Although a number of private equity sponsors tout their ability to unlock value by rescuing corporate orphans, the job of buying subsidiaries and divisions of larger corporations and unraveling the assets and liabilities of a business from its corporate parent is not for the faint of heart. Most of these carve-out divestitures are complex and bespoke transactions. Among the most challenging issues are those involved in financing the acquisition of a business that is not being run on a stand-alone basis and, therefore, does not often have historical financial statements sufficient for optimal execution of the financing.
Are Financial Statements Even Available?
Historically, companies did not, in most cases, prepare comprehensive financial statements for their component businesses. As a result, when a company decided to divest an operating unit, it was unlikely to have financial statements for the unit on a stand-alone basis. Since the release of FAS 131, segment reporting by public reporting companies with respect to divisions that operate as a separate business has become more stringent and, as a result, public sellers are more likely today than in the past to have comprehensive financial statements for a subsidiary or division being divested. In addition, even where FAS 131 is not applicable, in most well-run auction processes today, historical financial statements will have been completed well in advance of approaching potential buyers.
However, notwithstanding these reporting requirements and market practices, in more cases than one might expect, private equity buyers seeking to finance a carve-out acquisition find themselves in the same position as they might have been 15 or 20 years ago, with insufficient historical financial statements to pursue their desired financing. This may occur because, following negotiations between the buyer and the seller as to the precise scope of the business to be sold, the historical financials produced for the auction process no longer match the actual assets and liabilities that will be acquired. New financial statements can usually be produced, given sufficient time and management attention, but these resources may be in short supply in the context of a fast-moving sale process.
More infrequently, historical financial statements either cannot be produced or cannot be audited, as a practical matter. For example, we have seen a run-of-the-mill carve-out divestiture (if there is such a thing) become much more complicated because the business to be divested had itself recently sold component businesses and the corporate seller had disregarded these earlier dispositions and the related discontinued operation accounting impact for financial reporting purposes. Even worse, it didn’t have access to the relevant information necessary to produce audited financials reflecting the impact of the discontinued operations in historical periods because the records had been turned over to the buyers of the assets without a clear obligation to provide access to the corporate seller. In that case, the private equity buyer found itself in a very difficult situation; it needed to finance a carve-out acquisition but the audited financial statements that most financing sources would demand could not be produced because, without the discontinued operations taken into account, the financials did not reflect all of the historic assets and liabilities of the legal entities being audited and, thus, were not GAAP compliant. Ultimately, the buyer had to market the financing using “special purpose financials” and endures a difficult negotiation with the auditors with respect to whether, and to what extent, prospective lenders could rely on the financials.1
Are the Financial Statements Sufficient for a High Yield Offering?
The simple fact of life for any private equity buyer is that some combination of historical audited and unaudited financial statements of the target business will be needed in order to obtain debt financing. It is also generally true that the more historical financial statements that are available, the more financing alternatives there will be and, in the end, the more likely that the private equity buyer can pursue the financing structure of its choice.
A marketing of high yield bonds is likely to require as much, if not more, disclosure with respect to historical financial statements as other forms of financing. High yield bonds are usually sold to investors in a transaction exempt from the registration requirements of the Securities Act of 1933, pursuant to the “Rule 144A safe harbor.” In order for an offering to be eligible for this safe harbor, an issuer must meet certain informational requirements, including providing investors with the “issuer’s most recent balance sheet and profit and loss and retained earnings statements, and similar financial statements for such part of the two preceding fiscal years as the issuer has been in operation (the financial statements should be audited to the extent reasonably available).”
Notwithstanding the apparent flexibility of the rule (note that audited financials are required only if they are “reasonably available”), under customary market practice, an offering of high yield bonds under Rule 144A is modeled on a public offering, which would typically be made by way of an offering prospectus including two years of audited balance sheets, three years of audited statements of income, changes in stockholders’ equity and cash flows and two additional years of selected financial data (i.e., up to five years of financial statements and data in total), with appropriate comfort from auditors, all as required under Regulations S-X and S-K of the Securities Act of 1933. Market practice does allow for variation from this standard in cases where the full package of historical financials is not available, but it would be very uncommon for disclosure with respect to any high yield offering to include fewer than two years of historical audited financials statements.
In addition, most high yield bonds offered under Rule 144A are accompanied by registration rights for the benefit of investors. In a case where registration rights are offered, an issuer will need financial statements which comply with the requirements of Regulations S-X and S-K by the negotiated deadline for the filing of a registration statement with respect to the A/B exchange offer. This deadline customarily ranges from 45- to 420-days after the closing of the acquisition, with 180 days being the most common.2
As a result of market practice, if at least two years of historical audited financial statements and unaudited interim financial statements for the target business cannot be provided within the contemplated time frame for the closing of the transaction, a private equity buyer risks losing the option of tapping the high yield bond market to finance its acquisition, and may instead need to close with a more expensive and less flexible financing. Moreover, even if this limited set of historical financials is available, it is also possible that the historical financial statements necessary for a registered exchange offer will not be available during the 45- to 420-day period for filing a registration statement expected by investors.
What Can Be Done if There Are Deficiencies?
