Why You Should Not Trust the Financials of Private Equity Owned Companies

Yesterday, we saw how Hamilton “Tony” James, the chief operating officer of Blackstone and head of its private equity business, is also a principal in a family private equity firm, Swift River Investments, whose activities overlap with his official duties at Blackstone in ways that are troubling from both fund investor and Blackstone shareholder perspectives. One of the things we discussed was Swift River’s purchase from Blackstone itself, in a related party transaction, of a software company called iLevel Solutions.

Today, we are going to examine iLevel in greater detail. We will see that this company is built from the ground up as vehicle to convince PE investors and the SEC that Blackstone and other PE firms have implemented robust financial controls over the companies they own. The reality, however, is the opposite: by design, iLevel gives PE firms unprecedented ability to cook the books of their portfolio companies while maintaining a facade of compliance.

At first glance, iLevel appears to provide legitimate and important services to PE firms. It extracts, compiles and analyzes the financial and operating data of the dozens of portfolio companies that a firm like Blackstone owns. A large PE firm resembles a conglomerate. Its portfolio companies are the equivalent of operating divisions, each with its own set of books that must be reported back to the PE firm “headquarters” on a regular basis. Unlike a conventional conglomerate, however, a PE firm doesn’t typically implement a shared general ledger accounting system across its portfolio companies. It’s too expensive and complicated, particularly since a PE firm expects to own a portfolio company only for around five years or so. So there is real value added in presenting financial and operating results on a consistent basis across the businesses.

iLevel’s website gives the impression that the purpose of the company’s software is to bridge portfolio companies’ disparate accounting systems. The iLevel website talks about “automated data collection” from the portfolio companies and the value of that data for PE firms performing “cross-portfolio analytics.”

But a closer look shows that one of iLevel’s main claims, that iLevel performs anything that could be fairly labeled as “automated data collection,” is false. Instead, individuals at portfolio companies manually enter data into an Excel spreadsheet on a monthly basis, or use macros to export data from other Excel spreadsheets, and the populated spreadsheet is then uploaded into the iLevel database. The “automated” part of the data collection, to the extent there is any, consists merely of the iLevel software generating the blank Excel spreadsheet template every month and automatically emailing it to the portfolio company employee responsible for inputting the data. The completed spreadsheet then has its data “automatically” extracted into the iLevel database.

As this 2011 video states starting at 1:39:
The iLevel platform replaces the manual, labor-intensive process of assembling data from portfolio companies with an automated, web-based process and a secure central data repository that serves as a single source of truth. First, the iLevel database is configured to contain all relevant chart of account information required for monthly and quarterly data collection and reporting [notice that the video shows someone clicking on empty template pages and inputting information], including industry-specific or unique portfolio company KPIs. 
Next, Excel-based templates for collecting data are created for each portfolio company. The iLevel platform sends automated e-mail notifications and the Excel template to your portfolio companies on a schedule you determine: monthly, quarterly, or on-demand. Once the template has been populated with the required data, portfolio company representatives simply click “Submit” to securely transmit the data back to you. With the data submitted, key stakeholders you identify are notified automatically to verify and approve the data.
This may all seem like a very arcane discussion of reporting workflow, but it is important to understand that the PE firms want your eyes to glaze over. The key issue is that PE firms want their investors and the SEC to believe that their iLevel database has been constructed in a tamper-resistant fashion, which is always a central design goal of accounting software systems. If an accounting system allows people to change entries after the fact, that system is absolutely, utterly worthless. But that’s what iLevel explicitly allows to occur because, rather than extracting the data directly, it requires portfolio company employees to re-enter information into iLevel from their general ledger accounting system. Moreover, iLevel presents as one of its advantages that “key stakeholders” can “verify and approve the data”. That’s code for “tamper with”.

