By Tim Mundy, Deloitte & Touche
One of the biggest shifts in corporate finance since Sarbanes-Oxley is barreling toward private companies and their PE backers.
We’re talking about the new revenue-recognition-accounting standard from the Financial Accounting Standards Board and International Accounting Standards Board.
On Jan. 1, private companies in all industries will have to conform to the new revenue-recognition model and follow new principles for reporting on the nature, amount, timing and uncertainty of revenue from customer contracts.
The new standard could also have a profound effect on how PE investors treat their owned private companies by influencing several key financial metrics and ratios, including revenue and Ebitda.
Broader implications for dealmaking and pre-transaction, post-transaction and ongoing fair-value measurements are also likely. Although the new standard introduces a consistent framework, as with any regulation, ambiguity in areas that require judgments clearly exists – and it will take time to get clarity around those.
As a result of changes to financial metrics, the new standard could have a variety of positive and potentially negative effects on the valuations of portfolio companies that investors should consider.
For example: Imagine it’s Q1 2019. A portfolio company has maintained business operations identical to Q4 2018, yet it is reporting $25 million less in revenue at the same multiplier. Consequently, the company’s valuation has gone down and the limited partners are demanding an explanation.
What happened? The company shifted toward a revenue-recognition model wherein it now delays recognizing revenue until after services are rendered.
In other scenarios, valuations may rise if a company moves to recognize revenue earlier (i.e., upon contract signing), while other companies may report no changes at all.
These potential outcomes will require investors to evaluate each portfolio company and customer contract to assess the impact on valuation. Following are samples of key considerations PMs can use to hedge against risks associated with current portfolio holdings, acquisition targets, and divestments.
- Implementation plans (existing investments): Timing is vital, particularly when a portfolio company plans to adopt the new standard compared to its peers, as well as the method of adoption – i.e. full retrospective versus modified retrospective. Doing this will help PMs align entry multiples pre- and post-adoption, determine the impact of the standard on cash-flow projections, and adjust valuation models.
- Acquisition due diligence (pre-transaction): How prepared is the target company for the accounting change? Do you know when it currently recognizes revenue and how the new standard may change that? It’s also important to get a sense of potential impacts on the company’s cash-flow projections, as well as the costs and resources necessary to implement the standard. If identified, any new finance arrangements could prompt consideration of the impact on financial metrics before negotiating debt covenants.
- Taxes (post-transaction): Assess how changes in the timing of revenue recognition versus cash receipts potentially affect recognition of tax expenses, benefits, and deferrals as well as state apportionment factors, sales and property taxes, and transfer pricing.
In closing, let’s address a misconception often heard on this standard.
Many PE investors are at first dismissive of it, arguing that it will flush itself out by the time they exit current investments.
Our response: Anytime there is a change to how companies judge or evaluate revenue, it will likely affect investors. Understanding the new standard now will not only help PE investors address the potential shifting financial results of their investments but may also position them for stronger returns in the long run.