In carve-out transactions, it is not uncommon for a private equity buyer to find itself without the historical financial statements necessary to meet market demands with respect to Rule 144A offerings. Here are a few practical solutions that may be available depending on the situation.
- Push the Seller. Given the potential impact on a private equity buyer’s cost of capital and on the portfolio company’s post-closing operating flexibility (each discussed below), before pursuing one of the alternatives below, a buyer should vigorously probe assertions that the necessary financial statements are not available or cannot be produced on an acceptable timeline or that the target’s auditors cannot provide necessary comfort, and the issue should be addressed at the earliest possible point in the transaction. The absence of these financial statements and the related auditors’ comfort reduces the buyer’s flexibility with respect to its financing and there is often a real cost to this loss of optionality. Depending on the dynamics of the sale process, it may be useful to share with the seller the impact of these costs on the value of the target business to the buyer and, as a result, the purchase price that can be offered. In the end, a more costly financing is a shared problem and there can sometimes be a shared solution.
- Push the Arrangers. If historical financial statements necessary to meet the bare minimum required for a customary marketing of high yield bonds will not be available on the desired timeline, a private equity buyer should still consider pressing its prospective arrangers to provide bridge commitments supporting the high yield bond offering. As noted above, the Rule 144A safe harbor requirements with respect to historical financial statements are more lenient than customary market practice requires (i.e., at least two years of audited financial statements). Therefore, an offering supported by meaningfully less in the way of financial statement disclosure (e.g., only one year of audited financial statements, if additional audited financials are not “reasonably available”), may still comply with Rule 144A. Given the highly unusual nature of this type of bond offering though, it may be difficult to predict market appetite and, as a result, potential arrangers are likely to be resistant to underwriting a bridge on this basis or, at least, at pricing that would be acceptable to the private equity buyer. However, given the right circumstances, including an attractive credit and a competitive “bake-off,” it may be feasible.3
- 144A-For-Life and Variations Thereof. In the more common situation where at least two years of audited financials for the target business are available but a third year of audited statements of income, changes in stockholders’ equity and cash flows and/or two additional years of selected financial data will not be available during the customary 45- to 420-day period for filing a registration statement, it is not uncommon for a private equity buyer to obtain bridge commitments supporting a 144A-for-life offering (i.e., an offering without registration rights) or a “modified” 144A offering with long-dated filing periods that will allow the issuer to ultimately satisfy the Regulation S-X and S-K requirements. However, for several reasons, the market for and liquidity of, these types of bond offerings may be limited. Most importantly, many high yield investors have limits on the percentage of unregistered securities they may hold in their portfolios and the absence of meaningful registration rights under 144A-for-life and “modified” 144A offerings may preclude some investors from participating in the offering. As a result, financing sources are typically less willing to commit to bridges for these types of offerings and, when they do, a private equity buyer can expect to pay accordingly.
- Mezzanine Financing. Depending on the size of the financing shortfall, a sponsor could consider a mezzanine or private high yield financing. These types of financings are likely to be more expensive and the related covenants are likely to be more restrictive than could be obtained in a traditional high yield offering. A private equity buyer will need to take into consideration both the direct incremental costs and the potential impact of lost operating flexibility of these financings. Moreover, while the number of financing sources and the magnitude of debt available in this space have both increased significantly over the last several years, supply in this market is still relatively limited, when compared to the high yield market. As a result, this may not be a solution for the largest of large cap deals.
- Seller Paper. Whether in the form of debt or equity, seller paper might be considered as a bridge to a time when the necessary financial statements can be produced and a customary 144A offering can be made. Obviously, this option is unlikely to be viewed favorably by the seller but, in many cases, a private equity buyer might reasonably conclude that the seller should bear some responsibility for the lack of requisite financials and play a role in resolving the issue. A private equity buyer will need to consider the dynamics of a given sale process to determine whether this is a reasonable alternative. The cost and flexibility of covenants, if any, in seller paper will depend on the negotiating leverage of the parties and, therefore, will differ on a case-by-case basis.4
None of these alternatives is perfect. Each carries its own peculiar cost/benefit analysis. However, when confronted with a carve-out acquisition in which there is a meaningful possibility that customary financials statements will be unavailable when needed for an optimal financing, one of these alternatives might prove to be a workable solution for what otherwise appears to be an intractable problem.
1. While this article focuses on a private equity buyer's need for historical financial statements of a target in connection with its financing, it should be noted that strategic buyers, including portfolio companies, might have a separate and distinct need for a similar universe of financial statements either because they are public reporting companies or have covenants in their existing financing agreements that contain analogous financial reporting obligations.
2. For a detailed market survey of registration rights in 144A offerings, see "Registration Rights in High Yield Debt Offerings - A Market Survey," Debevoise & Plimpton LLP Private Equity Report, Winter 2012.
3. As a cautionary note, even if the private equity buyer is confident that it can obtain a bridge to this unique bond offering, it will also need to consider whether the available financial statements, together with other disclosure, will be sufficient to satisfy applicable antifraud rules and regulations applicable to offering, including Rule 10b-5 of the Securities Exchange Act of 1934.
4. For special considerations regarding seller paper, see "Covering the Capital Structure: The Seller Note," Debevoise & Plimpton LLP Private Equity Report, Fall 2011.