Accounting Update 2012

FOR PRIVATE FUND CFOs, COOs AND COMPLIANCE OFFICERS

ACCOUNTINGUPDATE2012

FEATURING

CLOSING THE GAAPWill the US adopt international accounting standards?

CONSOLIDATION VICTORYInternational standard setters take private equity into account

CALCULATING CARRYProfit share or service payment

AND MORE...

Introduction

In the accounting world, everything seems to be in flux. Virtually every country is undergoing a top-down review of their respective accounting processes in the hope of creating a universal set of standards for CFOs to share across borders.

The problem is that each country has their own ideas of what these global financial standards should look like, which has created a stalemate on any financial compromise for over a decade now.

Add to this the uncertainty around accounting practices at the firm level, specifically the issue of how to treat carried interest - either as a performance fee or a return on investment - it becomes clear that accounting is by no means a black and white numbers game.

In this white paper comprising recent articles and features from PE Manager’s ongoing coverage of accounting, we take a look at the long awaited working paper on convergence from US authorities and the clues it gives to future global accounting standards; receive in-depth insights from account-ing expert Mariya Stefanova on carried interest; the British Virgin Islands expected decision to increase auditing and accounting standards; and more.

We hope you enjoy PE Manager’s Accounting Update 2012.

Nicholas DonatoEditor | Private Equity Managere: [email protected]

ACCOUNTING UPDATE 2012 | PAGE 1

Closing the GAAP? by Nicholas Donato

The SEC has not yet made any final decision on wholly adopting interna-tional accounting standards but a long awaited working paper from the agency lists a number of requirements if the US were to do so

Nearly two and a half years in the making, a team of staff at the US Securities & Exchange Commis-sion (SEC) has revealed its findings on whether, when, and how the current US financial reporting system would transition to international standards.

The plan provided no specific recommendations on whether transitioning to International Fi-nancial Reporting Standards (IFRSs) would be the right approach for US issuers but listed many concerns if that were the route ultimately taken by the SEC.

Perhaps the biggest cause for concern has been the International Accounting Standards Board (IASB), representing much of the world community and its US counterpart, the Financial Ac-counting Standards Board (FASB), failure to complete a number of joint projects agreed in 2006 that aimed to strip key differences between US and international accounting standards. The boards have completed, either wholly or partially, a number of their joint projects, however, “there are several projects that both boards acknowledge are in need of improvement, but the boards are not currently devoting resources toward completion of those projects (e.g., financial instruments with the characteristics of equity)”, the report said.

In the report the team of SEC staff noted a number of differences between US GAAP and IFRS but said that their elimination would not be necessary for the SEC to adopt international standards. “However, the existence of differences indicates a need for the [SEC] to consider specifically such differences to determine whether investors and other users of the financial statements would be losing or gaining significant informational content and to determine the effect on transitional con-siderations if IFRS were to be incorporated.”

Looking forward, the working paper will now be used by the SEC’s top brass to evaluate the impli-cations of adopting international standards as the financial reporting system for US issuers, mean-ing no final policy decision on the matter has yet been reached. The SEC declined to comment past what was released in the 127-page report.


Sources say that if adopted the SEC will have to address the low support shown for international standards among US issuers. Having to convert US GAAP – which is embedded in laws and regu-lations and in a significant number of private contracts – was cited as one reason why conversion was not embraced by the financial community.

No matter what the outcome it has now been more than a decade since governments worldwide set out what was, in retrospect, an ambitious project: the convergence of international account-ing standards. Indeed Scott Saks, co-chair of the international securities practice at law firm Paul Hastings, told PE Manager that “it makes no sense that there is not a more immediate roadmap for the US to convert to IFRS as have most major economies”.

The US for its part has been paying lip-service to the convergence goal but is in actuality signaling an “endorsement” approach of international standards. So instead of a wholesale adoption, sources say, the US envisions the SEC working alongside international standard setters in finding common ground, all the while reserving the right to tweak the rules as they see fit. That’s not exactly the outcome many had been hoping for.

