Leveraged buyout IFRS 3 best reporting

Leveraged buyout IFRS 3 best reporting – In corporate finance, a leveraged buyout (LBO) is a transaction where a company is acquired using debt as the main source of consideration. These transactions typically occur when a private equity (PE) firm borrows as much as they can from a variety of lenders (up to 70 or 80 percent of the purchase price) and funds the balance with their own equity. Leveraged buyout IFRS 3 best reporting

1 The process and business reason

The use of leverage (debt) enhances expected returns to the private equity firm. By putting in as little of their own money as possible, PE firms can achieve a large return on equity (ROE) and internal rate of return (IRR), assuming all goes according to plan. Since PE firms are compensated based on their financial returns, the use of leverage in an LBO is critical in achieving their targeted IRRs (typically 20-30% or higher).

While leverage increases equity returns, the drawback is that it also increases risk. By strapping multiple tranches of debt onto an operating company the PE firm is significantly increasing the risk of the transaction (which is why LBOs typically pick stable companies). If cash flow is tight and the economy of the company experiences a downturn they may not be able to service the debt and will have to restructure, most likely wiping out all returns to the equity sponsor. Leveraged buyout IFRS 3 best reporting

2 What type of company is a good candidate for an LBO?

Generally speaking, companies that are mature, stable, non-cyclical, predictable, etc. are good candidates for a leveraged buyout.

Given the amount of debt that will be strapped onto the business, it’s important that cash flows are predictable, with high margins and relatively low capital expenditures required. This steady cash flow is what enables the company to easily service its debt. In the example below you can see in the charts how all available cash flow goes towards repaying debt and the total debt balance (far right chart) steadily decreases over time.

But also larger companies in an industry mainly consisting of smaller companies, building on economies of scale.

3 IFRS reporting specifics

The IFRS reporting specifics are IFRS 2 Share-based payments, IFRS 3 Business combinations, IFRS 5 Non-current Assets Held for Sale and Discontinued Operations,  IFRS 13 Fair value measurement, IFRS 7/IFRS 9 Financial instruments, IAS 38 Intangible assets or:

• Recognise the identifiable assets acquired and the liabilities assumed, Leveraged buyout IFRS 3 best reporting
• Identify intangible assets, Leveraged buyout IFRS 3 best reporting
• Measurement of identified assets and liabilities assumed at fair value at the acquisition date, Leveraged buyout IFRS 3 best reporting
• Disclosure of the acquisition: Leveraged buyout IFRS 3 best reporting
• Intangible assets, Leveraged buyout IFRS 3 best reporting
• Fair value measurement, Leveraged buyout IFRS 3 best reporting
• Related party disclosures Leveraged buyout IFRS 3 best reporting
  • Financing arrangements private equity firm, Leveraged buyout IFRS 3 best reporting
  • Key management personnel Leveraged buyout IFRS 3 best reporting
  • Share-based payments Leveraged buyout IFRS 3 best reporting

4 Recognise the identifiable assets acquired and the liabilities assumed

Often, a target will have assets (e.g., internally developed intangibles) and liabilities (e.g., contingent liabilities) that are not recognized in the predecessor financial statements, even though they meet the definition of assets and liabilities.

4.1 The identifiable assets acquired

Assets are considered identifiable if

1. the asset can be separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, or
2. the asset arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations

Examples of assets that can be recognised under 1, the separability criterion are (among others):

• Customer lists and non-contractual customer relationships. Customer lists may include data such as name, age, geographical location or history of orders. Customer list is recognised as an intangible asset if the terms of confidentiality or other agreements or simply the law do not prohibit the entity from selling, leasing or otherwise exchanging the list. (IFRS 3 IE24, IFRS 3 IE31).
• Technology-based intangible assets (IFRS 3 IE39-IE44)

Examples of assets arising under 2, from contractual or other legal rights are:

• Licences to operate in a specific sector, geographical area etc. even if not separable from the related assets or legal entity.
• Legally protected trademarks (IFRS 3 IE18-IE21).
• Internet domains (IFRS 3 IE 22).
• Customer contracts and orders, together with related customer relationships (IFRS 3 IE25-IE30). Contracts and placed orders (even if cancellable) arise from contractual rights and therefore need not meet the separability criterion in order to be recognised. In other words, they are recognised even if the terms of confidentiality or other agreements or simply the law prohibit the acquirer/target from selling, leasing or otherwise exchanging these contracts.

Customer relationships meet the contractual-legal criterion if an entity has a practice of establishing contracts with its customers, regardless of whether a contract exists at the acquisition date (IFRS 3 IE30(c)).

