21st June 2009
As the financial crisis moves through to new phases, we are seeing the inevitable reactions from different parts of the industry.
The regulators are stepping up their focus and it appears the private equity industry has a battle on its hands regarding the EU Directive. This is particularly an issue in the Channel Islands since they are not part of the EU. However, both Jersey and Guernsey are working hard to put forward their case and recent comments by the UK Financial Services Secretary, Paul Myners, give comfort by at least acknowledging the deficiencies in the proposed Directive.
In our guest article, Adrian Brown from fund structuring lawyers SJ Berwin summarises the main impacts.
In this edition, we also look at the new combined Consolidation IFRS due to be issued in the second half of 2009 and what action General Partners should be taking.
We hope you enjoy this edition and as ever please do let us have any feedback.
Rob Short | firstname.lastname@example.org
Investment companies, including private equity entities and venture capital firms, may not be excluded from the requirement to consolidate investee companies under the new combined Consolidation IFRS due to be issued in the second half of 2009.
In the tentative decisions to date included in the latest update on consolidation issued by the International Accounting Standard Board (IASB) it is stated that “The Board affirmed that investment companies (such as private equity entities and venture capital organisations) should not be excluded from the scope of the proposed standard. The Board concluded that the information needs of users are best served by financial statements that consolidate investments under the control of the reporting entity”.
IFRS currently does not have a carve-out along the lines of US GAAP for investment companies in respect of subsidiaries and the IASB has provided little indication that it would extend the scope of the exemption available in respect of joint ventures or associates to include subsidiaries. Indeed, it would appear that the current exemptions available under IAS 27, SIC 12, IAS 28 and IAS 31, where there is no control but only significant influence, may now be limited under the single standard due to the proposed amendments in the definition of control.
Per the latest update “The Board has tentatively decided that a reporting entity controls another entity if it has the power to direct the activities of that other entity to generate returns for the reporting entity.A reporting entity has the power to direct the activities of another entity if it can determine that other entity’s strategic operating and financing policies. Furthermore the update goes on to say... “IAS 27 clearly contemplates that there are circumstances in which one entity can control another entity without owning more than half of the voting power. During its deliberations, the Board has confirmed its view that an entity holding a minority interest can control another entity in the absence of any formal arrangements that would give it a majority of the voting rights”.
In effect the level of influence rather than how the investment is structured will determine the existence of control.
As a result of this, it is likely that investment firms applying IFRS will be required to consolidate all investments where it is deemed to have control and will need to review all current structures to establish if control now exists where previously it did not.
This would have a number of implications not only in terms of the presentation of the financial statements and underlying accounting but also from a practical operational perspective.
If an investment company or fund were required to apply consolidation requirements to its investments under IFRS, this could lead to a significant distortion in the presentation of the financial position and performance of the company or fund. For example, investment companies or funds investing in private operating companies would need to consolidate the sales, cost of sales, inventory and other assets of the entity.
Many users and investors believe that to fully consolidate investee companies would effectively misrepresent the investment company’s financial position and performance. In theory, it would mean that it would not be uncommon for a typical multi-sector private equity fund to include such diverse items as sales of beer, motor vehicles or pharmaceuticals within its turnover figures.
They would argue that carrying investments at fair value provides more relevant information to stakeholders than consolidating the underlying assets and liabilities of the investee entity. The IASB, despite many responses to the Exposure Draft, appears to disagree.
Many investors feel that the AICPA Investment Guidelines which provides for a fuller exemption reflects a more appropriate result and as convergence between IFRS and US GAAP continues, it is this area where investors and managers are aligned in hoping the US GAAP approach will prevail.
From a practical perspective, managers will need to ensure that they have sufficient information to allow them to pull together and prepare consolidated results within the reporting timeframes previously required by investors and other stakeholders.
Note, IFRS currently requires that the parent and consolidated subsidiaries’ financial statements are prepared as of the same date using similar accounting policies. It is possible that investment companies or funds could have investments in hundreds of entities in multiple industries and geographies thereby requiring a massive operational task to align accounting standards, reporting infrastructures and performance of audit.
Private equity and venture capital managers might be well advised to discuss these developments with their auditors and administrators.
Going forward care will need to be given to both the indicators of control and the implications of consolidation on managers’ reporting infrastructures. Furthermore,where possible,managers might seek to carve out the requirement to consolidate within fund formation documents.
David Adler | email@example.com
The proposed Directive on Alternative Investment Fund Managers (AIFM) seeks to regulate the managers of Alternative Investment Funds (AIF) established in the EU.AIF are defined as all funds that are not regulated under the UCITS Directive, so include private equity funds, real estate funds, hedge funds, commodity funds, infrastructure funds and other types of institutional fund. This lumping together of very different beasts has been a criticism of the Directive, which homogenises bespoke arrangements into one uniformly regulated industry. Furthermore, the Directive will in areas regulate AIF managers more heavily than UCITS retail funds.
The Directive covers AIFM irrespective of where the AIF is domiciled, whether the AIFM provides its services directly or by delegation, whether the fund is open or closed-ended and irrespective of the legal structure of the AIF or the AIFM. Although most private equity fund managers and many real estate fund managers already operate in a regulated environment, those real estate fund managers which currently need not be authorised by virtue of
appointing a third party operator and investing only in directly held real estate will also be caught by the Directive.
The Directive seeks to regulate AIFM (rather than funds), who manage portfolios in excess of €100 million, or €500 million if the fund does not employ leverage and locks in investors for at least five years. However, firms not meeting these thresholds may be forced to opt into the AIFM regime in order to market their AIF (see below).
