As I noted in my July/August column, Quintiles’ June 30, 2013 balance sheet shows Total Assets of $2.64 billion, Long Term Debt of $2.04 billion, and a Shareholders’ Deficit of $798 million. Just before the company was taken private in September 2003, it had Total Assets $2.14 billion, Long Term Debt of only $16 million and Shareholders’ Equity of $1.68 billion. A conservative estimate suggests that the company generated profits of more than $1.0 billion from late 2003 to mid-2013; so how can it now have a negative net worth? The answer lies in the accounting for various transactions, as Quintiles was taken private in September 2003, recapitalized in 2007, and taken public again in 2013.

Space does not permit a complete explanation of all the accounting entries required to accomplish the tasks just noted, or the difference between certain entries that involved cash and others that involved non-cash accounting adjustments. Moreover, the company did not make its financial reports public during most of that 10-year period. However, as part of the September 2003 going-private transaction, the private equity buyers had Quintiles float an issue of publicly traded bonds. So it is possible to trace some of the financial flows of that transaction from changes in the company’s balance sheet as recorded in its filings with the SEC. There were several noteworthy changes from the end of the second quarter of 2003 (the last balance sheet for the predecessor company) to the end of the third quarter of 2003 (the first balance sheet for the successor company):

• Cash & Equivalents decreased from $754 million to $333 million; Long Term Debt increased from $16 million to $773 million. The private equity buyers used part of the company’s cash balance, bank debt, and long-term debt to finance the takeover.
• Retained Earnings decreased from $771 million to $1 million. That line item represents the sum of a company’s profits, after dividend payments, since its inception. In this case, it included only the results of the successor company from the date of the takeover, i.e. September 25, 2003.
• Common Stock decreased from $909 million to $522 million. That line item represents the notional value of the interest of shareholders. In this case, its value had to be adjusted to a new level, based on the assets and liabilities of the successor company.
• Total Assets decreased from $2,142 million to $1,988 million. Total Liabilities increased from $462 million to $1,465 million. Therefore, to make the books balance, total Shareholders’ Equity (made up of the Common Stock and Retained Earnings accounts) had to decrease from $1,680 million to $523 million. Like its components, it had to reflect the new value of the successor company’s assets and liabilities.

From September 2003 to June 2013, the Shareholders’ Equity account had to reflect additions (net income), subtractions (dividends paid to the private equity owners), and at least one recapitalization, in which one private equity fund liquidated its position and others made new investments. The result of those changes led to the current negative value of that account.

Several observations are in order:

• When PE investors use a large amount of debt to take a public company private, the value of the successor company’s Stockholders’ Equity account has to decline to reflect the addition of that debt.
• In the absence of post-transaction SEC filings, the public never sees the revaluations noted above.
• Those revaluations will become visible when such a company returns to the public market.

Several readers have asked why I’ve bothered to try and explain a relatively straightforward accounting issue that is well understood by financial professionals and not particularly relevant to most CRO/CMO/CSO employees. Well, some of those professionals only buy stocks of companies with tangible book value. They shy away from emerging biotech companies with a negative net worth. Will they ignore the strange-looking numbers that show that the world’s largest outsourcing service provider has no net worth? Will they ignore the stocks of Catalent, inVentiv Health, PPD, PRA International and other outsourcing companies as their books show similarly strange looking financial numbers when and if their private equity owners decide to take them public during the next few years? I hope not. But it seems worthwhile to illustrate this issue now rather than wait for a hue and cry from some investor, reporter, or blogger who panics over the “negative net worth” of a substantial portion of the outsourcing industry.

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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.