deconsolidation and outsourcing
Companies regularly announce securitisation transactions
(e.g. Chargeurs with its inventories, Odeon with its box office revenues) or
real-estate leasebacks (e.g. Fiat, Capio, the Swedish leading hospitals operator).
These are merely the logical extension of the discounted bills and leasing deals
of an earlier generation. Companies have always sought to reduce the size of
their balance sheets and to back financing with specific assets in order, theoretically,
to reduce their cost. This trend is becoming more pronounced. Some companies
go so far as to outsource all their manufacturing (see Alcatel/Flextronics deal).
Here is how the evolution of asset deconsolidation might look:
1 The principle
Transactions at each end of the spectrum above are relatively straightforward, while securitisation and leasebacks often use more complex formulas.
2 Accounting treatment
The arrangement is simple in its principle, but less so in how contracts are drawn up so that assets are truly taken off the balance sheet. Indeed, accounting rules have quickly caught up and now demand a restatement of transactions that are mere window-dressing, with the assets having to be reinstated on the balance sheet and debt booked accordingly. Discounted bills and leasing deals have long been restated in consolidated accounts. So a game of cat and mouse has arisen between companies, who attempt deconsolidating financing, and the guardians of accounting standards, who try to separate the wheat from the chaff. As regulations currently stand, the principles are as follows:
IFRS rules are quite strict and offer very little latitude.
US GAAP is significantly more flexible in terms of asset deconsolidation.
3 Financial analysis
Such deals often have complicated effects on the accounts, the most obvious ones being as follows:
- It reduces assets;
- It reduces net debt;
- It generally lowers EBITDA and EBIT, as lease payments cover both the cost of financing and asset depreciation. Some structures, such as synthetic leases, help lower this negative impact considerably, by limiting the leasing payments almost to the cost of financing; the asset must then be bought back at the end of the contract at a price close to the current price. These can be thought of as a simple carrying transaction.
- It raises the break-even point in terms of cash, as these deals replace a cash cost (rents) with a calculated charge (goodwill).
- The impact on the bottom line and shareholders' equity depends closely on the transaction that is used, as companies must decide between the discounted rent it has pledged to pay in the future and sale price of the assets today. The higher one is, the higher the other will be.
Hence, a company that wants to immediately realise
a capital gain and significant liquidity must pledge to pay rents significantly
higher than the market average over a long period.
Financial analysts are increasingly familiar with this type of transaction, and while they only rarely restate them, they do take them into account in their overall assessment of the company's risk profile. Ratings agencies, for example, systematically reinstate onto the balance sheet those assets that have been securitised or are involved in a sale-leaseback. The also consider that if a group's financing is provided by a significant portion (20%) of securitisation, leasebacks or structural subordinated financing, that is reason enough to give the company a negative outlook (an example is US airlines practice of securitising their spare parts), as the quality of the accounts has been lessened.
4 Why do it?
To see how worthwhile such transactions are, let's
take the simple example of factoring, which actually covers four types of services
to companies, sold either individually or in a package:
1. Financing with a competitive cost;
2. Outsourcing of bill collection;
3. Insurance against unpaid bills;
4. Having debt off balance sheet (used by some companies to dress up their balance sheet).
These services perfectly illustrate the objectives of securitisation, outsourcing and sale-leasebacks:
- Financing: finding a new source of financing that is less expensive than the overall cost of a company's financing. The purpose is for the entity that owns the deconsolidated asset to obtain a higher rating than the parent company. By breaking down the risks, the company is better able to find specialised investors for the type of risk offered (e.g. real-estate risk, default risk, etc.). However, for the transaction to create value, the increase in total risk on the rest of the assets must not cancel out the savings from the cheaper source of financing! And the efficient markets theory does not hold out much hope of that...
- Transferring a risk: a company may consider that the risk of fluctuations in the real-estate market, in the value of used vehicles, etc., is not part of its core business. A sale-leaseback deal, for example, can isolate this risk. Similarly, a company can be hit hard by a customer default, whereas a factor reduces this risk by playing the law of averages. He develops a special skill in assessing a risk that a company does not control, skill that it makes available to the company so that it can choose its clients better. It is only on this latter condition that the transaction can create value, as the transfer of risk does not create value, but is only a simple rebalancing between risk and reward.
- Window dressing: reducing balance sheet debt and improving financial ratios is one clear motivation, albeit one that, as we have seen, has limits, such as the risk of a deterioration in future operating performances. A deconsolidating package generally carries higher financing costs. So the choice is often between optimising financing costs and dressing up the balance sheet. Value creation in this case is an illusion.
- Reengineering/Operating flexibility: the
most intensely structured deals make varying use of outsourcing of certain
services that can restore a company's flexibility: for example, a renter has
less hesitation in moving into more suitable premises than an owner would.
However, this flexibility is somewhat limited by the sometimes-long duration
of contracts signed when the deal is being set up, especially when it involves
a very specific asset.