A Brouhaha Over Balance Sheets

Europe's venture capitalists fear new reporting rules will scare away investors away

Accounting standards aren't normally the sort of thing that quicken the pulse. But a war of words with serious implications for European growth has broken out over an esoteric provision of the new International Financial Reporting Standards. Critics say the accounting rules, if activated as scheduled in 2005, could damage the region's fledgling private-equity business and undermine Europe's effort to foster entrepreneurship and innovation.

The new rules are part of a decade-long international effort to harmonize financial reporting around the world. They're meant to prevent Enron-style scams by requiring companies to incorporate in their own books the financial results of entities that they control. But unlike in the U.S., the new rules make no distinction between large multinationals with operating subsidiaries and private-equity funds -- financial companies that invest in startups or leveraged buyouts with the idea of selling out later at a profit. "If you control it, you consolidate it -- no ifs, ands, or buts," says Wayne Upton, research director for the London-based International Accounting Standards Board (IASB), the group writing the new standards. The European Union is committed to adopting IASB rules, and eventually they're supposed to converge with America's Generally Accepted Accounting Principles.

Problem is, conglomerates and private-equity firms are different types of businesses. If the accounting rules stick, experts say, financial reports from private fund managers will simply lump together all the losses and all the debts of the companies in the fund, rather than telling investors how much their stakes are estimated to be worth at the moment. The new rules "remove the very information investors most want to see," says Les Gabb, a partner with Advent Venture Partners in London. "It makes them practically useless."

The potential repercussions are sobering. For instance, most companies in a typical venture-capital fund -- a private-equity fund that invests in startups -- bleed cash as they build up their businesses. Reporting these losses instead of reporting what venture capitalists call the "fair value" of the holdings -- their estimated worth based on market comparisons and so-called "impairment" tests -- will make fund returns look rotten until the investments are sold. That could make it harder for European firms to compete for capital against their American rivals, which don't have to follow the same rules. "This is a big step backwards," says Jean-Bernard Schmidt, chairman of the Brussels-based European Private Equity & Venture Capital Assn.

HEDGING FUTURE BETS?

The danger isn't just for private-equity firms. More worrisome is that large institutions that pour capital into the funds -- banks, insurance companies, and corporate investment arms -- may also have to roll reported losses into their books, pulling down their financial results. Such investors provided 40% of the $25.8 billion in private equity raised in Europe last year, and the new rules could make them less willing to make future bets. "Anything that inhibits or distracts investors can't be good for Europe," says Ashish Patel, director of Intel Capital Europe.

The IASB plans to revisit the issue of consolidation early in 2004. But it says it is still waiting to hear a compelling case for why private-equity firms should get special treatment. "The IASB's focus is investor information," says Kathryn Cearns, an accounting consultant with the law firm Herbert Smith in London, "not protecting or advancing private equity in Europe."

Is there any way out for Europe's private-equity firms? One solution is for funds to produce two sets of books: consolidated accounts and unaudited results showing detailed returns from an equity fund's investments and disposals. The firms could also avoid the entire problem by giving up controlling interest in their portfolio companies to other investors. But that would upend their entire business model, which relies on close management oversight to wring out big returns for their investors. "The industry would never go for that," says Advent's Gabb. The last option is to push policymakers for better rules. Europe's risk capitalists had better hope that European rhetoric about nurturing growth turns to action when it counts.

By Andy Reinhardt in Paris

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