This technical article examines how partially-owned investments can complicate purchase price mechanics, and looks at how you can align the Sale and Purchase Agreement (SPA) or Enterprise (EV) to equity bridge with the desired value position.
Introduction
When a target group includes entities that are not wholly owned (whether subsidiaries, associates, joint ventures or joint operations), establishing the correct pricing becomes more complex. Although group accounts consolidate these interests according to IFRS (or other relevant body of accounting standards), the economic reality of ownership does not always align with its financial presentation in statutory reporting.
This article looks at:
- the basics of the underlying accounting for various forms of investment under IFRS,
- why this matters in a transaction context, and
- what practical steps buyers and sellers can take to ensure the impact on the equity value is reflected appropriately.
This article focuses on the balance sheet position, as it is an aspect that often does not receive sufficient attention pre-signing of the SPA.
Underlying Accounting Treatment
It is important initially to assess how the investments are accounted for in the underlying accounts.
Associates and Joint Ventures (IAS 28):
Where significant influence exists (usually indicated by a shareholding over 20%), equity accounting is applied. For associates or joint ventures fulfilling this criterion, the investment is initially recorded at cost, then adjusted for the investor’s share of post-acquisition profits, losses, and other comprehensive income of the investee. The carrying amount of the investment is reduced for any dividends received.
Joint Arrangements (IFRS 11):
Joint arrangements exist where there is joint control by two or more parties, and are classified as either:
- Joint operations: The joint operators have direct rights to the underlying assets and direct obligations for the liabilities of the arrangement. Accordingly, each operator recognises their share of assets, liabilities, revenues, and expenses.
- Joint ventures: The joint venturers have rights only to the net assets of the arrangement. For this reason, joint ventures are accounted for using the equity method (as discussed above), reflecting the investor’s share of the net assets rather than its share of the individual assets and liabilities.
Subsidiaries (IFRS 3):
Where control exists, the transaction is accounted for under the acquisition method. This requires the acquirer to consolidate the subsidiary on a line-by-line basis, recognising, separately from goodwill, all identifiable assets, liabilities, and any non-controlling interest. These are recognised on a 100% basis, even when the acquirer’s shareholding is less than 100% (with the difference being recognised in the “Non-controlling interest (NCI)” line on the balance sheet).
Implications for Purchase Price
When pricing a business that includes non-wholly owned entities, the parties will usually consider the impact of partially owned investments on enterprise value, by applying the relevant ownership percentage to EBITDA (where the valuation is based on an EBITDA multiple). However, ownership is not always given sufficient attention when it comes to the balance sheet, even though this also impacts the final equity value, either (a) in the EV to equity bridge in the case of a locked box mechanism, or (b) in the way completion accounts are specified to be drawn up under the SPA in a completion accounts mechanism. It is the balance sheet aspect in the deal context that we focus on in the remainder of this article.
Associates and Joint Ventures:
Associates and joint ventures typically present fewer issues. The balance sheet presents the investment as a single line item within fixed assets. In most transactions (where typically the starting point for the price adjustment is a debt-free, cash-free valuation, with a target level of working capital), fixed assets are excluded from the pricing mechanics. This means the investment does not feature in target working capital, final working capital, or net debt calculations, and so it sits outside the scope of the price adjustment mechanism, whether under a locked box or completion accounts mechanism. In this case, the accounting and valuation treatments are generally aligned.
Parties should also consider whether there are any amounts due from associates or joint ventures recognised on the balance sheet. Amounts relating to any dividends receivable would not typically be considered working capital in nature and, therefore, would not be expected to be included in any target working capital calculation.
Joint Operations:
For joint operations, the investor has rights to assets and obligations for liabilities, so a proportionate share of these balances is consolidated. In pricing mechanics, the same ownership percentage should be consistently applied when calculating both target working capital and the final net debt and working capital as at the relevant effective date. Under a locked box mechanism, this proportionate share can simply be taken from the underlying accounts and included in the EV to equity bridge. For completion accounts, it is important that the SPA drafting requires the same consolidation method, and that specific policies don’t inadvertently aggregate 100% of the balances.
Subsidiaries:
Subsidiaries is where the greatest potential for misalignment arises. Subsidiaries are consolidated line-by-line under the acquisition method, meaning 100% of their assets and liabilities appear in the group’s balance sheet, even where the investor owns less than 100%. Unless carefully considered, this can lead to 100% of the subsidiary’s working capital being included in target working capital calculations, and 100% being included in final net debt and working capital. This can lead to over- or understating the economic interest, depending on the level of cash, debt, and differences in working capital between the target level and final “actual” position shown by the subsidiary’s balance sheet.
For non-wholly owned subsidiaries, to maintain the integrity and proper working of the price adjustment mechanism, and thus arrive at an appropriate final equity value, it’s important to adjust to the appropriate ownership percentage when setting working capital targets and calculating actual balances, or at least assess the risk that any impact on amending the percentage ownership might be material. This helps ensure the pricing mechanics reflect the true economic position, not just the underlying consolidated accounting view.
Simply removing the non-controlling interest (NCI) may not provide the desired outcome, as the value of the NCI is based on the full balance sheet, and will therefore reflect line items such as fixed assets, which are generally excluded from the pricing mechanics.
Where a proportionate method is applied (either through the agreed EV to equity bridge in a locked box mechanism or within completion accounts) care must also be taken with intragroup balances (i.e. between different entities in the target group). These balances normally eliminate on consolidation, but if two entities with intragroup balances are held at different ownership percentages, there may be a portion that does not fully eliminate.
Of course, in M&A, there may be alternative views. For example, a buyer or seller may argue that the parent, as the controlling entity, will ultimately be responsible for funding the subsidiary’s working capital, and therefore it’s appropriate to use 100% of its assets and liabilities in the price adjustment mechanism. Either way, the approach should be considered carefully and agreed by the parties in advance and a consistent approach should be applied when calculating the target working capital and the “actual” position to ensure they are compared on a like-for-like basis. This is particularly important in a completion accounts mechanism, where any divergence in expectations can lead to unexpected outcomes when the completion accounts are drawn up at completion and the final price is determined.
Recommendations:
Conclusion:
Whether operating under a locked box or completion accounts mechanism, the objective remains the same: to ensure that the pricing mechanics reflect the true economic substance of the deal, not just the accounting presentation. Careful consideration should be given to the group structure, ensuring that it is appropriately reflected in the agreed EV to equity bridge or basis of preparation for the completion accounts in the SPA.
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If you would like to discuss these issues further, or understand how tailored drafting can improve value protection in your next deal, please feel free to get in touch.
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