The European Private Equity and Venture Capital Association (EVCA) has warned that International Accounting Standard 27 (IAS 27) could be applied to private equity funds in Europe even though the Financial Accounting Standards Board (FASB) has confirmed that in the US all investment companies will be exempt from similar measures.
IAS 27 forms part of the ‘Improvements to International Accounting Standards’ being drawn up by the London-based International Accounting Standards Board (IASB). It stipulates that companies prepare consolidated accounts, meaning that financial information relating to a parent company and all its subsidiaries will have to be presented as if the group were one single entity. While aimed at public companies, unlisted companies – including those owned by private equity firms – have not been exempted from the measure.
EVCA is currently lobbying for an exemption from IAS 27 for private equity, but has concerns that the industry will be overlooked by the IASB as too small a fish in a big sea. In a special briefing at its recent Annual Summit in Paris, the association warned of the consequences for early-stage funds – and consequently for entrepreneurship in Europe – should an exemption not be won.
At the briefing, EVCA chairman Jean-Bernard Schmidt said the FASB’s decision in the US was a ‘good sign’ but that the IASB remained ‘terrified that exemptions might be misused’ after a string of accounting scandals that have rocked the corporate world. IAS 27, which demands consolidated accounts be produced for all companies where ‘control rights’ are exercised, are expected to become compulsory for quoted businesses in Europe as from January 2005.
EVCA argues that having to mesh together the accounts of all private equity funds’ underlying portfolio companies into a homogenous entity would be misleading for investors in those funds because it would fail to reflect that companies in a private equity portfolio of direct investments are typically at different stages of development.
To illustrate the effects of IAS 27 on private equity funds, Javier Echarri, EVCA secretary general, unveiled two case studies where IAS 27 had been applied to real-life funds: a biotech fund and a buyout portfolio (the identity of the funds was not revealed).
Echarri showed that when using ‘fair value’ accounting, the value of the biotech portfolio at the outset was E138m. By year four, the portfolio’s successes had more than compensated for the losses so that the total value rose to E304m. By year six, the value of the portfolio had risen further to E463m.
However, applying consolidated accounting to the same assets yielded an opening value of E150m. By year four, with all factors other than financial results eliminated from the equation, the total value had slumped to E0.3m. By year six, with realisations having been achieved, the total value had risen to E463m.
When applied to the buyout fund, the outcome was the same although the difference between the respective values at the end of year four was not quite as dramatic.
Because of the inevitable losses incurred by young companies early on in their existence, Echarri argued that consolidated accounting would make fundraising for early-stage funds more difficult. “In our example [of the biotech fund], how can you set out to raise a new fund in year four of your current fund when it is showing all the losses but none of the potential?” he asked.
Although funds would be allowed to provide investors with fair value accounts alongside the consolidated accounts, Echarri suggested this would be confusing, particularly for investors who are new to private equity. The implications could be dire at a time when institutions are already sceptical of the European venture market following the losses sustained in recent years.
The EVCA is now in full lobbying mode ahead of a meeting of the IASB in March 2004 when the new rules for consolidation are set to be officially drawn up ahead of application of the rules in January 2005.