Exploring the Private Equity Landscape

Amanda Tso:

Well, I think definitely is to make sure we have proper financial information in place, especially monthly information as well, as part of a due diligence process important to take into that. If they don't have audited review statements, consider having a vendor due diligence package where our due diligence team can also help procurement just to have everything ready to go and present it to potential buyers. It'll make the process go a lot faster and if there's any information they need, it's already all there.

Narrator:

Welcome to Accounting for the Future, a BDO Canada podcast for financial leaders to navigate change and achieve business growth. We'll uncover the challenges financial leaders may not have dealt with yesterday, but we'll definitely have to manage for the future.

Armand Capisciolto:

Hello and welcome to Accounting for the Future. I'm your host Armand Capisciolto.

On this episode we're going to do something a little bit different. At BDO, we recently held our assurance and accounting conference for managers and partners of our assurance and accounting practices. At that conference, I had an opportunity to have a chat with Ian MacDonell, an assurance partner, and Amanda Tso, evaluation partner. And we spoke about how private equity is impacting the clients we serve. Take a listen to our discussion. I hope you enjoy it.

I'm really happy to be talking to you about the topic of private equity. Mike just mentioned private equity. And it's a topic I think about a lot, that's regardless of if I'm wearing my BDO hat or my accounting standards setter hat as I continue to see private equity ownership increase in private companies. And that creates accounting issues, it creates changes in who and how financial statements are used. As you can tell, the accounting nerd and me is coming out. I'm getting really excited talking about private equity, but I know you don't want me to nerd out on you. So, I'm going to invite two non-accounting nerds to join me.

Today I'm joined by Amanda Tso, and Ian MacDonell. Amanda has advised private equity funds and companies selling to private equity funds, and Ian has clients that have been purchased by private equity funds. The three of us are going to chat about how private equity impacts the clients we serve. Amanda, Ian, welcome to the A&A conference.

Ian MacDonell:

Thanks very much, Armand. I'm happy to be a non-accounting nerd. I've never heard that before, quite frankly.

Armand Capisciolto:

Well, as many of you know out there, when I've done the hosting, I talked a lot about Saturday Night Live, I've talked a lot about Star Trek. Today I would like to start off by talking about one of my favorite movies that doesn't star Adam Sandler or feature the United Federation of Planets: Barbarians at the Gate, an absolute fabulous movie about the '90s, about the '80s from the '90s, about the acquisition of RJR Nabisco by KKR.

For those of you who don't remember the '80s, those were the days when one company could sell cookies, crackers, and cigarettes and market them all to the same demographic. ESG was clearly not a thing in the '80s. This movie usually finds its way on HBO at least once a year. If you see it, highly recommend watching it. James Garner, fabulous in this movie.

So why do I bring up Barbarians at the Gate? Well, the KKR acquisition of RJR and Nabisco is a great example of why private equity isn't always seen in the best light. It was highly levered; it actually had a crippling amount of debt. It in involves significant cost-cutting, which led to significant job losses and resulted in the sale of assets and the breakup of the company.

I'm going to make a prediction here. Within 10 years, they will be making another movie called the, I Guess He Wasn't a Genius at the Gate. I'm sure you know what acquisition I'm talking about with that.

But Amanda, ignoring Elon for a second, the private equity funds you work with, is this what they do? Look for companies to break up and jobs to cut?

Amanda Tso:

It's actually interesting that you're bringing this up because a couple years ago we were actually engaged by a credit corporation to look into all these PE-backed transactions that didn't quite work as they planned it to back then, and really come up with lessons learned for the risk team and their deal team of the private equity arm.

As we're going through 30 cases or so, we're seeing same pattern. It's an aggressive capital structure. There's a lot of synergies that they're hoping for overestimating that but underestimating the cost it would take to realize these synergies. Then there's also a lot of focus on short-term cost-cutting versus long-term growth. So, we helped the credit corporation to go through that exercise and really came up with a checklist for their deal teams to make sure that these are things need to watch out for.

So other PE funds I have also watched and seeing these transactions happen, and now things are not being done that way. They're still gearing transactions up, that's still part of the investment thesis normally, but to an optimal level, that wouldn't be an overly aggressive capital structure, and they would be focusing more on investing in long-term growth rather than just focusing on cost-cutting in the near term. So that's really key.

