Private Equity Club

The Impact of IFRS on the Private Equity Industry

27th September pwc

Agenda

• Introduction – Mark Pugh

• IFRS Update – Mike Bane
• IFRS – ‘Not my Problem’ – Paul Cunningham
• Conclusion

IFRS & Private Equity PricewaterhouseCoopers 2

 IFRS Update
Mike Bane

27th September pwc

Overview

• Scope and current status

• Components of financial statements
• Consolidation and equity accounting
• Importance and consequences of “fair value option”
• Difficult messages for secondaries and fund of funds
• Round up

IFRS & Private Equity PricewaterhouseCoopers 4

IASB stable platform
– recent changes

IAS
39 40 41 1 2
37 38 7
8
36
35 10
34 IFRS 11
33 1 2 3 12
32 14
31 4 5 15
30 16
29
28 17
27 26 18
24 23 19
22 21 20

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Components of financial
statements

• Similar to UK GAAP
• “SOCIE” = STRGL + transactions with equity investors
• “Recycling” of gains/losses different to UK
• Realised gains/losses must pass through P&L

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Recycling example

Year 1 Year 2 Year 3

Facts Buy 100 FV 130 Sell 155

FV 110
UK GAAP 1 Gain 10 STRGL Gain 20 STRGL Gain 25 STRGL

UK GAAP 2 Gain 10 STRGL Gain 20 STRGL Gain 25 P&L

IFRS Gain 10 Equity Gain 20 Equity Gain 55 P&L

Loss 30 Equity

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Consolidation and equity
accounting

• Consolidation
• IAS 27 – Consolidated and separate financial statements
• SIC 12 – Consolidation – special purpose entities
• IFRS 5 – Non-current assets held for sale
• Equity accounting
• IAS 28 – Investments in associates (equity accounting)
• IAS 31 – Jointly controlled entities (proportional consolidation)

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IAS 27

• A parent must present consolidated financial statements….

• Unless all following conditions met (27p10):
– parent is a wholly-owned sub
– parent’s debt/equity instruments not traded in public market
– parent not in process of filing for public listing
– ultimate parent produces publicly available consolidated
IFRS financial statements

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Subsidiaries

• A subsidiary is an entity that is controlled by a parent

• “Control is the power to govern the financial and operating
policies of an entity so as to obtain benefits from its activities”
(27p4)
• THERE ARE NO EXEMPTIONS (except p10) FROM
CONSOLIDATING A SUBSIDIARY…
• …unless it is “held for sale”
– apply IFRS 5
– Particularly no exemption “..simply because the investor is a
venture capital organisation.. or similar entity” (27p19)

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Control = power

• Presumed to exist when parent owns more than half of voting

power. Also exists if less than 50% when entity has power:
– over 50% voting rights via agreement with other investors
– to govern policies by statute or agreement
– to appoint/remove majority of board (provided board controls
the entity)
– to cast majority of votes at board meetings

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SIC12

• Applies to “Special Purpose Entities”

• Treat as subsidiary when substance of relationship is of control
• Autopilot
• Majority of benefits
• Exposed to majority of risks

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Associates and joint ventures

• “Significant influence” test for associates

• “Power to participate in the financial and operating policy
decisions of the investee but is not control or joint ownership”
(28p2)
• Presumed to exist with 20% or more of voting power
• STANDARDS DON’T APPLY TO ASSOCS/JVS HELD BY
INVESTMENT STRUCTURES THAT DESIGNATE
INVESTMENTS AS “AT FAIR VALUE THROUGH PROFIT OR
LOSS” AND ACCOUNTED FOR UNDER IAS39

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IAS 39 - Classification –
Financial
Assets (Four categories)
1. Financial assets at fair value through profit or loss
2. Loans and receivables
3. Held to maturity
4. Available for sale

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Classification – Financial
Assets (Four categories)

At fair value through profit or loss

Held for trading Designated at

inception

Intention of short term profit; No restrictions on designation;

All derivatives except hedges. Irrevocable – cannot be moved.

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Classification – Financial
Assets (Four categories)

Loans and receivables

Non-derivative financial assets.

Fixed or determinable payments.
Not quoted.
No intention of trading.

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Classification – Financial
Assets (Four categories)

Available for sale

All equity securities not classified in FVTPL category.

All financial assets not in another category.
Any financial assets other than those held for trading
may be designated to this category at inception.

