Combining Portfolio Companies — Demystifying the Accounting Implications
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Strategic restructurings are behind many successful private equity exits. To unlock value, boost investor returns, and strengthen exit readiness, private equity firms often reorganize their portfolio companies. Sometimes, they merge businesses held in the same fund; other times, they combine companies from different funds under a single entity.
When these transactions occur, private equity firms and their portfolio companies must determine whether the transaction results in a business combination or a transaction between entities under common control. Correctly classifying these transactions can be complex; however, the resulting accounting significantly affects the financial statements. Reaching appropriate conclusions is important for accurate financial reporting and timely completion of audit procedures. This Bulletin demystifies the accounting.
Key Takeaways
- Combining portfolio companies within the same fund may result in a common control transaction.
- Combining portfolio companies from separate private equity funds (even within the same family of funds) often results in a business combination.
- Reaching a conclusion requires analyzing whether the portfolio companies are under common control, as determined under U.S. GAAP.
- Common control occurs when one person or entity has control (as determined under U.S. GAAP) both before and after the transaction, which may be under the voting model or the variable interest entity model.
- The variable interest entity (VIE) model requires both power and economics for control to exist.
- The accounting outcome significantly affects asset valuation, goodwill recognition, and historical financial statement presentation.
Business Combination vs. Common Control: Why Does it Matter?
The accounting for business combinations significantly differs from the accounting for common control transactions. Therefore, when combining portfolio companies that are held in the same fund, or in two different funds of the same private equity firm (often referred to as a family of funds), it is important to determine which accounting model applies.
First, it is important to understand how “business combination” and “common control transaction” are used in practice:
- Business Combination: A transaction in which an acquirer obtains control of a business, which is “an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.” (ASC 805, Business Combinations)
- Common Control Transactions: The transfer of net assets (or a business) or the exchange of equity among entities under the control of the same ultimate parent, which could be an entity; individual; or common control group, such as a married couple. To be a common control transaction, the same entity or person must control both companies both before and after the transaction. (ASC 805, Business Combinations — Related Issues)
If a change in control occurred, the transaction may require business combination accounting. However, if a change in control did not occur, it is accounted for as a common control transaction.
Some portfolio companies and private equity firms might prefer business combination accounting because the financial statements will reflect the current fair values of the acquiree’s net assets. Other portfolio companies and private equity firms might prefer carryover basis (as is required in a common control transaction) because it facilitates greater comparability of the companies’ performance pre- and post-transaction. However, the accounting for the acquisition of one portfolio company by another is not a free choice; rather, the accounting is determined by an evaluation of the facts and circumstances, which can be time-consuming. Reaching the right conclusion requires gathering all relevant information, including governing documents and capitalization tables, not only of the portfolio companies involved, but often also for the funds and their general partners (GPs).
| BUSINESS COMBINATIONS | COMMON CONTROL TRANSFER OF A BUSINESS |
|---|---|
| The accounting acquirer recognizes net assets acquired generally at their acquisition date fair values, with some exceptions.2 Noncash consideration issued and noncontrolling (or minority) interests outstanding after the transaction are both also measured at fair value. These valuations can be time-consuming. | The receiving entity1 records the acquired portfolio company’s net assets at their carrying values (or at the parent’s basis if different from carrying value). In this context, the “parent” would typically be the fund that previously controlled the acquired portfolio company. |
| The accounting acquirer recognizes goodwill for the excess of the sum of (i) the fair values of the consideration transferred, (ii) the noncontrolling interest, and (iii) the acquirer’s previously held equity interest, over the net assets acquired.3 | The receiving entity records any difference between the consideration transferred (including equity issued) and the carrying value of the transferred portfolio company’s net assets as an equity contribution or distribution. |
| The accounting acquirer recognizes the business combination on the date it obtained control of the acquiree, which typically is the closing date of the transaction, with no retrospective revision to the financial statements. Accounting policies and fiscal year ends are generally conformed prospectively. | The receiving entity generally revises retrospectively revises its financial statements as if it had controlled the acquired portfolio company for all periods presented. This may require retrospectively conforming accounting policies and fiscal year ends. |
| Transaction costs are expensed. | Transaction costs are generally presented as a reduction in equity. |
This bulletin also discusses:
- How common control is determined under U.S. GAAP
- When transferring a portfolio company is a common control transaction
- Whether common control is the same as common management
- Common pitfall in common control analyses
Download this bulletin to learn more about these topics
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1 The accounting acquirer and the receiving entity for accounting purposes in a common control transaction are not always the same as the legal acquirer. Additional analyses may be needed to make these determinations.
2 See Chapter 4 of BDO’s Blueprint, Business Combinations Under ASC 805, for recognition and measurement exceptions.
3 In the rare circumstances where the consideration transferred is less than the net assets acquired, the accounting acquirer recognizes a bargain purchase gain.