And then the way PE funds are adding value is first on tuck-in acquisitions, right. They can source deals; they can assess them and execute them. They can also, number two, improve the operational capabilities of the portcos. Mostly with the technology, a lot of the funds now are, and even with us working with us too, to help them increase technology capabilities in terms of dashboards, data analytics, and how to really cascade that down to the portcos.

Third, I would say they give access to the portcos in terms introducing them to key suppliers, their relationships, talent, access to advisors. These are all the things that PE clients are doing, working really closely with portcos and the management team to really drive value.

Armand Capisciolto:

Amanda, just pause for one second. You kept on saying, "Portcos." When we talk about portcos, we were talking about portfolio companies right, the companies at the private equity funds invest in?

Amanda Tso:

Yes.

Armand Capisciolto:

Okay. Just level setting for those of the audience who might not know the lingo. And related to that, some of the audience might be wondering, "Why is this relevant to me? Why are we talking about this? The type of companies I work with are not the size of RJR and Nabisco."

Ian, I'm assuming the clients that you've worked with that were acquired by private equity funds weren't this size. And maybe just before you answer that question, maybe tell everybody where you're from and the size of the community that you work in?

Ian MacDonell:

Yeah, Armand, I remember at the Evolve at our recent partner conference, there was a lot of conversation about private equity. And the first thing that came to light for me was, "Okay, this is not relevant to me. I'm in small town Ontario. I don't have these types of clients. How's this even going to resonate with me?" And here I am, talking at the A&A conference about two recent acquisitions that private equity has done in my client base.

So, yeah, small town Ontario. Three years ago, we had a private equity acquire one of my clients, a Canadian private company, ASPE assurance client. So, a decent size, 200 million in revenue and multiple locations across Canada and US. So quite a large and growing successful company. But the second one, which just closed less than a month ago, was a gross revenue of $8 million. So private equity, I can say, is looking at all size of transactions and can be in anyone's client base. The first one is certainly a success story for BDO. And the second one remains to be seen, but all indications are saying that it's going to be a future success for us as a firm, as well.

So don't discount your location and don't discount the types of clients you have. I think private equity is everywhere at this point.

Armand Capisciolto:

Yeah, Ian, I think that's really important. You and I have had chats about these two clients. The size is interesting, especially the $8 million revenue one. But the other thing that I find really interesting about it is I believe one is kind of in the forest products business, one's in the trucking business.

Ian MacDonell:

Exactly.

Armand Capisciolto:

So, these are old school businesses. These are not high-flying tech companies, anything like this. This is traditional business that is common in offices across the country.

Amanda, when you look at the clients you're working with, when you're advising some of the funds, is what Ian described typical for what private equity is investing in today?

Amanda Tso:

Well, I mean, the funds vary, right. Some of the larger pension funds are investing in huge companies. Then there are ones that are focusing on more SMBs, mid-market, and across different sizes and geographies and industries. Sometimes they would acquire one, and really, that becomes a platform, and they'll do multiple tuck-ins to kind of expand that. That's where they can really add value. They know the industry, they have these relationships, they've done deals, so that's when they can source, assess them, bring them into this platform, and really help expand.

Armand Capisciolto:

Yeah. Amanda, when again, "Tuck-in." I tucked in my shirt today, dressing casual.

Amanda Tso:

Very good.

Armand Capisciolto:

But can you explain what "Tuck-in" means for those that aren't familiar with the terminology?

Amanda Tso:

It's when you start with a platform almost, and you have the acquisition subsequent to it or smaller but together, we call them tuck -in because you're just putting them as part of the platform, expanding that initial, original acquisition. But I'm going to be more mindful with your words I keep using for portcos.

Armand Capisciolto:

That's okay. That's okay. I got to crack a joke about tucking in a shirt, so I'm glad to use that terminology.

What's really interesting, you talked about direct investment and then you talked about the tuck-in. Ian, again, you and I were chatting that the one from three years ago was a direct investment by private equity, but the recent one, the $8 million was a tuck-in, right? It was a trucking company acquired by another trucking and that private equity had already invested in. So, I just think it's interesting, as Amanda's talking about the trends, it's actually what you've actually seen happen in practice.

Ian MacDonell:

Exactly, Armand. I mean, once you get used to working with private equity, they're pretty quick to try and solicit future tuck-ins. So, we help them through the one transaction, but they're actively looking for more. So, we actually traveled down to meet with the private equity firm and, of course, one way to build a relationship with them is to try and find more. We can't always be successful in that right away, but certainly opened my eyes to be mindful for other potential opportunities for them.

