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Gearing up for private equity
August, 16th 2007

Private equity (PE) is the latest financial innovation to take the world by storm.

Although there are various types of PEs, a typical one raises money from rich investors willing to play with high risk for a fixed period and look for companies or projects to invest in.

Over a timeframe of 4-6 years, the funds work to unlock value in these companies by cutting costs and improving operations.

Though historically Indian entrepreneurs hesitate to sell out their companies lock, stock and barrel, it is only a question of time before the trend reverses.

The theme of this article is not to look at statistics of PE in India but about their accounting and tax implications. The issue of valuation came to the fore in the book Private equity as an asset class (Wiley), by PE industry veteran Guy-Fraser Sampson. In that, the author recalls a transaction wherein he was a partner in an American Fund of Funds manager and three venture funds that had participated in the same venture had valued it in their annual accounts at $960 million, $480 million and 0.

The questions that arose from this situation were: Whether there is no single undisputable method of valuation?

And what value would the investor value this in his own accounts?

Although valuation is a technique that cannot put in a measurable value for a transaction that can be considered final, the problem appears to be in the methods used for the valuation and the assumptions made by the valuers.

There could be a solution in the form of fair value that is being bandied about as the cure for all accounting ills.

The Institute of Chartered Accountants of India (ICAI) has stated that it would make it mandatory for all Indian entities to adopt International Financial Reporting Standards (IFRS) with effect from 2011.

This could call for tweaking a few accounting standards and the issue of new accounting standards on financial instruments, fair value and stock options.

Tax conundrum

One of the biggest PE groups in the US, Blackstone, recently went public. A huge tax conundrum ensued because of the mechanism devised to pay partners whose shares were being diluted.

The partners were given a payment schedule of 15 years at 85 per cent of the tax that the PE fund would save because of amortisation and depreciation costs on the goodwill generated by the dilution.

Some were of the view that the amount of capital gains tax that the partners would pay on their dilution would be far lesser than the amount they would get in payments over the 15-year timeframe.

This opinion was shot back with the argument that a wrong cost of capital percentage was used to calculate future cash flows since a PE manager probably gets the best returns from the market. Thus, several valuation and tax issues could arise once PE comes into India in a big way.

It would be appropriate to think of such issues and their solutions in advance rather than wait for an issue to arise.

It is a fact that AS-23 (Accounting for Investments in Associates in Consolidated Financial Statements), AS-27 (Financial Reporting of Interests in Joint Ventures) combined with AS-13 (Accounting for Investments) and the yet-to-be-issued standard on financial instruments would tackle these niggling issues.

But matching these to international standards would take some time and effort which needs to be invested in now.

Mohan R. Lavi
(The author is a Hyderabad-based chartered accountant.)
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