Advisory boards have played a big role in recent private equity history, particularly in helping buyout shops make the transition to fair-value accounting standards. With several regulatory and tax changes on the horizon, they’re poised to play an even bigger role in the months ahead.
One of the many changes facing buyout firms is the prospect of having to register as investment advisers under the Investment Advisers Act of 1940. If President Obama signs legislation passed late last year by the U.S. House of Representatives, buyout firms will face a host of new compliance requirements.
Among them, buyout shops will likely have to monitor and disclose potential conflicts of interest to the Securities and Exchange Commission; retain and store (in an easily searchable archive) all employee emails, instant messages and text messages; and keep records of employee trades involving public equities. According to the SEC, compliance procedures developed by registered advisers should also address, where relevant, the accuracy of information provided to investors, how investment opportunities are divvied up among backers, and how well their portfolio matches up with the investment strategy promoted to investors.
Along with the prospect of becoming registered investment advisers, buyout shops face a proposal in Congress to tax carried interest as regular income, a movement toward international accounting standards that would require the creation of consolidated financial statements for all portfolio companies, and legislation that would require buyout shops to provide information to the IRS about its investors in off-shore vehicles.
Advisory boards will almost certainly be called upon to play a role in helping buyout shops deal with these proposed requirements and tax changes. After all, they’re already on the front lines of corporate governance. According to the PE/VC Partnership Agreements Study 2010-2011, published by Thomson Reuters, advisory boards commonly count among their responsibilities approving mark-ups and mark-downs, approving valuation methods and addressing conflicts of interest.
As such, it may be time to take stock of the make-up and charter of your advisory board. To help you figure out current market practice, below are some of the main findings regarding advisory boards in the just-published study:
• The boards are generally made up of limited partners that meet twice a year or once a quarter;
• The most common size of the advisory board is four to six members (57.1 percent of our sample of U.S. buyout shops). Fourteen percent have 10 or more members, and another 14 percent have just two to three. One in 10 has seven to nine members.
• Board members typically play no role in actual investment decisions, to avoid putting at risk the limited liability status of investors. However, nearly half (44.4 percent) of the advisory boards to buyout shops in our sample do have the power to approve investments in portfolio companies that would otherwise violate investment restrictions, such as a limit on how much money from a fund can be invested in any given company;
• The most common role of the advisory board at U.S. buyout shops is to address conflicts of interest (85.2 percent have this role). That’s followed by providing strategic input (55.6 percent), approving related-party transactions (44.4 percent), overriding investment restrictions (44.4 percent), approving crossover investments (37.0 percent), reviewing key-person events (37.0 percent), approving valuation methods (37.0 percent) and approving mark-ups and mark-downs (37.0 percent).