Armand Capisciolto:

Okay. And Amanda, just switching gears a little bit, because I think when people think about private equity, as well, they think about selling the entire company. Is that what you're seeing? Are they always looking at acquiring 100% or controlling interests or do some take minority interests in companies?

Amanda Tso:

Yeah, that's a great question. They do take a minority position. Actually, I was reading an article on the Canadian side, I think in the first half of 2022, the minority investments accounted for over 50% of the investments in the first half. And there are funds out there that specifically say they're going after minority investments. Their key is to really find a great management team to partner up with and to really help them execute the growth initiatives. So no, it doesn't always have to be 100% stake in an investment.

Armand Capisciolto:

Okay. So, what I'm hearing so far is that many of the companies we work with at BDO, they could be potential targets for either direct investment for private equity or a secondary investment by invest via tuck-in. Amanda, what are some of the characteristics of a company that would be a good target for private equity? And when should our A&A teams think about reaching out to yourself or others on the private equity team to look at options for their clients?

Amanda Tso:

So, PE funds, they have their strategy in terms of, again, geographies, industries they want to go after. Overall, they want to look for a management team that's the same growth mindset as them, a proven track record, proven business model, and that the business itself has potential for growth, and that the proceeds that they can use would put then back into business for expansion and future growth initiatives.

And I think in terms of when should our clients be reaching out, honestly, as early as possible. There was one incidence where it was a client that wanted to really manage a whole negotiation process on their own. They felt that they really knew the other side and they thought that they would just bring us in at the end. What ended up happening was, even though the valuation that they thought they got was 40, 50% higher than what they would do, what they actually got in cash was only like 10% of that. They ended up getting shares of the other entity that the PE, private equity, fund owns, so that being tucked-in under. And that company at that time was burning cash. So, they will only realize that value if their synergies and everything work out together, as combined business. But because of the way it was structured, their client was taking all the risk. And if we had been in there earlier on to talk to them, we would've advised them the valuation is one piece, but what you're getting back as your proceeds, whether it's flash or shares or warrants, anything like that, that's really important and you need advisor you to help you assess them.

So as soon as they're starting to think about potentially exiting or selling off a percentage, get us involved, we can do a pricing analysis just to get a sense where the value should be at. But we can also support them in terms of the procedure process.

Armand Capisciolto:

Okay. Continuing that, Ian, we work with many companies where the owners are looking to exit or looking to fund investment in growth, and private equity may be an option for these companies. You've worked with your clients going through such an acquisition. What would you suggest to these companies as they prepare for a sale?

Ian MacDonell:

Yeah. It's actually exactly what Amanda just described. We didn't chat through this in advance. But really, this client came to me more than five years ago. It was a new client to me. He said at the time that he had made enough money and that he was ready to leave, he wanted to exit then. We talked through it in a little bit more detail and he was just tired of the day-to-day issues of managing a trucking company. But I said, "If we look at the value of the company today, the value is all in you."

So, first and foremost, I wanted to understand exactly what his intentions were and what he'd be open to in terms of a transaction. Then we went through a quality of earnings type scenario, to understand where he was creating value and where there might be gam from an acquirer's standpoint.

Well, along the way, it gave him an opportunity. He did have family that was involved in the business, so it gave him an opportunity to kind of professionalize his business along the way and really understand if family was truly interested in the long-term. The good news was that over that five-year period, he was able to implement a management team and remove himself from the operations, and ultimately create a lot more value because the value wasn't all in him exclusively.

So, we did a lot of things along that path, from starting with quality of earnings and then valuation reports. We implemented a complex tax structure to be able to take advantage of the ultimate disposition, removed redundant assets. And then as the buyer came to the table, this is an $8 million company, they don't have a huge accounting team, they don't have any real legal team. So, the advisory practice and myself working to help the client through the due diligence process, through the share purchase agreement, right through to the finish line, and actually, basically held the lawyer's hands through the bulk of the transaction because he did not have a sophisticated lawyer that was dealing... On the other side, they have a full team of professionals that are guiding them through the acquisition process.

The client is extremely happy with how the process went. At the end of the day, we can play the bad cop and help negotiate certain aspects of the deal, right down to working capital calculations and things of that nature. So, we had our client well set in terms of understanding what the process was going to look like, what to expect, what to expect in terms of timeframes, and what might come out of the due diligence process. Ultimately, he was extremely satisfied.