“It makes no sense that there is not a more immediate roadmap for the US to convert to IFRS as have most major economies”

However, the paper said there was still “substantial support” for exploring other methods of incorporating IFRS that demonstrate the US’ commitment to a single set of global accounting standards that would make reading financial reports across borders more simple.


Getting consolidation right by Nicholas Donato

CFOs rejoice! International accounting standards setters are taking greater pains to understand the private equity industry

A few weeks back the International Accounting Standards Board (IASB) did something unprec-edented: it blocked out time to discuss what consolidated reporting means for investment entities (like certain buyout funds) right down to the nitty gritty detail around “master-feeder” struc-tures.

What’s more is the board has finally realised that requiring buyout funds to roll up their portfolio companies into one jumbled financial statement – as is demanded by current international stand-ards – makes no sense.

It was about time, really. One of the biggest gripes private equity CFOs have is how worthless consolidated financial statements are under international accounting standards. Investors can’t decipher consolidated portfolio financial numbers in any meaningful sense and GPs view them as a waste of time and resources.

IASB’s (prior) lack of understanding on the issue has resulted in the large majority of European buyout firms neglecting international standards in favour of US Generally Accepted Accounting Principles (GAAP), which provide private equity firms an exemption from consolidated report-ing. But now that IASB has shown a deeper understanding of the industry, it’s entirely possible that European funds could begin adopting standards that are closer to home.

So why the change in stance now? The answer is most likely the IASB’s closer involvement with its US counterpart, the Financial Accounting Standards Board (FASB), which oversees GAAP. The two boards have had a number of joint meetings throughout the year but in June they discussed whether the consolidation exemption should go beyond traditional buyout funds and also capture fund of funds and master-feeder structures.

Mariya Stefanova, of consultancy house PE Accounting Insights, told PE Manager the IASB has tentatively decided that international standards will not require investment entities to consolidate financial statements under any circumstances while FASB decided to require a feeder fund in a master-feeder structure to attach its master fund’s financial statement along with its own. It’s a



small divergence, but one that speaks volumes about IASB’s progression in understanding buyout markets.

Private equity CFOs should be delighted to know that a consolidation exemption seems imminent under international standards. But more importantly, they should be happy that standard setters are now discussing the industry in a level of detail not seen before.

Calculating Carry

Is carried interest a profit share, or payment for a service rendered? Mar-iya Stefanova of Private Equity Accounting Insights sheds light on the question and other related matters in this how to guide for accountants wondering how to book carried interest arrangements

When accountants look at the way a fund structures carried interest payments, one significant question they must ask is if carry will be recognised and if so at what point.

There are some important points to consider before deciding on the answer of this question – when to start accounting for carry – whether to recognise/accrue for it earlier in the life of the fund or to wait until actual cash payment is made. There are also some obvious triggers that would provide good pointers about when to recognise carried interest.

The first trigger point is when the value of the assets is higher than the outstanding loan account (in UK funds) or the capital-contributions account (in US funds) and past the hurdle. Although the fair value of the private equity investments, which accounts for most of the net asset value (NAV) of the fund is highly hypothetical and subjective, this is a time to consider accounting for carry. This is based on the same assumption, mentioned above, namely that the partnership is liquidated/wound up on the reporting date and it had realised all assets and settled all liabilities at the fair value re-ported in the financial statements, and then allocated all gains and losses and distributed the net assets to each class of partner at the reporting date in accordance with its LPA provisions. Since the NAV of the fund is sufficiently high to hypothetically pay out carried interest to the carried inter-est partners (CIP), and because of the accrual concept, it is time to consider accounting for carry. Before that point, there is no need to do anything in terms of accounting, although it would be a good idea to start modeling the carry and testing it in preparation for that trigger point.

