Many CRO employees are critical of a common methodology that private equity firms employ to finance their acquisitions, i. e. the use of debt. Typically, a private equity firm buying a publicly owned company uses the cash contributed by the partners in one of its funds for approximately half of the money it pays shareholders. It borrows the rest, using as collateral the assets and overall creditworthiness of the company it’s buying.

Private equity managers are hardly the only class of financial professionals who regard the use of financial leverage as an appropriate tool to help finance an acquisition. But CRO managers who have not had an extensive financial education might view the imposition of debt on a service business as unwise. Indeed, some with whom we have discussed this issue view the imposition of financial leverage as a major constraint on management’s ability to continue increasing revenue and profits. After all, as many outsourcing firms’ employees have pointed out to me, a CRO is a service business and its employees are its most productive assets. While many firms have small laboratory divisions, they have fixed asset bases made up largely of office buildings, not extensive campuses of laboratories, vivariums, and manufacturing facilities. It doesn’t seem to make sense to use debt as an important element of a service business’s capital structure.

Historically, most publicly held CROs have used modest amounts of long term debt. SEC filings for the quarter ended March 31, 2013 show the following data:

	Short Term Debt	Long Term Debt	Stockholders’ Equity	Total Assets
Covance	$325 million	none	$1.34 billion	$2.25 billion
ICON	none	none	$767 million	$1.23 billion
PAREXEL	$10 million	$386 million	$552 million	$1.69 billion

PAREXEL intends to use the proceeds of its recently announced private placement of $100 million to refinance much of its existing debt.

Quintiles used $360 million of its IPO proceeds of $496 million to repay a portion of its debt. Its post-IPO capital structure looks like this:

	Short Term Debt	Long Term Debt	Stockholders’ Equity	Total Assets
Quintiles	$55 million	$2.02 billion	($896 million)	$2.50 billion

The large deficit in the Stockholders’ Equity account reflects many years of dividend payments and common share issuance to the company’s private equity owners, and an extensive recapitalization. In the transition from public to private ownership back in 2003, the balance in that account shifted from $1.65 billion to $520 million. During the last three years, Quintiles has added more than $575 million in net income to its Stockholders’ Equity account, but has shifted more than $900 million out of that account as returns to its owners. It’s important to understand that both figures reflect accounting entries, not cash flows.

Are you confused about the flow of funds involved in a going-private transaction? Or about the impact on the balance sheet of a subsequent public offering of a company previously owned by private equity investors?

There’s not enough space in this column for me to lay out more details of the accounting entries used in such transactions. But stay tuned for next month’s exciting episode in a long-term saga that could be called “The financial impact of private equity ownership of the outsourcing industry.”

---

Michael A. Martorelli is a Director at the investment banking firm Fairmount Partners. For additional commentary on the topics covered in this column contact him at Michael.martorelli@fairmountpartners.com or at Tel: (610) 260-6232; Fax (610) 260-6285.