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IAS 27 and the issue of consolidation - a retrograde step for the European private equity and venture capital industry

The new proposals for consolidated accounts from the International Accounting Standards Board could have serious implications for the ways in which general partners report to their investors, says EVCA chairman Jean-Bernard Schmidt.

The private equity and venture capital industry’s value-creation model, based as it is on hands-on investment, has proved itself particularly effective for funding entrepreneurial businesses. Because of the risks they take, investors demand regular and detailed financial reports on the progress of their investment portfolios, as well as the development of specific companies in which they have interests. As a result, the private equity industry has set itself very demanding financial reporting requirements.

Going some way beyond the changes to accounting standards proposed by the International Accounting Standards Board (IASB), EVCA’s industry-wide guidelines – which are already applied by more than 80 per cent of EVCA members – play an essential role in helping investors to understand and keep track of the growth and evolution of individual funds, as well as monitoring their ongoing risk exposures. It is no exaggeration to say that the credibility of the private equity industry, and its long-term future, are to a large extent reliant upon the quality and extent of its financial reporting.

International accounting standards (IAS), as proposed by the IASB, are absolutely necessary for creating – and restoring – trust in companies’ financial reporting. IAS - endorsed by the European Commission on 20 September, except for IAS 32 and IAS 39 – will benefit European investors/shareholders, by helping to improve stock market confidence and, more widely, facilitating cross-border business.

That said, some aspects of IAS raise significant concerns for the private equity industry. Specifically, IAS 27 (which looks at how company reports should be consolidated) will also apply to private equity and venture capital funds because of the ‘control’ that a venture capitalist requires in his investee companies. The imposition of consolidation will oblige general partners to combine their accounts with those of their portfolio companies, threatening to undermine the transparency of reporting on which the industry depends. This will confuse investors and, as a consequence, hinder much-needed financing of entrepreneurial activity across Europe.

IAS 27, as it currently stands, assumes that growth in capital value is solely profit-related and therefore ignores the rationale on which private equity is built: that a nexus between management talent, technological know-how and market need has the potential to build exponential value in a growth business at a rate far beyond what would be conceivable in a major company. The values of growth businesses are aligned with their future potential rather than representing simple multiples of last year’s, this year’s and next year’s profits.

Applying IAS 27 to a private equity or venture capital fund will require general and limited partners to merge together all the constituent companies’ results. This could potentially hide the losses of some behind the profits achieved by others.By amalgamating the balance sheets of companies at different stages of evolution, as well as companies from across different industry sectors, applying IAS 27 will replace some of the most open and complete reporting to investors with headline numbers that deliver little valuable information.

Instead of creating a more transparent reporting environment, IAS 27 will constitute a severe step backwards for the private equity and venture capital industry. It will boost ‘intransparency’, producing an additional layer of unnecessary information, increasing the cost burden for general partners and masking the true picture that investors need to be able to make fully informed, risk-aware decisions.

Another extremely important implication of IAS 27 is the effect that its imposition may have on venture capitalists’ willingness to invest in businesses that look set to be loss-making for some time before realising their true potential in profits and increased value. In an economic downturn the private equity and venture capital industry is often the only hope for smaller businesses that have excellent potential, but nevertheless find their access to investment capital blocked.

EVCA’s priority is to demonstrate that, while IAS is absolutely necessary and welcome for mainstream listed companies, the private equity and venture capital industry stands outside the mainstream and should not be made to fit into the same reporting model. EVCA’s IAS Working Group is already in discussion with 30 of its listed members to demonstrate the impact of IAS 27 and more specifically the notion of consolidation. It will also explore solutions capable of delivering the end goal sought by the IASB, while taking account of the private equity economic value creation model.

As it stands today, IAS 27 represents a rule too far for the European private equity and venture capital industry. EVCA is working hard to put its views across and remains confident that a platform of constructive communication can and will be established with the IASB.

Jean-Bernard Schmidt is EVCA chairman and chairman and managing partner of Sofinnova Partners.

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