Accounting for Leveraged Buyouts

Leveraged buyouts refer to the takeovers using debt financing. LBOs often happen outside the control of the acquiree firm. The acquirer may take over the target company for several reasons.

The accounting basis for leveraged buyouts is set to analyze the new entity’s control and the transaction’s monetary value. If the takeover meets certain conditions, it can be taken as a new accounting basis form.

A leveraged buyout can use different debt financing methods to fund the transaction. Most of these debt sources come in the form of fully or partially unsecured loans or Junk bonds.

Let us understand the concept of leveraged buyouts and the accounting treatment for these transactions.

What is a Leveraged Buyout?

A leveraged buyout is an acquisition that uses borrowed money to fund the transaction. Usually, the target company’s assets are pledged as collateral to obtain new debt financing for the buyout transaction.

An important attraction in leveraged buyouts for acquirers is that they do not need to use equity capital. Instead, acquirers use debt financing to take over a target company. The motive behind the move is often to resell the company when it becomes profitable.

Since the acquirer uses the acquiree’s assets to pledge for the debt financing, it also uses the cash flows from the same entity to service that debt. In other words, the target company funds its acquisition (often a hostile takeover) and service the debt as well.

A leveraged buyout can take the following four forms:

  • The Repackaging Plan – It is used to buy all stocks of the target company. The acquirer aims to turn the target company profitable and sell it through an IPO.
  • The Portfolio Plan – The acquirer aims to bring the target company to its existing portfolio to bring the synergic effects for the acquiree as well.
  • The Split-Up Plan – It is used when the acquirer thinks the target company can be sold for more value when split into parts.
  • The Savior Plan – The management and employees of a company can buy the shares of an unsuccessful company to save it from liquidation.
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Accounting for Leveraged Buyout

Hostile takeovers such as in the case of a leveraged buyout do not take into consideration the acquiree’s consent. Thus, as a general practice, the GAAP rules do not consider it as the new accounting basis.

Some experts opposed the accounting treatment for leveraged buyouts. The proponents claimed that even with a hostile takeover, the new entity would form the basis of new accounting such as a step-up entity.

Thus, the assets and liabilities of the newly formed entity must be reported in accordance with the other mergers and acquisition regulations. The newly formed entity must consolidate its assets and liabilities on a step-up basis.

Leveraged Buyouts – New Basis for Accounting

The current accounting methods for leveraged buyouts are defined under the FAS 141 (R), business combinations. The topic is codified as ASC 805.

The guidelines from the FAS 141 were largely driven by its predecessor regulations under the EITF. The newly established consensus now offers guidelines on the basis of the newly established entity’s ownership stakes.

The guidelines state that it must be observed whether the LBO transaction resulted in the change in control of voting interests or not. For that purpose, the analyzers can consider three key groups (stakeholders) of voting interests, namely:

  1. Shareholders of the newly formed entity.
  2. Management of the old entity.
  3. Shareholders of the old entity.

Note: shareholders of the old company may or may not have any stakes in the newly established entity after the LBO transaction.

The analyzers can then form the opinion on the change in the control of voting interests of these companies to establish one of the two possibilities.

  1. The transaction resulted in a business combination; thus, the new accounting basis should follow.
  2. The transaction was for the purpose of restructuring or recapitalization; hence, a carry forward accounting basis should apply.
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The guidelines also offer a monetary test to evaluate the newly established entity’s accounting basis. If the acquirer uses at least 80% of the funds in monetary terms, the newly established entity must follow the step-up basis.

The monetary terms in this sense include:

  • Cash and cash equivalents
  • Debt
  • The fair value of marketable securities given to the shareholders of the old entity.

In some cases, a leveraged buyout may fulfill the change of voting interest criteria as stated above but not the monetary test. For instance, an acquirer may 60% of paid capital in the form of monetary items and the remaining in-kind such as stocks. In that case, the step-up accounting should be used in a proportion to the monetary percentage of the paid capital. In this example, it would be 60%.

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