Definition
Transaction costs refer to the fees and expenses incurred in the execution of an M&A deal, particularly relevant in leveraged buyouts and other private equity transactions.
These costs are typically incurred at closing and reduce the total equity available to the buyer. They are categorized into financing fees, advisory fees, and other one-off expenses. While often overlooked in strategic discussions, transaction costs can have a meaningful impact on investor returns and must be accurately reflected in the Sources and Uses schedule.
Common types of transaction costs include:
- Advisory fees (e.g. investment banking, legal, due diligence)
- Financing fees (e.g. upfront fees for arranging debt facilities)
- Accounting and audit fees
- Regulatory or filing fees
- Management buy-in costs (e.g. retention bonuses, equity rollovers)
Modeling
In a typical LBO model, transaction costs are modeled in two main areas:
- Sources and Uses: Costs appear on the “Uses” side and are added to the purchase price to determine total funds required.
- Pro Forma Balance Sheet:
- Advisory and other deal costs are expensed immediately and flow through the Income Statement via retained earnings.
- Financing fees are capitalized and amortized over the term of the debt, typically modeled in the debt schedule.
Key Considerations
- Financing fees affect both the balance sheet and cash flow statement.
- Expensed transaction costs reduce equity value and thus impact IRR.
- Assumptions must be made regarding fee percentages (e.g. 1.5% of debt raised) or flat amounts (e.g. €3m total advisory costs).