No love for IFRS

Although a road map has been laid for the ultimate convergence of US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), one would be hard pressed to find a UK or European private equity firm that currently follows IFRS. The reason can be summed up in one word: consolidation.

As panelists at the recent Private Equity International CFOs and COOs Forum in New York noted, there is no equivalent to the US' investment company accounting under IFRS. Investment funds with a controlling stake in a portfolio company must consolidate the company's financials into the fund's financials. And furthermore, the fund's financials must also be consolidated up into the management company's financials, especially if the fund manager owns a stake in the fund.

This is not a form of reporting that has any value to limited partners, said Katharina Lichtner, managing director and head of research at investment advisor Capital Dynamics.

“Unless we're seeing value shifts in the individual underlying investments of the funds we won't be able to monitor funds adequately and assess our risk positions with these funds,” she said during the panel. “Typically it's a small number of investments in each fund that really require the focus and determine the overall risk situation of a given fund. If push comes to shove and IFRS has to be adopted, the only way around this is for funds to provide double accounts. At the end of the day, it will just create additional cost.”

Not only does consolidation completely obscure any information about the performance of the underlying portfolio company, but it could trigger unpleasant consequences for the management company. Debt from portfolio companies could work its way through the funds and to the general partners' financial statements. If the general partnership has its own lines of credit, those would have to be renegotiated due to the new levels of debt on the balance sheet.

Under US GAAP, private equity firms are exempted from consolidating financial statements. Yet the International Accounting Standards Board (IASB) has not made any changes or exceptions to IFRS for the private equity community, despite the fact that neither general partners nor limited partners wish to receive consolidated financial statements.

Neil Beaton, partner in charge of Grant Thornton's valuation practice and another panelist at the event, suggests that because private equity is a relatively smaller component of the reporting firms that use IFRS, the industry doesn't get much “ear” with the IASB.

Lichtner, who is also a member of the International Private Equity and Venture Capital Valuation Guidelines (IPEV) board, agrees that the IASB has been slow to react to the industry's complaints, and in fact has yet to formally address the issue at all.

The European Private Equity and Venture Capital Association (EVCA) has handed in case studies showing the negative impact of consolidation on reporting, and the EVCA, the British Private Equity and Venture Capital Association (BVCA) and the Institutional Limited Partners Association (ILPA) have all been in dialogue with the IASB. But no exemption for private equity funds has yet been granted.

At the end of March there will be another consultation appointment, at which point IPEV and the other bodies hope to make their case again.

Lichtner argues that the accounting authorities are risking nonadoption of IFRS in the fund community by not addressing the problems created by consolidation.

None of the panelists at the CFO and COO event said they had seen private equity firms anywhere using IFRS. Lichtner said she saw no adoption of IFRS among fund managers. John Gort, CFO of Edgestone Capital Partners, said he looked through the UK Companies House, a registry of limited companies in the country, and was unable to find any of Edgestone's peers that reported using IFRS. Rather, the firms reported using the historical cost method.

“Right now, it's really only large external reporting companies that you'll find using IFRS,” Beaton says. “It's typically not a private equity firm.”

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Why we don't consolidate
Below is an excerpt from a financial report of an unnamed european mid-market private equity firm. The excerpt was presented at the 2009 PeI CFos and Coos Forum in New York as evidence that european private equity firms are not adopting IFrs:

“Accounting policies: Consolidation. The consolidated accounts include in full the Company and all its subsidiary undertakings except as detailed in the following paragraph.

The attributable proportions of the assets and income of the limited partnerships should be consolidated in full. However, the directors consider the accounts would not give a true and fair view if the assets and income as a whole were to be consolidated since the company's interest in these assets is, except to the extent that they are proportionally consolidated, merely that of investment managers.”