Introduction
It is well known that the private equity industry is in the midst of a dramatic evolution in size and influence. Less well appreciated is the beginning of a sea change in transparency and corporate governance. This will transform it from a low profile, private industry dominated by a deal-making culture into one that conforms to a far greater extent with the norms of the public-listed markets.
The industry’s greater size and visibility, as well as its potential desire to access public equity markets are seen as major drivers of this trend. But accounting and regulatory changes are also reinforcing the paradigm shift, as is the need to manage growing tax risks.
Private equity general partners (GPs) are approaching this trend in a variety of ways. At the industry level, the UK’s British Venture Capital Association (BVCA) is conducting a review of transparency and disclosure with the intention of establishing a voluntary code. And individual groups are beginning to take actions ranging from boosting their corporate governance structures through to adopting ‘fair value’ accounting for portfolio companies.
This is a significant change for a traditionally discreet industry that has tended to create value through the unique skills of its principals. It has focused on acquiring businesses at the right price, improving operational performance and then selling them on. Leading GPs have relied on their impressive historical returns to attract ongoing capital from investors. However, little information has been shared publicly.
But the industry’s growth means this has to change. Fund raising is at a record high and likely to remain so – Private Equity Intelligence forecasts global fund raising will reach US$450–500 billion in 2007, up from US$404 billion in 2006. The PricewaterhouseCoopers comprehensive survey of regional fund raising data shows that such growth has propelled private equity beyond its US roots into Europe and Asia. It is widely acknowledged that the UK has evolved as a serious player in this sector over the last ten years. As the proportion of the economy influenced by private equity grows, a wider group of stakeholders is demanding greater disclosure.
Demands for disclosure have been loudest in Europe, where private equity business models have clashed with Continental Europe’s stakeholder models of capitalism. Politicians and unions have called for curbs on private equity activity, although this has been matched by high level support from sources such as Charlie McCreevy, the European Union internal market commissioner, and the European Central Bank.
The wider range of investors now allocating to private equity funds is also pushing for greater disclosure, as well as more formal corporate governance. In particular, as GPs list Permanent Capital Vehicles (PCVs) on stock exchanges, they have to report more frequently and to a wider audience. Even more importantly, GPs’ management firms themselves are listing, which is even more significant in terms of the transparency it will force. Some industry leaders now expect most major firms to become public companies over the next few years.
Industry growth is also breeding a new set of tax risks. As portfolio companies are acquired further afield, the holding company structures employed are getting more complex. Some tax authorities are challenging these tax structures – most notably, the South Korean and German governments.
Finally, changes in accounting practices and financial services regulation are forcing change. In particular, the move to ‘fair value’ accounting is having an impact.
Below we highlight some of the key areas:
Transparency
There is a global move towards greater transparency and disclosure, although this is most immediately apparent in Europe, where the BVCA is working towards introducing a voluntary code.
Current listings in the US and Europe of private equity firms and PCVs are leading to increased focus on the quality of reporting financial performance and balance sheet structures, descriptions of how performance has been achieved, directors’ remuneration and even the primary risks faced. For an industry that has closely guarded such details as fund valuations, this is a major departure.
Another important driver of transparency is the move towards ‘fair value’ accounting. The convergence of worldwide accounting standards in respect of fair value accounting will have a significant impact on the industry. Historically, private equity firms have tended to value portfolio companies on a conservative basis, at times equating to cost. This had the advantage of allowing them to report smooth returns. But recent developments in accounting standards pushing funds to ‘fair value’ their investments on an exit basis mean that growing numbers are reporting what they judge to be the potential realisable values of portfolio companies. Fair value is being defined as ‘the price that would be received to sell an asset in an orderly transaction’.
As this method of valuation becomes more common, it will lead to greater volatility in reported fund performance. Furthermore, GPs will have to describe why portfolio companies have both risen and fallen in value. They will also have to explain how they have reached a valuation, disclosing in detail the valuation methodology applied.
