Private Equity (PE) shopping introduces complex financial structures that make it difficult to track the performance of portfolio companies. The use of acquired vehicles may obscure financial reports. This means investors and analysts can have a hard time trying to understand a company's true debt level, profitability, and overall financial health.
This post is the second in my three-part series. We investigate the differences between operating entity accounts and integrated group accounts, highlighting the implications of key financial discrepancies and investment analysis.
In my first post, I demonstrated how creating an acquisition vehicle to promote PE buyouts creates challenges for analyzing performance in Topco, Midco, and Bidco examples. Understanding these vehicles (shown in Figure 1) is important to provide a clear understanding of the target group's finances during the PE ownership period.
Figure 1. Topco, Midco, Bidco.
After the company is acquired in PE acquisition through such a structure, the integrated accounts of the target group are usually recorded at the newly created TopCo level, but the operating entity often submits unresolved accounts. . Other acquired vehicles, such as Midco and Bidco, often submit unintegrated accounts. However, these accounts may not have full financial information.
In some cases, multiple companies in the group structure submit consolidated accounts. The key to recognizing the most relevant set of accounts to fully understand the financials of a group is to capture the ownership structure of the complete group and identify which entities are at the top of the company tree .
To further complicate the process, the integrated reporting entity after Buyout may change during the PE retention period. This often happens, for example, when other investors acquire shares in the target group, or when the target acquires or merges with other companies. All this allows you to accurately investigate difficult exercises after pre-purchase performance of a portfolio company.
Operating entity accounts often do not capture the complete group capital structure and in some cases may be totally lacking financial information. Furthermore, it may not reflect the group cost structure as some costs may be charged more in the chain, such as at the TOPCO level. Therefore, it may be more profitable at the operating entity level compared to consolidated groups.
Additionally, the obligations used to fund the acquisition are often acquired only in one or more accounts on the newly created acquisition vehicle. In other words, the total obligation figures on the balance sheet of the target management company are diagrams of the integrated group. This naturally becomes even more important for acquisitions that use substantial amounts of leverage to fund a transaction.
Integrated Group Account and Management Company Account
Table 1 shows buy transactions and reports the key financials of both integrated group entities created for acquisition purposes using open operating entity accounts. The deal is the acquisition of UK-based company Xtrac Limited by UK-based PE Investor Dellexion Private Equity Partners LLP.
Three vehicles were created for the purpose of the acquisition: Viola Bidco Limited, Viola Midco Limited and Viola Holdco Limited. The latter vehicle consolidated group accounts during PE's tenure. Panel A shows the finances of the operating entity, while Panel B shows the finances of the consolidated group entity.
There are differences in reported sales, assets and personnel. All of these are low at the operating entity level. Meanwhile, EBITDA (revenue before interest, taxation, depreciation, and amortization) is higher at the business entity level. Short-term and long-term corporate liabilities are fairly low at the sales entity level. These differences naturally affect the calculated financial ratios, such as profitability and leverage.
Table 1 shows the acquisition of XTRAC Limited's XTRAC Limited in 2017 and Delflexion Private Equity Partners, which had its withdrawal in 2023. Panels A and B compare the financial accounts of both the operating entity (Panel A) and the consolidated group entity (Panel B). Purpose of the 2017 acquisition.
Table 1. Integration and Operating Company Accounts.
I have studied about 3,000 PE shopping samples in the UK over the past 20 years and have summarized my findings in a recent research article. In it, I will document the differences in PE Target Group finances between the operator and the integrated group entities. There are significant differences in sales, assets, revenue, liabilities and cash holdings.
For example, the median difference in total assets in the first year following acquisition between consolidated group accounts and operating company accounts is 77%. The median difference in total liability is 244%, highlighting that the entity's accounts do not fully reflect the size of the portfolio company's integrated group balance sheet. These differences are even greater in purchases and building transactions where the target company acquires other companies during the PE holding period.
Key takeout
Understanding the differences between operating entity accounts and consolidated group accounts is essential for accurate financial analysis of PE-owned companies. The evidence shows a major discrepancy in reported assets, liabilities, revenues and profitability. However, these metrics can have a significant impact on valuations, risk assessments and investment decisions.
As PE landscapes evolve, investment experts need to understand how to properly capture the overall performance of portfolio companies. In the final post in this series, we will look into some of these differences when studying the capital structure and performance of PE-owned companies. Sheds light on key accounting elements of the buyout target balance sheet.