• Copyright materials such as films, books etc. (IFRS 3 IE32-IE33).
• Contract-based intangible assets. Lots of examples of contract-based intangible assets are given in IFRS 3 IE34-IE38
• Technology-based intangible assets (IFRS 3 IE39-IE44)

Potential identifiable assets to consider that are not identifiable are included in goodwill (IFRS 3 B37-B40). Examples of such assets are:

• assembled workforce
• potential contracts
• synergy benefits
• contingent assets
• expected renewals of reacquired rights

Other specific identified assets under IFRS 3 are:

• Identified in-process research & development projects,
• Identified assets not intended to be used

But off course ‘normal’ assets are also part of the identifiable assets such as property, plant and equipment, inventories, trade debtors, etcetera.

4.2 The liabilities assumed

On acquisition, entities recognise all liabilities if there is a present obligation and possibility of reliable measurement. In particular, entities recognise assumed contingent liabilities for which a present obligation exists, even if the probability of outflow of resources is lower than 50% (IFRS 3 22-23).

Conversely, entities cannot recognise liabilities for future expenditures for which there is no present obligation as at the acquisition date. So any restructuring that the acquirer plans to carry out is not recognised at the acquisition date.

Only a restructuring documented by management of the acquired entity on a date before the acquisition date is recorded in the acquisition balance sheet (i.e. a restructuring that was already on the way before the acquisition process was even started).

5 Measurement of identified assets and liabilities assumed

5.1 Measurement of assets

Once it has been determined that an asset exists as of the acquisition date and is part of the business combination, the asset is measured at fair value in accordance with IFRS 13 (i.e., the price that would be received to sell the asset in an orderly transaction between market participants). This includes assets acquired that an entity does not intend to use to their highest and best use.

Defensive assets are those that an acquirer purchases in a business combination that it does not intend to actively use, develop or exploit, but intends to retain in order to prevent competitors from obtaining them. Although the acquiring entity does not intend to use these assets, the measurement of these assets is based on a market participant perspective.

5.1.1 Exceptions to the recognition and/or measurement principles

There are certain exceptions to the recognition and/or measurement principles which cover contingent liabilities, income taxes, employee benefits, indemnification assets, reacquired rights, share-based payments and assets held for sale.

Income tax assets and liabilities

For periods prior to the transfer or exchange date, deductible temporary differences and operating loss and tax credit carry-forwards of one of the combining entities cannot offset taxable income of another combining entity because a consolidated tax return could not be filed for those periods.

However, if the combining entities expect to file consolidated tax returns subsequent to the combination, the realizability of a deferred tax asset related to either of the combining entity’s carry-forwards and deductible temporary differences in the restated period should be assessed presuming a consolidated tax return will be filed subsequent to the combination date.

A valuation allowance would be recognized if it is more likely than not that a tax benefit will not be realized through offset of either (1) the other entity’s deferred tax liability for taxable temporary differences that will reverse subsequent to the combination date or (2) combined taxable income subsequent to the combination date.

Tax basis differences

In a taxable transfer of net assets or exchange, the tax basis of the acquired company’s assets and liabilities may be adjusted to fair value. Because a new basis is not established for book purposes, a change in tax basis results in temporary differences for which deferred taxes must be recognized.

Employee benefits

Employee benefit arrangements within the scope of IAS 19 are exceptions to the measurement and recognition criteria and are to be measured in accordance with the applicable standard. Due to the intricacies and complexities associated with valuing pensions and other post-retirement benefits in accordance with existing requirements, the IASB concluded that the only practicable method of accounting for such obligations and related assets in a business combination would be under the applicable standard.

Indemnification assets

The target in a business combination may contractually indemnify the acquiring entity for the outcome of a contingency or uncertainty related to all or part of a specific asset or liability. In other words, the target will guarantee that the acquirer’s liability will not exceed a specified amount, resulting in the acquirer obtaining an indemnification asset.

The asset is recognized at the same time and on the same basis as the indemnified item (i.e., the related contingent liability). That is, if the pre-acquisition contingency is measured at fair value on the acquisition date at acquisition-date fair value, the same is done for the related indemnification asset.

Reacquired rights Leveraged buyout IFRS 3 best reporting

As part of a business combination, an acquirer may reacquire a right that it previously granted to the target to use one or more of the acquirer’s recognized or unrecognized assets. IFRS 3 requires a reacquired right to be recognized as an identifiable intangible asset separate from goodwill, and a settlement gain or loss to be recognized to the extent the terms of the contract differ from current market terms. Leveraged buyout IFRS 3 best reporting

From a measurement perspective, IFRS 3 precludes including the value of any renewal rights in determining the fair value of the intangible reacquired right asset. Although market participants generally would include such renewal rights in determining fair value, the IASB observed that an acquirer who controls a reacquired right could assume indefinite renewals of its contractual term, effectively creating an indefinite-lived intangible asset.

