Common Pitfalls in Private Equity-Backed IPOs
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Invest. Grow. Exit. This is the modus operandi of the vast majority of private equity firms. Private equity exits come in various forms – generally IPO or sale to a strategic or other financial buyer. Because of the uncertainty surrounding exits, portfolio companies and their sponsors often employ a dual-track strategy – preparing both for a potential sale and a potential IPO. Riveron Consulting has executed a dual-track strategy for many clients and found that this approach provides for flexibility and a more certain path to liquidity. That said, the process of preparing for and completing an IPO is arduous and fraught with potential pitfalls. In most cases, these pitfalls can be avoided through a combination of preparation, experience, and raw horsepower.
Insufficient planning and preparation.
The IPO market is fickle, and it is difficult to predict when IPO “windows” will open and close. As a result, IPO-focused companies are often at the whim of the market and must be ready when the next “window’ opens. That said, one of the keys to an efficient IPO process is planning and preparation. The starting point of a successful IPO process is deliberate assembly of the internal and external team. This generally includes a cross-departmental internal team (e.g., accounting, finance, legal, divisional/business unit leaders, and HR), along with an external team to include the private equity sponsor, underwriter(s), auditor, and legal and accounting advisors. Once the team is assembled, the best practice is to develop a detailed project plan and to agree upon a reasonable timeline – typically between six and eighteen months. Finally, regular communication among the project team and active project management are critical to an efficient IPO process.
Overestimate the relief provided by the JOBS Act during and after the IPO process.
The Jumpstart Our Business Startups (JOBS) Act was enacted to create an easier path to IPO for “emerging growth companies.” That said, it is often not all it’s cracked up to be. For example, the JOBS act reduces the number of years of audited financial statements and selected financial data that an emerging growth company, or EGC, must include in its Registration Statement. However, many companies choose to include additional data in order to show track record and based on feedback from underwriters and the investor community. In fact, an Ernst & Young survey showed that only 34% of EGCs take advantage of this provision of the JOBS Act in their IPO filings. Additionally, while the JOBS act provides a deferral of the auditor attestation requirement under Section 404(b) of the Sarbanes-Oxley Act, an EGC that elects to defer this requirement still must comply with the requirement that management assess the effectiveness of the company’s “Internal Control over Financial Reporting,” or ICFR, generally beginning with its second annual report on Form 10-K. This requires companies to implement the same ICFR framework that would be required for auditor attestation. Further, most audit firms will request and review management’s ICFR documentation, including evidence of management testing over ICFR. Finally, the JOBS act does not provide relief from Section 302(a) of the Sarbanes-Oxley Act, which requires that both the principal executive and the principal financial officer attest to, among other things, the effectiveness of the company’s ICFR. This attestation must be included, in the form of signed certifications, with the company’s first quarterly or annual filing following the IPO.
Fail to properly address areas of complex accounting.
PE-backed companies often present a unique set of complex accounting issues, particularly in the areas of debt, stock-based compensation, and historical acquisitions. PE debt often contains call options or other features tied to liquidation events. Such features may represent embedded derivatives that may need to be valued and accounted for separately of the debt instrument. Additionally, debt issued by entities other than the sponsor is often modified in connection with the IPO transaction and may trigger complex accounting requirements. PE-backed companies frequently grant options and other forms of stock-based compensation to key employees. Often, these instruments are tied, entirely or partially, to growth of the company or to the sponsor’s return on investment. Accounting for these types of instruments is complex and typically requires external valuation opinions. Additionally, the issue of “cheap stock” is a continued area of focus for the SEC and is typically addressed by historical external valuation opinions supporting the increase in company’s enterprise value, ultimately reconciling to the enterprise value implied by the IPO transaction.
Historical acquisitions also present a variety of complex accounting considerations, including those related to the identification and measurement of goodwill and other intangible assets and to the potential presentation of separate audited annual and unaudited interim financial statements of acquired entities in the registration statement. The latter can be particularly challenging for acquisitive companies that purchase carved-out operations from other entities that were not historically audited on a stand-alone basis, or private companies that were not previously subject to SEC rules. Recent experience has shown that the SEC Staff will work with potential registrants if the solution satisfies the needs of IPO investors, but, of course, the Staff will never simply waive the rules. This is an issue that can take a significant amount of time to resolve, especially if additional audit work must be performed. Also, management must open a line of communication with the predecessor auditor to obtain necessary consents. Lastly, be wary of situations in which interim financial statements of an acquired company must be presented – SEC rules do not require these financial statements to be reviewed, but most audit firms will insist on reviewing interim financial statements in order to provide their consent to include their previously-issued opinion in an SEC filing.
Other complex accounting areas to be addressed when preparing for an IPO may include the calculation and presentation of earnings per share, identification and disclosure of segments, and presentation of pro-forma financial information. Every IPO or dual-track candidate should plan to compile a comprehensive set of accounting and financial reporting policies prior to filing. A good starting point is to identify an appropriate publicly-traded peer group and perform an analysis of their disclosed accounting policies. This analysis should include a review of recent SEC comment letters to identify potentially sensitive policy areas.
Underestimate the level of effort post-IPO.
Transition from private to public represents a paradigm shift for most, if not all, companies. One area in which this shift is particularly evident is that of investor relations. Post-IPO companies experience a significant increase in IR activity to support the new shareholder and analyst base. And pennies matter. Missing quarterly estimates out of the gate will cause significant issues with the investor community and is generally considered to be unacceptable. This means a company must establish robust financial planning and analysis (FP&A) and IR functions in connection with its IPO. From an external reporting perspective, an effective Registration Statement is merely a starting point – the first post-IPO quarterly or annual filing comes quickly and provides for very little “cool down” period following the IPO. Corporate governance is another important area of focus for aspiring or newly-public companies. Organizational change is required to achieve an effective control environment and quarterly financial information must be approached with a rigor similar to annual financial information. Stock exchange rules require the establishment of various committees of the Board of Directors within a relatively short period of time following IPO. Depending on the exchange, these include an Audit Committee, a Compensation Committee, and a Nominating Committee. Additionally, the majority of the Board must ultimately be independent, except in the case of controlled companies. This is really the tip of the iceberg from a post-IPO effort perspective and, again, preparation is key.
Riveron Consulting has successfully executed dual-track processes for many private-equity backed IPOs. The pitfalls outlined above, and recommendations as to how to avoid them, are based on real world examples
 “The JOBS Act: One-year anniversary,” Ernst & Young, April 2013