are structured as mergers using simple stock purchases so the goodwill here does not amortize, but this is not the case for asset purchases.
Purchase Price = Stepped-up assets + Goodwill = Liabilities (including new debt) + SH Equity (from sponsor).
The I/S and CF statements are generally the same, except tax deductible interest expenses would likely go up since you have more debt.
Also, if there is a step/up in assets, then you'll have higher D&A expenses, which is good for the sponsor since he gets a tax amortization benefit which ultimately helps his cash flow available for debt service.
Goodluck!
Wouldn't the Financing part of the CF Statement also go up because new debt was issued?
Yes new debt is issued (loans, junk paper, and refinancing of exisiting debt), but the debt is really used to buyout the company's stock that trades in the market, so net-net while you are correct in that you raise capital now for the buyout ("CF from financing activities, new debt issue") you spend it almost immediately in buying out the existing shareholders and then you de-list and start over with a fresh balance sheet after the 13e3s only for GAAP.
Technically, the line that nets out the debt issue is ("CF from investing activities (-ve, stock buyback)", but this never happens because by then the company doesn't have to file with the SEC unless it has more than ... I think 50 shareholders or so, you can look it up.
Think of it this way - LBOs and frankly all leveraged forms of recapitalizations all have one thing in common. Debt always increases and shareholders equity always reduces (-VE contra equity account, so B/S always balances) and unlike productive debt used to fund operations and results in capex and new assets captalized on B/S ....., leveraged recap debt never adds new assets to the asset side of balance sheet, that's why debt associated with leveraged recaps and buyouts are all non-productive debt. In fact, if you over lever in a leveraged recap, you will eventually end up with -ve SH equity on B/S.
Dude, this is some solid info you've posted. Thanks much!
posts like thedonmega are a great example how you can become a Certified User and get the bright yellow star next to your name. may we all aspire to such lofty goals.
Very good post.
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