How should we treat financing fees in an LBO?

Financing fees are any upfront costs associated with issuing new money.

Typically, whenever companies issue new debt, they must pay the lender a commitment fee of 0.25% to 2%.

Even the financial sponsor may charge fees on total sources less fees in contributing capital to close the deal and organizing the financing.

The fees are paid to close the deal. That is, you need capital in order to buy out the company.

If we view debt as a product, it is being used over the course of the investment in order to fund the deal, then we should spread the cost over the deal.

Most sponsors aim to sell the company after 3-5 years.

So, we should amortize the financing costs over the life of the deal.

So, if we had $10M in financing fees from all the different tranches of debt issued, we would capitalize the fees on the balance sheet as a long-term financing asset of $10M at close.

Then, after each year, we would amortize $2M ($10M / 5 years) of the fees.

This amortization of financing fees would show up on the income statement as an interest expense (cost of issuing debt). So, net income drops $2M (assuming no taxes).

Then, it would be reversed on the cash flow statement. So cash is unchanged.

On the balance sheet, the financing asset would fall by $2M and equity would drop $2M.

Bottom-line? Financing fees are used to underwrite the deal which spans multiple years. So, we need to allocate those financing costs over the course of the deal.