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Classification – Financial
Liabilities(Two categories)

1. At fair value through profit or loss

Designated at
Held for trading
inception

Intention of short term profit; No restrictions on designation;

All derivatives except hedges. Irrevocable – cannot be moved.

2. Other financial liabilities

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Why is classification important?

• Because it drives measurement

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 Subsequent measurement

Assets/Liabilities at fair value At FV through profit or loss

through profit or loss

Loans and receivables At amortised cost

Held to maturity

Available for sale At FV through equity

Other liabilities
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 Amortised cost

Unamortised
Amortised - Principal +/-
cost
= Cash paid
repayments
Prem/disc’t - Impairment
(inc interest)

Requires use of effective interest rate method

No option to use straight line method

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Fair Value Hierarchy

Active market –
Published quotations Best evidence

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Fair Value Hierarchy

Active market –
Published quotations Best evidence

No active market –
Valuation Alternative
Techniques

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Fair Value Hierarchy

Active market –
Published quotations Best evidence

No active market –
Valuation Alternative
Techniques
No active market -
Equity investments Very rare
only Î
Cost less impairment
IFRS & Private Equity PricewaterhouseCoopers 24
Fair value

Consider:
• Star owns 15% of shares of Moon.
• Shares of Moon quoted on a local stock exchange, trading
volume indicates sufficiently active market.
• The quoted market price is $100 per share.
• If decided to sell entire block of shares, the price they believe
they would be able to obtain would be $80 per share

Answer: $100

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Impairment

• Step 1 – Objective evidence of impairment

• Step 2 – Calculate recoverable amount/fair value

• Step 3 – Record impairment in profit & loss

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Impairment - loans
Objective evidence

High probability
Significant financial of bankruptcy Granting of a
difficulty of the issuer concession to the
borrower

Breach of contract,
such as default or
Disappearance delinquency in
of an Adverse change in
interest or principal payment status or factor
active market
because of financial (eg unemployment)
difficulties

And what about equities?

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Impairment - equities
Objective evidence

Adverse effect in the technological, Significant or prolonged

market, decline in the FV of an investment
economic or legal environment below its cost

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Pros and cons of FVTPL

PRO
• All gains/losses in one place
• Associates/JVs out of scope
• Hedging is irrelevant
• No impairment testing
• No splitting of FX component on
monetary instruments
CON
• More natural to defer unrealised
gains in equity
• Potential tax consequences
• Inconsistency with investor tax
reporting
• Transparency of transaction
costs

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Secondaries/Fund of Funds

• Measurement of cost on partial disposals

• What is fair value
a) Are underlyings IAS 39 fair valued
b) Has carry been accounted for
c) Tax
d) DCF modelling
• Distributions in specie
• Can you get a clean opinion?

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Round up

• Does IFRS apply to you – if so, when?

• What do your investors want?
• Lots of change still in the pipeline
• How can you deal with consolidation issues?
• Consider the merits of FVTPL
• Big problems for secondaries
• …..GET HELP

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 IFRS – ‘Not My Problem’
Paul Cunningham

27th September pwc

IFRS – “Not My Problem”

– View held by many in our industry

• “It only applies to Listed Corporates…”

– But….

• IFRS WILL be adopted as UK GAAP

• What are a large proportion of our Investors?

– Different for Captives?

• Must Comply from 01/01/05

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So – I am Caught. What does it
mean?

• Consolidation?
– 2 Potential Problem Areas

• Investments > 50%

– CONSOLIDATE
• GP/Limited Partnership Relationship
• IFRS 27 - “Control is the power to govern the financial
and operating policies of an entity so as to obtain
benefits from its activities”
• “Fiduciary Capacity”
• Heading towards “Rebuttable Presumption” of control

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 So – I am Caught. What does it
mean?

• Accounting For Investments

– Holding < 20%

• “Fair Value” through Reserves

• “Fair Value” Through P&L

– Holding >20%

• “Fair Value” through P&L

• Equity Account

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So – I am Caught. What does it
mean?

• What is “Fair Value”?

– “Willing buyer, willing seller”

• Illiquid Market
• Difficult to measure

• “Could fair value at cost” BUT

– BVCA Guidelines
– Investor Reporting

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So – I am Caught. What does it
mean?

• Debt
– Impairment

• No Real Change
– Interest

• Not Straight-line

• “Constant Effective Yield”

• Earliest date could be sold/redeemed?

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Other Problems Caused

• Transition Rules
– Revenue “Lost Forever”
– Could mitigate BUT

• Impact on Substantial Shareholding Exemption

• Remuneration
– Bonus?

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