AIFM covered by the Directive may only provide management services and market shares or units of AIF if authorised in advance in its home Member State.All AIFM covered by the Directive will be required to demonstrate that they are suitably qualified to provide AIF management services, and will be required to provide detailed information on the planned activity of the manager and its internal arrangements with respect to risk management. Of more concern is a requirement for AIFM to separate the functions of risk management and portfolio management.Whilst this might be entirely appropriate in the context of, for example, a hedge fund, it is less obvious that it is practicable in the context of a private equity or real estate fund.
The AIFM must employ an appropriate liquidity management system for each AIF it manages to ensure that the liquidity profile of the investments of the AIF complies with its underlying obligations. Again, this does not seem appropriate for closed-ended funds with long lock-in periods and with underlying assets of an illiquid nature.
One of the most concerning features of the Directive is that AIFM are to have own funds of at least €125,000.Where the value of the portfolios of the AIF managed by the AIFM exceeds EUR €250 million, the AIFM must hold additional own funds equal to 0.02% of the amount in excess of €250 million. Regardless of that, such own funds are not to be less than one quarter of their preceding year’s fixed overheads as required by the Capital Adequacy Directive. Some commentators believe that in reality it will be this latter calculation which will apply to most AIFM. For example, a real estate fund with five deal guys each earning £200,000 and an office and staff costing £100,000 will have to maintain capital of £275,000. But what protection does this capital really give? It will certainly not cover investors’ losses. Following the collapse of Lehmans, it seems to be agreed that capital is for loss absorption and general liquidity which are both irrelevant to closed-ended funds, therefore such capital requirements can be seen as a barrier to entry and an unnecessary cost.
The AIFM must appoint a ‘valuator’ (sic) independent of the AIFM to establish the value of the assets acquired by the AIF and the value of the shares and units of the AIF. For closed ended funds, it has been suggested that such a system is irrelevant and increases costs. Real estate and other closed-ended funds should have no interest in manipulating the value of assets, as fees are calculated on managed funds and values realised upon sale.
For each AIF it manages, the AIFM must appoint an EU regulated bank to act as independent depositary to receive all payments made by investors, and verify whether the AIF has obtained effective ownership of all assets in which it invests. The depositary will be liable to the AIFM and the AIF’s investors for any losses suffered by them as a result of its failure to perform its obligations. This seems to be another unnecessary and costly requirement in the context of real estate and private equity funds which do not require the services of a custodian in the same way that a fund investing in listed securities does.
For each of the AIF it manages the AIFM must prepare an annual report for investors. Even before investing in the AIF, the AIFM must make detailed disclosures to investors. Such disclosures very broadly include a description of the investment strategy and objectives of the AIF; the identity of the AIF's depositary, valuator and auditor; a description of all fees, charges and expenses; and the identity of any investor receiving preferential treatment and a description of that treatment. The final disclosure would effectively end the use of side letters, creating something akin to a statutory most favoured nation clause, whereby no alternative deals could be agreed with investors without having to reveal such deals. Revealing the identity of investors could also be problematic, allowing funds of funds for example to see competitors’ EU positions.
To be able to market units in the EU, a UK AIFM must notify the FSA, which must in turn notify its EU counterparts of any proposed fund marketing including any information on the AIF available to investors. The FSA must approve the marketing materials. Subject to these procedures, the manager may market the fund throughout the EU to ‘professional investors’ (as defined in MiFID). There is currently no ability to market units to anyone not meeting the very high MiFID professional investor standard. The Directive has left scope for member states to vary this, but currently it remains to be seen if member states will relax this threshold. It was suggested that being given a passport to market AIF around Europe would be one of the great benefits of the Directive, but the imposition of such notification requirements would still create a huge administrative burden and time delays whilst waiting for approvals.
AIFM managing an AIF which either individually or in aggregation with another AIF acquires 30% or more of the voting rights in a non-listed company domiciled in the Community, has to notify the non-listed company and all other share-holders. It also has to notify representatives of employees of such an acquisition, providing a business plan for the company. In the event of a P2P, the AIFM will have to continue to provide all information required by the Transparency Directive for two years after de-listing. Any other buyer of an EU company, no matter how sensitive or important, will have no such obligation, such as oligarchs, Continental banks, and even US private equity funds which have no European investors.
The Directive only allows AIFMs to market in the EU AIFs established outside the EU from three years after the Directive is implemented (so, probably 2014). Such third country AIFs will only be permitted to be marketed in the EU if:
During the three year period AIFMs will be permitted to market non-EU AIFs under existing private placement regimes but once this transitionary period is over non-EU AIFs are likely to be put at a significant competitive disadvantage.
The EU Parliament and Council will be debating the terms of the Directive over the next few months and it is likely to be implemented in 2011. SJ Berwin is actively involved in the lobbying process and is representing the interests of its clients in the AIF sector.
SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris, Brussels, Milan and Turin.
Langham Hall is pleased to announce that we have extended our regulatory permissions in Jersey to include the Trust Company Business licence which falls under the provisions of the Financial Services (Jersey) Law 1998.
Langham Hall is a specialist provider of fund accounting, administration and consultancy services to over 40 private equity and real estate funds from offices in London, Jersey, Guernsey and Hong Kong.
Our aim is to add value to fund managers by providing specialist support. On the private equity side we won the ‘Specialist Professional Advisory Firm of the Year 2009’ at the BVCA Private Equity awards. On the real estate side, we co-wrote the original INREV reporting guidelines that pre-dated the new integrated reporting guidelines. The integrated guidelines are now used as the standard framework for Managers’ reports across Europe.