Merger & Acquisition Disputes Involving Private Equity Firms

Private equity (PE) firms are built on business models unlike a traditional firm. The operating model of a PE firm is fueled by a shorter-term investment horizon and financial engineering/transformation; whereas, strategic and traditional buyers opt for a longer-term investment horizon. Due to their nature, PE firms are involved in more Merger and Acquisition (M&A) purchase price disputes.

We have found that most M&A disputes involving private equity firms generally involve complex accounting issues and poorly worded language in the Sale and Purchase Agreement (SPA).

Accounting Related and Reserve Related Merger & Acquisition Disputes 

Accounting related disputes usually involve one of the following areas:

• Reserves
• Unrecorded or undisclosed liabilities
• Capitalization of fixed assets and leases
• The loss of key customer(s)
• Revenue recognition
• Taxes
• Compliance with bribery and corruption regulations
• Adjustments to EBITDA (Earnings Before Interest Tax, Depreciation, and Amortization) including:
  • The impact of subsequent events
  • The definition of materiality
  • Changes to accounting methods
  • Cut-off and timing issues
  • Related party and intercompany transactions
  • Classification issues

Reserve related disputes typically involve either reserves for uncollectible accounts receivable, reserves for obsolete inventory, or warranty reserves.

Disputes involving unrecorded or undisclosed liabilities often involve: the underfunding of pension or other employee benefit plans, significant environmental liabilities, recurring expense accruals or unrecorded payables/liabilities.

SPA Interpretations of Accounting Framework May Lead to Disputes between Buyer and Seller

A key area that can lead to these disputes is the interpretation of the relevant accounting framework that is specified in the SPA. The accounting framework is usually based on one of the following methods:

• Generally Accepted Accounting Principles (GAAP)
• GAAP consistently applied
• GAAP except otherwise indicated
• Country specific GAAP,
• International Financial Reporting Standards (IFRS)
• Tax basis of accounting
• Pro forma financial statements
• Other non-GAAP method of specific agreed upon accounting principles.

Any of these accounting methods can lead to disputes. In fact, GAAP itself is often disputed. GAAP can be very complicated because it is a set of principles and rules that are subject to interpretations that are based on estimates and judgments, and it is also frequently changing. Further, GAAP has many areas of flexibility including different applications, different accounting methods, and is impacted by consistency and materiality.  Any or all the foregoing may ultimately lead to a dispute between the buyer and seller.

The SPA should clearly state which financial statements of the company are to be used for measuring company performance and calculating the relevant earn-outs, working capital, and any other financial component of the purchase price. The relevant financial statements could be internal or management statements, interim statements such as the last twelve months, carve-out statements, pro forma statements or adjusted statements could be audited, reviewed and compiled, depending upon the definition used in the SPA.

Additionally, the SPA may discuss specific terms which could have a specific meaning within a given accounting framework and whose definition and application may be disputed. These terms should be explicitly defined along with examples as to how they would be calculated and utilized in the calculations. These terms could include: working capital, net book value, reasonable detail, specific accounting, capital expenditures, depreciation, commitments, investments, and revenues, among others.

Look for future blog posts which will include tips on calculating the various types of damages for post-acquisition disputes as well as additional best practices for avoiding these types of disputes.