Corporate Governance
A number of GPs are establishing more formal corporate governance structures. In particular, this is a necessity for those seeking to list on stock exchanges. But also, the introduction of Basel II’s Pillar 2 requirements, which will affect few GPs directly, is one factor leading to a general improvement in corporate governance in the financial services industry that will undoubtedly be of influence.
Even without these factors, there is greater emphasis on middle and back office areas. A number of GPs have strengthened their teams in these areas. Third-party administrators typically carry out many of the back office functions, although the quality of their services offering can vary.
Those GPs that seek listings will need to create corporate governance models, if they do not already have them, and make these transparent to prospective investors. Any corporate governance model will need to have formal controls for managing and monitoring the investment portfolio. This might include systems for formulaic management reporting from portfolio companies. A number of GPs do not, as yet, require portfolio company finance directors to report in a uniform fashion. There should also be controls for managing risks, such as fraud risk within the underlying operating companies.
As the private equity investor base widens, we expect more GPs to commission SAS 70 type reviews of their corporate governance systems. An SAS 70 provides an insight into key control objectives established by management. These can be shown to prospective and existing investors performing due diligence.
Finally, the second pillar of Basel II, which is being introduced in many countries from the beginning of 2008, requires financial services firms to make holistic estimates of the risks they face and to allocate capital accordingly. Most GPs will escape having to comply with this directly – although it will apply to the few marketing retail investment vehicles. That said, this development is generally leading to the creation of more formal risk controls in the investment industry, and may raise investor expectations for private equity to follow suit.
Taxation Risks
GPs have a fiduciary responsibility to ensure that tax-efficient structures are utilised such that returns to investors are maximised. Investors are responsible for their own tax affairs in their domestic jurisdiction. If this is not properly addressed, there is a risk that investors will suffer tax twice. Investors expect to see evidence from GPs as to how such risk is mitigated. This is becoming a significant concern to investors as funds invest in a wider range of countries and as governments begin to challenge investing structures.
In South Korea, for example, the tax authorities have recently probed the payment of dividends to a Netherlands private equity holding company. They concluded that because the beneficial owners of the company were not based there, the Netherlands’ double taxation treaty with South Korea did not apply. As a result, the tax on dividends paid was increased from 10% to 25%.
Similarly, Germany’s tax authorities are challenging the status of private equity holding companies established in Luxembourg to acquire companies in Germany. The German authorities will only recognise the validity of these structures, and therefore honour the double taxation treaty between the two countries, if they are companies with substance rather than just ‘post box’ companies.
Some governments have also been looking at the way in which private equity portfolio companies structure their balance sheets, where interest payments have a significant impact on taxable profits.
Value Creation
As private equity grows, it is beginning to concentrate far more on creating value in portfolio companies through building their profits. Some firms have identified how they can help portfolio companies to improve performance. Typically, they are providing strategic advice, as well as help with management recruitment, expansion overseas and purchasing economies of scale. At a time when globalisation is posing significant challenges for many companies, there are many examples of private equity assisting portfolio companies in making the crucial transition to a new environment.
GPs are not obsessed with quarterly earnings of portfolio companies. They understand a company’s earnings may be volatile, and instead they focus on longer term goals. CEOs of portfolio companies have said that they value the insights of the private equity industry. GPs operate across jurisdictions and industries and are able to use their unique expertise to improve financial performance, broaden market opportunities beyond traditional domestic focus and increase employment opportunities as a result.
Studies have shown that private equity is good for economies in the medium-term. In particular, this is attributed to the strong alignment of interests between GPs and portfolio company managements. GPs recognise that appropriate financial engineering does not in isolation provide longer term value creation.
Private equity houses have significant internal resource charged with helping to guide strategy and facilitate operational improvements at portfolio companies. They are doing this primarily because fierce competition for deals means they have to pay high prices. Therefore, they have to create value by promoting profitable growth.
