Consolidated counter-attack

Last year, listed European private equity firms apparently bowed to the inevitable in being forced to undertake consolidated accounting of their assets for the first time. Led by a spirited lobbying effort from the European Private Equity and Venture Capital Association (EVCA), the industry had argued right up to implementation that the new accounting rules were not just unnecessary but would prove downright confusing to investors. The argument was lost but, one year on, a leading industry professional has reignited the debate in the hope that a way out for private equity firms might still be found.

The new rules stemmed from International Accounting Standard 27, a standard devised by the London-based International Accounting Standards Board (IASB) which aims to achieve greater accounting transparency and eliminate the scope for fraud. Consolidated accounting is seen as the tool with which to achieve this, by pulling together the accounts of all a parent group's subsidiaries into one homogenous entity.

However, whilst obviously applicable to corporate groups, the private equity industry has always maintained it should be exempt. Combining the balance sheets of portfolio companies, which may be very different types of businesses at very different stages of development, is, contends the industry, a nonsense which makes reports to investors more puzzling rather than more transparent. It is an argument that has been accepted in the US, where private equity firms succeeded in winning the exemption that proved elusive for their counterparts on the other side of the Atlantic.

Herman Daems, chairman of Belgian private equity firm GIMV, campaigned against private equity's adoption of consolidated accounting as chairman of the EVCA from 2004/05. But leaving the post does not mean he has also relinquished his opposition to the new legislative environment. Indeed, given that GIMV is listed on Euronext Brussels and is forced to implement the rules, he still finds himself very much on the frontline. In light of this, he has redoubled his efforts to find a solution.

In a recent interview, Daems revealed to Private Equity Manager that he has shaped an argument for exemption based on the respective business models of corporate groups and private equity firms, which he is sharing with relevant authorities behind the scenes. He is arguing that corporates operate a horizontal model, whereby there is a close relationship between all the subsidiaries as well as between the parent group and the subsidiaries. Private equity firms, by contrast, operate a vertical model whereby the parent (GP) has a close relationship with its subsidiaries (portfolio companies) but the subsidiaries are not closely related to each other, if at all (see accompanying chart).

Daems elaborates: ?Private equity funds never use the assets from one unit to cover liabilities in another. There is no attempt to generate common brand names or have sales forces operating across the different units.? In consolidating the accounts of companies that essentially have no inter-dependence, Daems says it becomes clear that the whole exercise is largely pointless.

He hopes that private equity firms can satisfy the concerns of regulators by committing themselves to a legal contract that would make the operation of a vertical model binding. ?I am advocating that as part of deal agreements we enter into a legal arrangement that never can the assets or liabilities of the company be used against assets or liabilities of other portfolio companies.? He claims that a number of lawyers he has spoken to are sympathetic to the idea.

Thus has a new front been opened up in European private equity's ongoing battle to avoid consolidated accounting

Cox vows hedge fund regulation
At a July 25 hearing before the US Senate Committee on Banking, Christopher Cox, chairman of the SEC, stated that the commission still plans to regulate hedge fund managers, despite a recent defeat in a DC Circuit Court of Appeals that vacated a prior attempt by the SEC to make hedge funds register as investment advisors. A client memo from law firm Debevoise & Plimpton called the testimony ?surprising for the strength of the views expressed.? Cox emphasized the many instances of hedge fund fraud, and stated that the SEC continues to have authority over any hedge funds that violate laws or antifraud provisions. He described the now-diminished SEC oversight of hedge funds as ?inadequate.? According to the Debevoise memo, Cox proposed new antifraud rules that would ?look through? hedge funds to the underlying investors as a way to enforce the ?obligations? that hedge fund advisers have to these investors. The DC court reversal essentially vacated the SEC decision to deem underlying investors as ?clients,? as opposed to the hedge funds themselves.

Swedish disclosure rules loom
The Swedish minister for local government and financial markets reportedly has noted his desire to see private equity and venture capital firms come under closer scrutiny. Sven-Erik Osterberg reportedly told a Swedish news service that he will inform the Swedish Financial Supervisory Authority that the agency needs more authority to inspect the information of private equity firms. ?We will wait and see which measure they suggest, but I do not rule out a new law in the longer term,? Osterberg is reported to have told news service Dagens Nyheter. The Swedish financial authority, called Finasinspektionen, is reportedly also concerned about levels of debt applied by private equity firms to portfolio companies. Erik Saers, the deputy director-general of the authority, reportedly said he wants to send a ?wake up call? to the private equity industry on the subject of debt. Tom Berggren, director general of the Swedish Private Equity and Venture Capital Association, reportedly called the authority's concern unjustified.

Merrill must refund LP capital
The National Association of Securities Dealers has ordered a fund of funds arm of Merrill Lynchto return roughly $500,000 to a client who claimed Merrill was complicit in artificially inflating the value of an underlying investment. The limited partner, Festus & Helen Stacy Foundation, said an investment in a fund that in turn committed to a TH Lee Putnam Ventures vehicle had been inappropriately overvalued. However, the NASD rejected the client's effort to seek $20 million in punitive damages from Merrill Lynch. Festus & Helen Stacy had committed $1 million to the fund. The lawsuit dates back to 2004 when the LP accused Merrill Lynch of luring it into an unsuitable investment vehicle. The complaint did not include accusations against TH Lee Putnam.

CDC hires PR firm
CDC, the UK government-backed emerging markets private equity firm, has hired Merlin as an external communications advisor, the firm announced. The decision comes after a competitive process among several public relations firms. CDC, based in London, is led by chief executive Richard Laing. The firm's corporate communications director is Miriam de Lacy. According to a press release: ?CDC has engaged Merlin to build its profile and reputation in the UK, as well as in the key emerging market territories in which it invests.? CDCwas formerly called the Commonwealth Development Corporation, founded in 1948. The firm focuses on backing emerging markets private equity funds. The firm today has commitments to more than 60 funds targeting Africa, Asia and Latin America. In 2002, its direct investment arm, Actis, spun out to become an independent firm.