Accordingly, the Board decided to measure reacquired rights based solely on the remaining contractual term.

Share-based payments Leveraged buyout IFRS 3 best reporting

In business combinations, share-based payments (stock, stock options and similar instruments) held by employees of the target frequently are exchanged for equity instruments of the acquiring company. The equity or liabilities exchanged (of both the former awards in the target and the new awards of the acquiring company) might be vested or unvested.

One of the exceptions in IFRS 3 to measuring assets acquired and liabilities assumed at fair value, as defined in IFRS 13, is the measurement of share-based payment awards. A liability or equity instrument issued to replace the acquiree’s share-based payment awards is measured in accordance with the fair-value-based measurement provisions of IFRS 2 Share-based payments.

Assets held for sale

The acquirer measures an acquired non-current asset (or disposal group) that is classified as held for sale at the acquisition date in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations at fair value less costs to sell (IFRS 5 15–18).

5.1.2 Measurement of acquired assets

Intangible assets Leveraged buyout IFRS 3 best reporting

The assets acquired in a business combination are measured at their acquisition date fair values (IFRS 3 18). However, there are a few exceptions to this measurement principle. If an asset has a quoted price in an active market (for example, listed shares), this price is used as fair value. However, few assets have such quoted prices. Fair value then needs to be estimated using a valuation technique. Leveraged buyout IFRS 3 best reporting

Estimating fair values can be a complex exercise requiring considerable management judgement. Many acquirers engage professional valuation specialists to assist in this stage of the process.

Valuation models and techniques can be grouped into three broad approaches: Leveraged buyout IFRS 3 best reporting

Whichever technique is used, the resulting valuation should be consistent with the definition and underlying concepts of fair value. The acquirer should ensure that the valuation:

• has an objective to estimate the price that would be paid or received in a hypothetical sale or transfer to other market participants (ie potential buyers and sellers)
• uses techniques and assumptions that are consistent with how other market participants would determine fair value
• does not take account of factors that are specific to the actual acquirer, such as the acquirer’s intended use of an asset or synergies that would not be available to other market participants
• reflects conditions at the acquisition date Leveraged buyout IFRS 3 best reporting
• utilises observable market inputs when available Leveraged buyout IFRS 3 best reporting
• incorporates IFRS 3’s specific guidance: Leveraged buyout IFRS 3 best reporting
  • Assets with uncertain cash flows (valuation allowances) (IFRS 3 B41) – the acquisition-date fair value of assets such as receivables and loans should reflect the effects of uncertainty about future cash flows. A separate valuation allowance should not be recognised Leveraged buyout IFRS 3 best reporting
  • Assets subject to operating leases – acquiree is the lessor (IFRS 3 B42) – the acquisition-date fair value of an acquired asset (eg building or patent) subject to an operating lease should take into account the terms of the lease (eg whether it is favourable or unfavourable compared to market terms)
  • Assets that the acquirer intends not to use or to use in a way that is different from the way other market participants would use them (IFRS 3 B43) – fair value should be determined in accordance with the asset’s expected use by other market participants and should not be affected by the acquirer’s intended use of the asset

5.1.3 Measurement of liabilities

The liabilities assumed in a business combination are measured at their acquisition date fair values (IFRS 3 18). If a liability has a quoted price in an active market, this price is used as fair value. However, few assets and even fewer liabilities have such quoted prices. Fair value then needs to be estimated using a valuation technique.

Estimating fair values can be a complex exercise requiring considerable management judgement. Many acquirers engage professional valuation specialists to assist in this stage of the process.

Pension and post retirement obligations Leveraged buyout IFRS 3 best reporting

Pension and post retirement obligations are recognised and measured in accordance with IAS 19 Employee Benefits. The present value of defined benefit obligations should include items (even if not previously recognised by the acquiree), such as: Leveraged buyout IFRS 3 best reporting

• actuarial gains and losses arising before the acquisition date Leveraged buyout IFRS 3 best reporting
• past service cost arising from benefit changes or the introduction of a plan, before the acquisition date

Any net plan asset recognised is limited to the extent that it will be available to the acquirer as refunds from the plan or a reduction of future contributions

The effect of any settlement or curtailment is recognised in the measurement of the obligation only if it occurred before the acquisition date

Contingent liabilities Leveraged buyout IFRS 3 best reporting

A pre-acquisition contingency of a target is a loss contingency that existed prior to the consummation of the combination (regardless of whether it was recorded by the target prior to the business combination).

A pre-acquisition contingency is contingent liability, and it represents one of the exceptions to the measurement and recognition criteria applicable to business combinations. Gain contingencies/contingent assets are not recognised in a business combination. Leveraged buyout IFRS 3 best reporting

If the acquisition-date fair value of the liability arising from a contingency can be determined during the measurement period, that liability is recognized at the acquisition date.