iLevel’s marketing materials to PE firms are explicit about why they should want the product. iLevel downplays any potential utility the software might have for the PE firms in tracking and managing their vast portfolios of companies. After all, the PE firms get the joke that iLevel isn’t designed as a robust financial reporting system that one should rely on, for example, to determine whether a portfolio company CEO met his numbers and earned a bonus. Instead, iLevel’s marketing materials make clear that the primary audiences for the pseudo-data it collects are the SEC and limited partner (LP) investors in private equity funds. For example, an early version of the iLevel website described the rationale for developing the software:
Increasingly stringent regulatory requirements cemented the need for a solution that could automate the industry’s still-manual processes and produce clear, consistent, and timely reporting of company-level data. At the same time, market forces led to increasing demand for transparent reporting to regulatory authorities and to Limited Partners.
Why do LPs and the SEC care about the data that goes into iLevel? In a version of its website that was labeled “test” and never posted live, but which was nevertheless crawled by Google, iLevel lays out its value proposition to PE firms in dealing with the SEC and LP investors:
The SEC has begun its initial ‘interviewing’ of Private Equity firms and their practice of valuing their investment holdings. The questions provided to several PE firms requests information such as supporting evidence for the valuations of all fund assets and any document establishing an assigned value for any assets owned by the fund.
The real purpose for a PE firm using iLevel is to trick the SEC and LP investors into believing that there is a reliable basis for the data underlying a PE firm’s portfolio company valuations, which in turn affects what the PE firm gets paid. As iLevel points out in the quote above, the SEC is asking for documentation to support valuations. With iLevel, the PE firms can say to the SEC and LPs, “The data was provided directly to the iLevel database by the portfolio company, via an automated process.” The SEC and LP investors are likely to hear this statement as, “The data was extracted from the portfolio company general ledger via an automated (and inherently tamper-resistant) process, in which we – the PE firm – had no role.” What the SEC and LPs should interpret this statement to mean is, “The data was manually input by a portfolio company employee whom we – the PE firm – have hiring and firing authority over. There is no process to reconcile or audit the data input to iLevel with a portfolio company general ledger.”

This scheme is actually quite ingenious. Whereas the SEC and PE fund limited partners have various degrees of audit authority over the PE firms themselves, that authority does not extend to the portfolio companies. If the data input into iLevel is inflated at a PE firm’s behest, neither the SEC nor the limited partners have any ready mechanism to compare the iLevel data with the portfolio company general ledger, so the fraud is overwhelmingly likely to go undetected.

iLevel has also been ingenious in its implementation of the “Wall Street Rule” – the idea that bad practices are most untouchable by regulators when they become industry standard. In that spirit, iLevel in late 2011 announced that the Carlyle Group had become a part owner of the company. This is presumably in addition to the continuing partial ownership of the Blackstone COO. Nominally, Carlyle and Blackstone are competitors, yet they teamed up on iLevel. Working together, they have been able to promote the product’s adoption among a large portion of large private equity firms, including Apollo, TPG, and Cerberus, and more than 30 other firms, in addition to Blackstone and Carlyle.

And finally, in a coup de grace of seediness, around the same time as the Carlyle deal, iLevel brought in another investor in the form of Hamilton Lane. This firm is the dominant “gatekeeper” performing due diligence and making recommendations to pension funds and other institutional investors on private equity funds. So, in its fiduciary role advising pension funds, Hamilton Lane sits in judgment of Blackstone and Carlyle. But on the side, Hamilton Lane is also in a deal with the Blackstone COO and Carlyle. Though this appears to be a material conflict of interest, it is worth noting that the conflict does not appear to be disclosed in the “Conflicts of Interest” section of Hamilton Lane’s Form ADV filed with the SEC.

We sent a draft text of this post to Blackstone, Carlyle, and Hamilton Lane last week. Blackstone indicated it would get back to us but has not; we will run their comment if and when they provide one. Carlyle and Hamilton Lane did not reply. We also sent messages to relevant departments at iLevel and did not get a response.


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