The second trigger point is when the loan-contributions account (in UK funds) or capital-con-tributions account (in US funds) plus the hurdle has been repaid to the LPs, after which point 20 percent of all the proceeds (essentially the carried interest) is due to the CIP, in which case this means that in most of the cases there would probably be little choice but to account for it.

With regards to the period between the two trigger points, there are two potential arguments with two accounting approaches, discussion of which follows.



FIRST APPROACH: NO LIABILITY, NO RECOGNITION APPROACH

This first approach is more in line with International Financial Reporting Standards (IFRS), but some argue that the second approach is also in line with IFRS, so I will leave it to you to decide which approach you adopt, depending on which arguments seem more convincing and of course subject to your auditor’s approval.

Unfortunately, for IFRS (and the same goes for UK GAAP) there is no guidance specific to private equity or at least generally to investment entities such as that provided by the American Institute of Certified Public Accountants (AICPA) for US GAAP, which informs exactly when to recognise or how to account for or present carry in the financial statements.

Back to the first approach: before the first trigger point, do not do anything, but monitor and make sure that the fund is not past that theoretical threshold.

For the period between trigger point one and two as explained above, the CIP can, hypothetically, start allocating carry based on the assumption that all the partnership’s assets are realised on the reporting date at the assets’ fair value, past the hurdle. However, the partnership’s investments are usually not marketable or feature limited liquidity that interim valuations are highly subjec-tive. Therefore, the argument that recognition needs to be delayed until gains can be measured objectively, or to put it in a different way, if the assets are realised (hypothetically) and they are realised at that value (that is, the fair value which is another hypothesis), then the carry partner will receive that amount, but that is just a hypothesis and there is no liability to the CIP based on that hypothesis.

Accordingly, considering the highly subjective nature of private equity valuations and that carry is not due to the CIP, that is, this is not a liability, the argument follows that carried interest cannot be put through the accounts.

However, for those for whom this argument seems appealing, it would be very useful if there is a disclosure note in the notes to the financial statements, such as a ‘contingency’ note but not a ‘contingent liability’ note as it cannot be a liability. Such a note could read as follows: ‘In the event that all the assets were sold at that carrying value, an amount of £X million will be payable to the carried interest partner.’


Bear in mind that this is a very important piece of information for the investors. My recommenda-tion would be that you make your waterfall calculation at that point in time and you run the num-bers through your waterfall model and make this disclosure based on the output from the model in the notes to the accounts.

After the second trigger point, as explained above, in most of the cases there would not be much choice but to account for it, that is, either, to reallocate 20 percent of the profits realised due to the CIP (a liability at that point) from the LPs to the CIP as it has been previously treated by many funds, or as an expense, if you chose to follow a relatively recent official treatment recommended by the Big Four accountancy firms as explained in the next paragraph; reallocate 20 percent of the net assets from the LPs to the CIP and of course account for the cash distribution in line with the cash waterfall.

What I will say now may sound as a bit of a surprise (and not a pleasant one) to some of you that may call for a change in your treatment of carried interest. Traditionally, as explained earlier, even under IFRS, carried interest has been treated as a reallocation of profit/gain, but now all the tech-nical experts at the Big Four accountancy firms have agreed that carried interest under IFRS is to be treated as an expense. What, for example PricewaterhouseCoopers states in one of its publica-tions is “unlike US GAAP where a carried interest may be presented as an allocation, a carried interest under IFRS will always be reflected as an expense (when the appropriately thresholds have been met)”, that is after the second trigger point which is past hurdle.

The argument, despite the legal form, is basically that: “A service is rendered by the GP, which gives rise to a financial liability (with a corresponding expense) as soon as the service is rendered as the obligation to pay meets the definition of financial liability in IAS 39 (obligation to deliver cash arising under a contractual agreement) and such obligation being recorded in income statement.” I would say that this argument has its merits, after all, despite the fact that carry has been traditionally structured by the lawyers in your LPAs as a profit share, not a consideration in exchange for a service ren-dered by the CIP to the fund, we all know what the carried interest is in essence, plain and simple – a performance fee.

