Taking the long view

Few people would claim to possess an ability to predict what is going to happen over the next ten years let alone prepare for all eventualities that may arise during that time. Yet that is precisely what an LPA is expected to do. It governs all aspects of the operations of a private equity fund and it is the key document that GPs, LPs and their accountants, administrators and lawyers refer to when any question or disagreement arises. It is essential, therefore, that an LPA is robust enough to stand up to scrutiny but retains enough flexibility to cope with the changing demands that will inevitably be placed on it throughout the entire life of the fund.

A key issue when reporting to LPs is if, when the LPA is drafted, the parties have agreed to use a particular reporting standard, but then later in the fund’s life, a competing standard is introduced. In this scenario, the requirements will have shifted and the fund will again have to seek investor consent to amend the standard set out in the LPA. This section looks at some of the problems that can arise as a result and proposes solutions to them.

Selecting the appropriate accounting standards in order to prepare the fund’s annual accounts and to report under would, on the face of it, seem to be one of the most straightforward decisions a fund can make. However, not having the flexibility to deal with enduring reporting standards, or standards that are not designed adequately to deal with investment vehicles, has created specific problems (as outlined below) in the past and valuable lessons in a wider context can be learned and applied when drafting all LPAs.

It is not unusual for accounting standards boards to update and revise accounting standards in response to market developments or inefficiencies. The International Financial Reporting Standards (IFRS), and the revisions made to them, is a typical example of the type of problem that can arise. These standards were historically seen as acceptable for funds to report under both by GPs and by LPs. The revision of one of the IFRS standards (IAS 27) in 1989, however, determined that all entities that were deemed to be controlled by another entity had to be consolidated within that controlling entity.

Many private equity portfolio companies fell within that definition and, as a result, their accounts had to be consolidated into the accounts of the fund. The income, expenses and profit of the fund accounts would, for example, have to include those from all the impacted portfolio companies. This rendered the existing accounts of the fund and, therefore, all associated fund reporting, all but meaningless for GPs and LPs.

If LPAs are not drafted from the outset to provide sufficient flexibility to deal with later changes to accounting standards (which are not specifically designed for fund reporting or which make fund reports less meaningful for investors) then, in order to implement the required change to the accounting standards set out in the LPA, the funds affected have to either seek investor approval to make amends to their reporting standards or, in the few cases where this is not possible, actually report under the revised reporting. Due to the complexity and additional data included, this results in increased cost with no meaningful benefit to GPs or LPs that do not want to receive financial information for the fund and all portfolio companies on a consolidated basis.

There are four ways to mitigate this problem:

1. Draft the relevant LPA clause to allow the fund to report under internationally recognized accounting standards, which allows the GP (often in consultation with the auditor or LPAC) to make required changes.

2. Include a provision to allow the GP to adopt accepted best practice at a given time in the life of the fund, rather than full adoption of standards, affording it the flexibility not to adopt IAS 27.

3. Have the LPA refer to a specific accounting standard disapplying the relevant provisions that are not practical for funds. While this deals with historic changes, it does not provide the flexibility to deal with future changes to accounting standards.

4. When drafting the LPA, do not refer to a specific accounting standard but rather set out a list of principles in a schedule to the LPA pursuant to which the fund’s accounts and reports will be prepared.

It should be noted that due to proposed amendments to the Partnership Account Regulations in the UK (notwithstanding what is in the LPA), funds generally established under the UK Limited Partnership Act may need to prepare and file UK GAAP-compliant accounts at Companies House. Similarly, some US investors, such as US insurance companies, ask GPs to prepare a second set of accounts in accordance with US GAAP irrespective of the standard that the fund is using in order to make their own financial reporting to their regulator and oversight body. This obviously has a time and cost impact for the fund too.

TAX TALK 

In the US, the K1 tax return, which detailed the partnership and investor returns to the Internal Revenue Service (IRS) on an annual basis, was historically the main tax form that private equity funds were expected to complete for their US investors or their fund of funds investors that themselves had US investors. However, given the current need by governments across the world for greater revenue and the increased scrutiny and, therefore, reporting imposed on tax payers, it is of little surprise that an increasing number of national tax authorities are now beginning to require more detailed information from investors resident in their jurisdiction that invest in private equity funds. A private equity fund, therefore, may find itself subject to enquiries from, and reporting information to, tax authorities in jurisdictions where the fund’s investors are based. For example, the German tax authorities launch tax audits once they have between three and five years of tax returns, looking through the fund at the distributions/proceeds from the underlying portfolio company divested. These audits are very detailed and very different from the tax returns themselves and are becoming increasingly common.

The costs of collating and completing this information, even with specialist advice, can be substantial, often running into tens and even hundreds of thousands of euros. It is essential that the LPA is clear about what responsibilities the GP has regarding tax reporting and providing tax information, and who is responsible for these increased costs – the fund or the investors requesting the additional data. It would seem to be a matter of simple common sense for this to be an investor-specific cost, but historically it has been ambiguous because, under the LPA, it is the fund that is often legally required to provide such information. Arguably these tax returns and audits fall within that definition.

More thought into how these clauses are drafted and what GPs agree to in LPA negotiations would prevent this becoming an increasingly contentious area between GPs and LPs. The LPA needs to detail clearly who is responsible for incurring the costs of reporting such information.

BE CAREFUL WHAT YOU PROMISE 

Both the European Venture Capital Association (EVCA) and the Institutional Limited Partners Association (ILPA) have reviewed reporting requirements, and both have proactively driven industry best practices to encourage and support long-term aligned partnerships between LPs and GPs. A move towards standardization in reporting methods and developing consensus on the level of information private equity funds should provide to investors has generally been accepted as useful and overdue. However, it is important to understand exactly what is regarded as EVCA compliant and what is ILPA compliant.

EVCA has two different levels of reporting guidelines, namely requirements and recommendations. The latter is far more extensive and necessitates substantial additional work within the financial statements and investment reports. For example, a set of quarterly financial statements reworked to be EVCA level 2 compliant, including adopting all EVCA recommendations, can potentially more than double the reporting pack that funds issue to investors. Unless it is a relevant factor in the ability to raise funds, a GP should, therefore, carefully consider EVCA recommendations (and indeed ILPA recommendations) before committing to them.

Similarly, stating that a GP will be ILPA compliant should not be done without considering the practical implications. ILPA guidelines are anything but a tick-box operation. They can involve significant additional work in terms of the fund’s ongoing call and distribution analysis and reporting. Again, what might seem to be a good fundraising or marketing tool may have longer term practical implications and costs for a fund.

It is understandable why investors want consistent and uniform reporting as they are likely to invest into numerous funds/positions and information is consequently presented in varying formats. However, there cannot be a completely standard set of reports, as this would not allow for the many possible variations and nuances of individual LPAs.

Furthermore, industry best practice changes and adapts over time. Guidelines adopted today may be superseded tomorrow. Rather than tie themselves to a particular standard or requirement in the LPA, GPs should only commit to reporting in line with accepted best practice at a particular time in the fund’s life. This leaves sufficient margin for the GP to use its own judgment as to the most appropriate way to report information to investors. As with accounting standards, being overly prescriptive in the LPA is not a recommended course of action, if it can at all be avoided.

Alan Ross is a director at fund administration service provider Aztec Group. He is responsible for the investor and financial reporting areas of the firm’s private equity business.