Armand Capisciolto:

Ian, I absolutely love that story, starting the conversation five years in advance.

I'm going to do a little plug for our podcast Accounting for the Future, I do that wherever I can. Because that's a lot of what we talk about is thinking about, not thinking about the here and now, but thinking about where a company is going in the future and making sure they're thinking about the structure, the tax planning, the financial reporting needs that they need to think about for the future.

Which brings me to my next question for Amanda. Do you have any recommendations for companies to consider to prepare so they're appealing to private equity, ensure they meet the private equity funds criteria for investment and prevent deals from falling apart? Because we have seen deals fall apart.

Amanda Tso:

Mm-hmm. One thing definitely is to make sure you have proper financial information in place, especially monthly information as well, as part of due diligence process, it's important to take into that. If they don't have audited review statements, consider having a vendor due diligence package where our due diligence team can also help prepare, just to have everything ready to go and present it to potential buyers. It'll make the process go a lot faster and if there's any information they need, it's already all there.

Armand Capisciolto:

Okay. Ian, what about subsequent to acquisition? Did anything change for the clients that you were working with, with regards to their financial reporting?

Ian MacDonell:

Yeah. So, I'll have to lean back to the one a few years ago because one one's just recently closed, we haven't even finished anything subsequent to closure yet. But going back to the one a couple years ago, I mean, the eventual acquire ended up being a US parent. And so, there was conversion to US GAAP, so we did a US-Canadian GAAP analysis. We've done all kinds of transfer pricing and a commodity tax consulting for the entity going forward. Our advisory team has done a $1.5 million dollar ERP implementation to help professionalize the financial reporting, to meet the standards of the parent. So, staying connected to the client, there was all kinds of opportunities coming out post-closing where sometimes people will think, "Oh, my client has sold, and that's going to be the end of our relationship." But encouraging everyone to stay close to the client and listen to their needs and get our talented advisory folks involved to make sure that they're well-served.

Armand Capisciolto:

Again, I love that story because a couple things, although we didn't retain the audit because we did assist with the transition to US GAAP, and we're providing a lot of advisory services now, which I think is really important to think about for a company that's acquired by private equity. Because they have to start thinking about independence a little bit different. So, the fact that we didn't retain the audit, it actually allows that company to get services without ever having to worry about their auditor not being independent. So, I really like that aspect.

Ian MacDonell:

Yeah. We didn't retain the audit only because, crazy enough, it's immaterial to the parent company's overall activity. But we still do the compliance reporting and all of their tax work, all their Canadian tax compliance work, which keeps us in the door in terms of all of this other advisory work that comes out of it. Yeah, it changed the relationship and our reporting requirements, but certainly allowed us to continue to demonstrate our strength as a firm.

Armand Capisciolto:

Great, it's a great story.

Amanda, an area I need to ask about sustainability or ESG, whatever you want to call it, an area getting a lot of attention, an area that needs a lot of investment. As we transition to a low carbon economy. What does private equity look at with regards to sustainability?

Amanda Tso:

Well, we're seeing a lot of PE funds, they have their own overall strategy and framework they have so they will execute and source a lot of the acquisitions based on that. What we're really seeing that they're leaning on us quite a bit on right now is once they make that acquisition, to really be tracking that data for them. So, they're monitoring, "Are we in line against our investment thesis? If not, what's the course of action?" So now that we're implementing data analytics and other solutions for them, they're asking for us to really make sure we incorporate that piece so that they can get, sometimes we all real-time data so that we can't actually assess and making sure that whatever they set out to do, that they're actually on target. It's really important for them.

Armand Capisciolto:

Okay, really interesting. It's interesting, they're considering it as part of their investment, but then it's that tracking that is needed. Again, when you think about the needs then, it's more than just A&A compliance that these clients that are acquired or companies that are acquired by private equity need.

Amanda, Ian, thank you for your insights. This has been a fabulous chat.

Okay, well, I hope you enjoyed my conversation with Ian and Amanda. I know I enjoyed the conversation when I had it. I'd like to thank you, our listeners, for tuning in today. I'm Capisciolto and this has been BDO'S Accounting for the Future. Please let us know if you found this topic interesting and useful and remember to subscribe if you liked it. We'll see you next time.