“It makes no sense that there is not a more immediate roadmap for the US to convert to IFRS as have most major economies”


SECOND APPROACH: THE ACCRUAL APPROACH

The counter argument is that when accountants prepare accounts, we prepare them on an accrual basis, on the basis of prudence and looking forward. If the assets are sold at that value, and the valuation is in excess of the outstanding loan, the relevant proportion should go to the CIP. If the valuation exceeds the amount of the outstanding loans, this excess amount (which is in revaluation reserve) is allocated to the CIP.

There is usually a single revaluation reserve, so a good approach would be to split the revaluation reserve into ‘revaluation reserve’ and ‘carry reserve’/’provision for carry’ (or anything that you deem appropriate that would make best sense to the investors), which is allocated to the relevant classes of partners, that is, the LPs and the CIP, respectively.

If accounted for under this accrual approach, this is all that is required when accounting for carry at this point – split of the excess revaluation reserve by class of partners in the partners’ accounts and still no liability to the CIP.

Keep in mind that this is a tax-sensitive issue and you may want to think carefully about the pres-entation in the accounts as the relevant tax authorities may be tempted to follow your accounting treatment and presentation. After the second trigger point, it should be similar to the first ap-proach, that is, to account for carry in the majority of the cases.

Auditing a veiled reality for some BVI firms by Nicholas Donato

Unbeknownst to some GPs, the British Virgin Islands is expected to in-crease its auditing and accounting standards in the coming months

Some private equity firms established in the British Virgin Islands may be unaware of recently in-troduced auditing rules.

For the past two years certain BVI-based firms, but not closed-ended funds, were required to appoint an auditor and file their audited financial statements with the Financial Services Commis-sion. But some firms appear to exhibit “a lack of awareness of their new requirements” according to Grant Green, an audit director at KPMG’s BVI office.

“Given certain managers have not had any financial reporting responsibilities to the FSC in the past, it has proved a difficult task to identify and notify these parties of their new obligations”, Green said.

Later this year the Financial Services Commission is expected to issue further guidance requir-ing covered firms to prepare financial statements under a limited range of acceptable accounting standards.

Originally the Commission intended for firms to begin following the stricter framework in 2011, but backpedalled after the industry argued a strict interpretation of the rules may have locked out auditors from mainland European countries such as Holland, Luxembourg, or Switzerland, “de-spite such countries having some of the most widely respected accounting standards”, said Ross Munro of offshore law firm Harneys.


LPs struggle with fairvalue auditing by Nicholas Donato

Most private equity investors are finding it difficult to implement a formal fact-checking procedure for a fund manager’s fair valuation report, ac-cording to a Northern Trust survey.

Nearly three-quarters (70 percent) of limited partners believe their fair valuation of private equity assets is not yet up to par with industry accounting standards, according to a recent survey.

Northern Trust surveyed approximately 50 of its LP clients (who together had a median invest-ment of $2 billion in private equity) regarding their ability to meet reporting standards set by the US Financial Accounting Standards Board (FASB).

About half the respondents said their auditing process needed greater documentation in place to meet ASU 2009-12, the FASB’s guideline for valuing private equity and other non-quoted assets. ASU 2009-12, which came into effect in late 2009, allows an investor to use the net asset value reported by the general partner to estimate their own fair value of an alternative investment.


Clients are facing an increasingly complex landscape with regard to fair valuation rules for which minimal process guidance is provided”Paul Finlayson

However, the guidelines say that on top of LPs’ normal due diligence processes, procedures should be put in place to de-termine that the GP has used appropriate rigour in coming up with a fair value estimate, which fund managers then use to derive NAV.

Nearly two-thirds of respondents (64 percent) said they have struggled to obtain sufficient information to verify a GP’s fair value calculation.

“Clients are facing an increasingly complex landscape with regard to fair valuation rules for which minimal process guidance is provided,” said Paul Finlayson, an alternative assets product manager at Northern Trust.

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Accounting Update 2012