After the affair

In a perfect private equity world, all the details of a transaction should fall into place once the deal closes. But even with the most astute due diligence process, disputes inevitably arise between buyer and seller over purchase price. In addition, the buyer may face a number of costly post-transaction issues with the newly acquired portfolio company.

As a result, there are a number of things a firm must keep in mind in order to facilitate the post-transaction process.

PURCHASE PRICE ADJUSTMENTS
?Plain vanilla contract breaches, such as undisclosed pieces of litigation and environmental breaches involving the portfolio company, are typically much easier to head off before the closing of a deal, especially since a battalion of lawyers is often involved in the contract-making process from the get go.

In purchase agreements, purchase price adjustments are usually tied to a certain level of working capital that is guaranteed by the seller. In the process of calculating the working capital, the buyer typically prepares a closing balance sheet and presents it to the seller, including documentation of the actual methods of calculation as to what the working capital was on the closing date.

However, these adjustments often turn into contentious situations, says Ed Bartko, a senior managing director of transaction advisory services for FTI Consulting. ?Price adjustments can turn out to be way in excess of the purchase price, sometimes exceeding 75 percent, says Bartko.

Once the buyer provides the closing balance sheet and the working capital calculation, there is a 30 to 60 day cooling-off period in which both parties can talk with each other in order to resolve the disagreement over the purchase price. Though Bartko says it doesn't occur that often, arbitration may be needed in certain cases.

?Knowing that a dispute resolution mechanism is in place prevents parties that would purposely bring in a dispute, says Michael Kendall, a Boston-based partner for law firm Goodwin Procter. ?One party can have the worse argument, but if they feel they have deeper pockets, they can create a dispute that will last a long time until the other side capitulates. If the procedure set in the contract is short and quick, they won't attempt it. The dispute resolution mechanism will save both guys a lot of money.?

Of course, one of the main reasons these disputes happen is that right before the closing, when the seller presents an estimated closing balance sheet and working capital number, there may be a natural movement in the business that no one can anticipate.

There is also the issue of the interpretations of GAAP accounting principles. Says Bartko:?Was the seller using GAAP to prepare the financial statement? That tends to be the bigger portion of disputes you get into, particularly if you include reserves for bad accounts receivable.?

Goodwin Procter's Kendall says the best practice for avoiding these disputes is to make everything more detailed, ?to the extent that you are very specific about your basis of accounting. I've done deals involving a six-to eight-page attachment detailing the accounting treatment? If you have a generic statement, such as,?We calculate working capital based on the seller's historical practice,? and that's all, then there may be a big argument of what the seller's historical practices are and whether they are disclosed properly.?

In addition, Kendall says to always get the accountants on both sides of the transaction involved in the drafting process to make sure both parties are aware how figures were calculated.

?The problem is that these things are drafted by attorneys, not accountants, Bartko points out. ?While attorneys think they draft a tightly written section, we can drive a truck right through them. Bartko adds that when the contract is written, the working capital should be calculated like it was on the last audited statement. The interim accounting method differs from the year-end one.

PORTFOLIO COMPANY INTEGRATION
Once the purchase price is sealed, the buyer may still face a number of issues with the new acquisition. Often, a portfolio company will need a temporary chief operating officer or chief information officer, particularly in a case in which a division of big conglomerate spins out and now is a standalone company. ?The company doesn't have the depth of resources to handle that split from the mother entity, Bartko says. ?It needs assistance in many areas, be it information technology, treasury or any other corporate-type function. You need to provide professionals to meet these needs on a temporary basis until the company has its own staff.?

In addition, a private equity firm may need to assist the portfolio company with various compliance issues. In the US, this would involve the Securities and Exchange Commission. For example, though most transactions are private, some may involve a form of debt classified under SEC Rule 144a that requires registration within one year of purchase. Often times, the companies involved in these types of deals are not public or are just units of larger public companies, and most likely don't have the wherewithal to register themselves.

And in the case of deals where companies must adhere to Sarbanes-Oxley requirements, a private equity firm may need to make sure the company is fully documented in its financial processes and controls. With smaller companies that lack a staff to meet compliance, Bartko says it is especially an intense first year with costs reaching into the hundreds of thousands, though from then on, it becomes relatively easy