March 16, 2018
Interviewed by: Privcap

New Revenue Recognition Rules: Why They Matter for PE

Stacy Dow, partner at RSM talks about the impacts of the new revenue recognition standard and what it will mean for private equity firms and their portfolio.

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New Revenue Recognition Rules: Why They Matter for PE

Privcap: Why is it critical for a PE to know about the new revenue recognition standard?

Stacy Dow, RSM:
This is a fairly impactful standard. It affects revenues and costs. It affects the timing and allocation of revenue, as well as the cost. So, if you think about things like EBITDA, debt covenants and metrics, all those trends will change. As a result, you really want to get ahead of it to understand what those changes are. As a private equity group, you always want to be prepared for liquidity event. So, in the event of a diligence exercise, now that we’re one year from the date of that standard, potential buyers are going to want to understand what are the impacts under 606 and how can we plan about thinking about this, about structuring this deal, about organizing ourselves to adopt the standard, and also negotiating debt covenants.

Why the rush?

Dow: If you are thinking that you’re going to go to be acquired by a strategic company, a public company, calendar-year public companies have already adopted that standard. It was effective January 1 of 2018. So, as a private company being acquired by a public company, you’ll have to be compliant with that standard within the next quarter for that public company. That is a pretty short window of time for a private company to try to adopt a standard that’s this impactful.

What impact this will have on certain types of business?

Dow: The ones that are most impacted by this standard, I would organize it more by industry group. So, when you think about industries that typically enter into multiple-element arrangements, sell a variety of products and services together in the same arrangement with the customer, think about technology companies, life sciences, construction, engineering—they could have changes in terms of how they allocate revenue to different products or services in those arrangements, and also the timing of that.

If we think about consumer products, industrial manufacturing and manufacturing, they often enter into a number of arrangements involving loyalty, reward programs and returns. This standard requires that although the returns reserve is fairly similar, in that you’re going to estimate a reserve for returned goods, you also now have to put an asset on the books for the right to receive that inventory and value that inventory and test it for impairment.

What did we learn from the public adoption?

Dow: The number one impact is that many public companies underestimated the impact of adopting this standard. What we learned is there’s a significant amount of time and effort required to adopt this standard, that there are judgements and estimates that require information that may not be tracked historically, and a lot of coordination needed within different groups in the organization in order to adopt the standard effectively and to make sure that you’ve considered all of the implications of adopting the standard.

How will these changes effect a portfolio company?

Dow: You’re dealing with changes that involve judgements and estimates and require a lot of input. So, it’s disruptive for the organization, it takes a lot of time and effort and you need to properly plan and think about that. As difficult as it is for the company to implement, it’s difficult for auditors to audit judgments and estimates. They need time to get through this standard and to think about how they’re going to audit that and how they’re going to get comfortable. It’s the amount of time required to do this in a thoughtful way.

What advantages do PE firms have by adopting the standard?

Dow: Private equity groups have the ability, unlike a standalone private company, to be able to utilize all the resources available to them across their portfolio and also to deploy some strategies, like training the trainer, taking management teams that either have more availability of resources or more competency among the management team and utilizing them across the portfolio.

What’s the right tone in collaborating with the portfolio company finance teams?

Dow: It’s important to have collaboration. The management teams are going to have a much more detailed understanding of what the impacts are organizationally of adopting this standard and being able to get historical information. Fund managers are going to have a much better understanding of the strategy of the fund itself and the individual portfolio companies in it and what the market might demand for trends and for analysis of information. I think the two groups need to come together in making sure they are thoughtful about that when they’re choosing both their adoption method and their plan for implementation and then their business model going forward.