If the acquisition-date fair value of the pre-acquisition contingency cannot be determined during the measurement period, a liability is recorded related to the contingency to the extent that the probable and reasonably estimable criteria of IAS 37 have been met. Leveraged buyout IFRS 3 best reporting

So contingent liabilities are recognised even if an outflow of economic benefits is not probable (uncertainty is considered in the determination of fair value). Other contingent liabilities and contingent assets are not recognised. Leveraged buyout IFRS 3 best reporting

6 Disclosure of the acquisition

6.1 Intangible assets

For intangible assets acquired either individually or as part of a group of assets (in either an asset acquisition or business combination), the following information shall be disclosed in the notes to the financial statements in the period of acquisition: Leveraged buyout IFRS 3 best reporting

1. For intangible assets subject to amortization: Leveraged buyout IFRS 3 best reporting
   1. The total amount assigned and the amount assigned to any major intangible asset class Leveraged buyout IFRS 3 best reporting
   2. The amount of any significant residual value, in total and by major intangible asset class Leveraged buyout IFRS 3 best reporting
   3. The weighted-average amortization period, in total and by major intangible asset class Leveraged buyout IFRS 3 best reporting
2. For intangible assets not subject to amortization, the total amount assigned and the amount assigned to any major intangible asset class
3. The amount of research and development assets acquired in a transaction other than a business combination and written off in the period and the line item in the income statement in which the amounts written off are aggregated. Leveraged buyout IFRS 3 best reporting
4. For intangible assets with renewal or extension terms, the weighted-average period before the next renewal or extension (both explicit and implicit), by major intangible asset class.

This information also shall be disclosed separately for each material business combination or in the aggregate for individually immaterial business combinations that are material collectively if the aggregate fair values of intangible assets acquired, other than goodwill, are significant. Leveraged buyout IFRS 3 best reporting

The information relating to intangible assets must be disclosed separately for each material business combination or in the aggregate for individually immaterial business combinations that are material collectively if the aggregate fair values of intangible assets acquired, other than goodwill, are significant. Leveraged buyout IFRS 3 best reporting

6.2 Fair value measurement

An entity shall disclose information that helps users of its financial statements assess both of the following:

1. for assets and liabilities that are measured at fair value on a recurring or non-recurring basis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements.
2. for recurring fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period.

Details on disclosure requirements are include in Recurring and Non-recurring fair value measurement.

6.3 Related party disclosures – Financing arrangements private equity firm – Key management personnel – Share-based payments

When a private equity firm conducts a leveraged buy out it uses a significant amount of debt. When purchasing a company, the private equity firm will usually provide anything between 30% to 50% of the purchase price in equity and/or (subordinated) shareholder loan(s), and borrow the rest.

The 30% to 50% range varies depending on market conditions and the type of company that is bought, but most LBOs usually fall in that range. The type of debt used, in order of risk (from the lending bank’s perspective), includes:

6.3.1 Senior debt

This debt ranks above all other debt and equity in the business, meaning it needs to be repaid before other lenders can receive any cash. Senior debt has very strict requirements (i.e. must comply with specific ratios), and is usually secured against specific assets of the company.

This means that the lender can automatically acquire these assets if the company breaches its obligations. Therefore, it has the lowest interest rate of all of these types of debt and, from the lender’s perspective, this is the most secure form of financing. Debt repayments usually spread over a four to nine-year period or sometimes are paid in one final payment in the last year.

6.3.2 Subordinated debt

This type of debt ranks (including shareholder loans and also called junior debt) behind senior debt in order of priority on any liquidation. Repayment is usually required in one payment at the end of the term (as opposed to spreading the repayments over a number of years), and the maturity can range between seven to ten years.

The requirements of the subordinated debt are usually less stringent than senior debt, but since subordinated debt gives the lender less security than senior debt, interest rates are typically higher.

6.3.3 Mezzanine debt

This is usually high-risk subordinated debt, and ranks behind senior debt and unsecured debt. Interest on mezzanine debt is much higher, but while part of the interest needs to be paid in cash, another part (called a PIK, paid in kind) is rolled up into the principal.

For example, if an entity borrows LC100 of mezzanine at 10% interest, with 5% cash and 5% PIK, the entity has to pay LC5 in cash and LC5 will roll over in principal. The next year principal is LC105 and interest is calculates as follows: 5% in cash over LC 105 is LC5.25 and 5% PIK.

The principal grows to LC110.25, etcetera. At maturity the full principal needs to be repaid (usually within 10 years). Sometimes the mezzanine debt will also include warrants or options so that the lender can participate in equity returns and profits on the sale of shares.

Leveraged buyout IFRS 3 best reporting