Senior staff at private equity firms seem much more focused on their accounts these days. Why?
PC: A major cause is the requirement for many advisors to private funds to become registered as investment advisors with the Securities and Exchange Commission. This change, introduced in 2012, has put private equity funds’ accounting practices under the regulatory microscope – and it’s not just the fund. When the SEC visits our clients, one of its first questions is, “Who is your audit firm and audit partner?” The SEC will then come and talk to us.
What kind of things is the SEC concerned about?
PC: The SEC is looking for high-quality outputs from fund managers – not only more information, but also information delivered in a more timely manner. The areas of focus remain valuations, custody of assets, fees and compliance programs. Its staff commonly ask us about our audit procedures, our oversight of valuation, custody and fees, and our ability to get information independently of the client. Amid the expected questions, they will tend to throw in a few surprises.
If accounting has redoubled in importance, what does this mean for costs?
PC: Audit costs are in fact stabilizing. This is largely because private equity fund managers have been doing a better job of preparing the books for audit – the industry is more consistently good at putting together high-quality accounts. But overall accounting costs are on the up because we have seen a ramping up of tax compliance costs. Rises in tax compliance costs have far outpaced rises in audit compliance costs in recent years.
Why are tax compliance costs on the rise?
PC: This is largely because of increased regulation, with rules such as the Foreign Account Tax Compliance Act, which requires US citizens to report on their foreign investments. Such regulations increase reporting requirements. They have also made the structuring of private equity funds more complicated, as fund managers respond and adapt. These days you do not just invest directly in a portfolio company’s common stock. There might be two, three or four tiers of vehicles, including offshore holding entities. When you have four tiers of tax compliance the costs will clearly be higher.
To illustrate the increasing complexity, one of our tax partners likes to point out that the typical tax return for a private equity fund used to be about three inches thick. The same return could be 20 inches thick today.
What are the implications of these rising tax compliance costs?
PC: As long as the funds are able to generate high returns, after allowing for all these costs, I do not think there is a problem. But if the costs get exponentially higher this could be worrying for investors and general partners – particularly if the EBITDA multiples for private equity purchases continue to rise. Private equity funds would then face severe downward pressure from two separate sources; this could be a killer combination.
As accountants, we have seen some private equity fund structures where the portfolio return for the fund designed for US investors is higher than for the fund set up for foreign investors, because of the higher tax compliance costs of the latter. In other words, tax costs can skew the performance between the different funds in the group quite substantially.
Private equity funds’ accountants face another challenge: valuing the illiquid assets that make up the portfolios. What are your thoughts on this contentious issue?
PC: The further you get away from any market information that is relevant, the harder you have to work to come up with reasonable valuations. Let me illustrate with two examples.
The first is a company in the auto sector. There is a lot of auto debt and there are a lot of listed auto companies, so there is a large body of information for comparable businesses that allows you to compute valuations.
The second example is a tech company offering something relatively new and unique. There are ways of valuing early-stage tech companies, and there are large tech companies for which there is already a lot of useful information. For example, if a big ride-hailing tech company is already earning a lot of income from millions of customers, and is already showing strong positive EBITDA, it is easier to value. But what about the company in the middle stage rather than the early or late stage? It has invested a lot in developing the technology, but most of its earnings are in the future. It is harder to value that kind of company.
So is it straightforward to value a company owned by private equity which is in the same business as companies that are listed or have issued debt traded on the secondary market?
PC: In some ways it is, but accountants can rely too much on this. In 2008, the notional values of some portfolio companies were slashed because of the stock and debt market crashes. Funds’ accountants even did this for companies with minimal exposure to debt markets. Some people said, “The debt market is down 30 percent and the stock market is down 30 percent, so the valuation should be down 30 percent.” But I do not think the answer is as black and white as that. You have to look at the specific circumstances of each company. If the company does not need to access the debt market or seek a listing in the near future, you do not need to slash its value in line with these markets. Perhaps you only need to cut it by 20 percent. Following the same logic, you cannot necessarily increase the value of the portfolio company in line with the rise of public markets.
Incidentally, I have noticed a definite downside bias among accountants grounded in our historical training in ‘conservatism,’ which I think is ill-founded in reporting consistent with fair value standards: they tend to cut portfolio company values sharply when public markets are down, but to be more conservative when the market goes up. We as auditors have to fight that same bias when evaluating valuations reported by fund managers.
What does the increased scrutiny of private equity firms’ accounting practices mean for finance professionals at private equity firms?
PC: If I were a CFO at a private equity shop, playing a key part in the operation of funds because of these new complexities, I would find it very challenging and rewarding. I think it is harder for junior staff: they bear the brunt of the cost pressures on private equity fund managers’ finance functions because of the need to spend more on outside consultants who can help deal with these complexities.
On the other hand, it is possible for talented junior staff within private equity firms to work their way up to the rewarding position of CFO, even if the most common route is to work up to a senior role at an accounting firm before transferring to a senior finance role at a private equity firm.
If the accounting issues facing private equity firms are complex, what kind of external accountants do they need?
PC: They need specialists. There are issues that a non-specialist will struggle with, such as the valuation methodology, incentive allocations, offsets and special deals. There are a lot of concepts that are unique to private equity, so someone not familiar with the nuances in this area is liable to slip up. ?
Peter Cogan is an audit partner with more than 25 years of audit, tax and advisory experience. He is co-leader of the firm’s audit and assurance services practice as well as the co-chair of the firm’s financial services group, leading the private equity group within that practice. In addition, Peter has been director of the Cayman Islands office since it was established in 2001.
Prior to his current role leading the financial services practice, he served as audit partner for several of the firm’s largest hedge and private equity fund clients. He has also represented clients as an outsourced private equity fund CFO through the firm’s fund administration practice.