August 28, 2017
One reaction that followed the FASB’s long-awaited revision of lease accounting standards from members of the private equity (PE) community (and their advisors) was, in a nutshell, “My portfolio’s whole leverage picture just changed — this impacts the economics of our deals!”
We expect that in the US, reality will be more of a GAAP compliance exercise (the effort involved is not to be underestimated, but more on that later) and not something that requires a complete overhaul of covenants or a major impact on deal economics. In fact, in a recent PwC survey on the new lease accounting standard, only 13% of finance executives expected the impact of the new standard to result in a necessary renegotiation of any existing debt covenants.
The new standards are certainly cause for careful review and consideration of all leasing agreements and related covenants, old and new. Compliance will mean real work – taking detailed inventory of all leases and their terms, even upgrading current accounting systems. A significant majority (66%) in our leasing survey expect to make some type of system change, with 43% indicating they will implement a new lease management system. But PE firms, and most other entities, can put away the fire hoses for the time being. The (leased) house isn’t burning yet.
Without question, PE players should acknowledge a key concern of how changes involving the treatment of leases as liabilities might impact its portfolio company’s ability to meet the terms of the debt covenants they have entered into with their lenders. Under the new standards, all leases longer than 12 months must now be carried on corporate balance sheets as a liability similar to capital leases under current GAAP. That’s the change that has prompted fear about upending debt structures. But it may be an unfounded fear that operating leases will have the same covenant impact as the old capital leases.
For entities that use GAAP financial reporting and are subject to FASB standards, what’s really changing is the presentation of operating leases, not the economics. When it revised its standards, FASB made a point of keeping separate classifications for operating and financing (formerly known as capital) leases, and the criteria for classification have remained largely the same. Further, the FASB went so far as to emphasize that the new operating lease liabilities are operating liabilities and should be distinguished from financing leases and other debt.
For PE firms thinking about next steps for their portfolio companies, consider these potential issues:
- For portfolio companies that apply US GAAP, be efficient in how you address your existing and new debt covenants and acknowledge the FASB’s continued dual-classification approach for leases. Engage your experts upfront – figure out what you need to change and where you don’t need revisions. That will enable you to go to your banks with an organized and fair proposal.
- Bear in mind that the international standard setters did not provide the same dual-classification approach, so a different strategy may be required if your portfolio company applies IFRS.
- Do a “dry run” – implement the required lease accounting changes throughout your portfolio companies early, before it’s required, to identify processes and compliance efforts that may require your management teams to adapt.
That latter point will prove important down the road because some companies have been surprisingly slow to take up planning for implementation with 23% in our survey indicating they hadn’t started yet. While deadlines are still more than a year away, companies need to be planning now for implementation at the operating level.