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 a 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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  1. Greg R

    Every time a piece like this prompts a trip to the tip jar I ask myself the same question: Where else would I get this?

  2. Mcmike

    What fascinates me is there has been no institutional investor revolt. The brazen conflicted interests, the muni price fixing, the massive derivatives scams, the double dealing and blatant fiduciary failures, the libor price fixing… I mean it goes back to mutual fund after hours trades, and the fight over bid decimalization.

    What will it take for pension boards and muni treasurers to tell the wall streets firms to shove it?

    1. diptherio

      How long before investors revolt? Dunno, but I once heard a mutual fund manager say “it’s better to be wrong in a crowd than right by yourself,” or something to that effect, so I wouldn’t hold my breath.

      1. Mcmike

        Doubly so when you are investing other people’s money.

        Indeed. For public sector institutional investors, there is no penalty for staying with the flock to be fleeced, and dragons await those who look beyond the fence.

    2. bluntobj

      I suppose it will take a wall street downgrade of muni bonds to junk level, or a refusal of the government, state or federal, to reflate pensions or at least “nationalize” all private 401ks and IRAs to “stabilize” retirements.

      Oh, think that last bit is crazy? Remember, quid pro quo.

      Anyway, only at that point would munis or pensions go to war against wall street.

  3. s spade

    Very nice work, but it isn’t as though you can trust the numbers reported by publicly traded companies, either. Accounting gymnastics make those numbers mostly fictions supported by incomprehensible footnotes.

    And the institutions are reaching for yield and have no alternative to being snookered by the PE firms.

    And the SEC is a public relations firm the mission of which is to smear lipstick on the pig, so there isn’t any reason to wake the bureaucrats up with disturbing news, or interfere with the resume polishing that must be going on there, if anything is.

    The guys in control of data entry can report anything they want and capture their bonuses until the roof caves in. That is the idea, isn’t it? Loot and scoot?

    Perhaps the next crash will involve a huge pension fund or university endowment vaporized by PE. Wouldn’t surprise me one bit.

    1. Mcmike

      In fact it would be extra stupid to change the numbers you get from the field by too much. After all, you are only supposed to be aggregating.

      I suppose you could argue that you are merely making items comparable. However, the existence of the original inputs leaves a huge paper trail of your massaging.

      No, the best place to fudge is at the source input.

      But it would be easy and tempting to do it at ilevel; so it is probably being done.

      1. Winston

        The PE guys are way too smart to manipulate the numbers once received into the iLevel system. You are right, this would clearly leave their fingerprints on the fraud. Instead, what they would do is call up the portfolio company CFO (or, better yet, meet him in person) and “guide” him to the results that the PE firm wants reported into iLevel. That way, the CFO is the one legally on the hook for fraud, which keeps the PE guys away from it and makes it hard for the CFO to report what’s going on once he’s done the manipulation even a single time, since he would be implicating himself.

  4. psychohistorian

    As someone who designed and developed automated data collection tools, interfaces and systems throughout my career as a supply chain systems engineer, the abuse of the term by these folks is appalling.

    Just reading that the source and destination of the data are Excel spreadsheets sends shivers through my psyche. That approach would never pass a system audit in the supply chain world, so how is it good enough for the financial world?

    It is further galling to read that my pension will be a victim of fraud like this.

    1. Mcmike

      I have no problem with excel bring used to aggregate heterogenus numbers from different companies with different ledgers and different onwership in different industries.

      What is annoying is that it is being sold as some automated web platform – and so sucking extra fees for what is merely glorified green eyeshade work.

      1. readerOfTeaLeaves

        I wouldn’t even dignify it with the term ‘green eyeshade’ — this is brazen hucksterism at best. I’m sure the Romneyites would call it ‘innovation’, which only reveals them as supercilious charlatans. (I can almost hear them: “Oooh! It has a keyboard! Keyboards always signify ‘innovation’! Whee!!”)

        I’ll have to come back later in the day and finish this post; it’s too early in the day to have a drink, and the first half of the post is so infuriating that I have to take a break before finishing it…

    2. bluntobj

      Most automated payrolls, claims checks, or utility billing done in the public sector is done with submission of excel .csv’s, entered manually or generated by the accounting software.

      Auditors never really look at the raw files either.

      I’m not sure how much of a victim status I would give to public pensions anyway, given their dogmatic usage of a 7 to 8% rate of return on their assets as the smallest example…

    3. Newtownian

      Thanks so much for confirming my initial impression – this article is central to understanding the vulnerability of pension funds and hence all our futures.

      As a user of Excel for science related risk assessment I’m aware of the potential for fudging’. But I’m still learning (esp. since 2008) how this relates to managing many years retirement income. The issue is so large one its hard to comprehend. Here in Australia alone ordinary people will deposit $6 Trillion by 2020 without us understanding the underlying games financial vehicles and funds play without understanding the facades and risks.

      To illustrate – Following disillusionment with arms length pension funds, recently I attended a ‘Self Managed Superannuation Fund’ advisor/facilitator seminar who usefully explained a number of the dodgy practices – but the question was – what traps for the unwary lay beyond these apparently transparent cost effective spruikers’ not insubstantial 0.35% ‘management + advice fee’? What alerted me that not all was as it seemed was their slipping in their own gentrification real estate development in New Jersey just opposite Manhattan (A quick look at the local sea level rise potential in the Jersey swamps confirmed the alarm bells).

      But less clear was the safety or otherwise in investing in their recommended so-called blue chip stocks. These turned out to be mostly banks (extremely vulnerable to a housing market crash) and mining companies (loaded up with un-burnable coal as assets) and especially diverse investment vehicles with a impenetrable acronyms – which they could identify and ‘advise on’ as you were paying them as part of the package while taking responsibility for any losses.

      How would these dodgy blue chips be valued by these spreadsheeters? Probably ‘safe as houses’ as we used to say.

      The wheels within wheels here are a thing of wonder.

      The moral of the above story of ‘knowledge management’ I guess is – you cant beat the bank when you gamble at their table – they will always play with a stacked deck and they will never lose – but you might and you will even pay them for the privilege.

  5. Erik

    In truth, this is no different from the consolidation systems used by many public corporate behemoths. I have worked on the financial systems of a number of them, and the truth is that the ever-churning world of mergers and divestitures means that most large companies are aggregates of relatively autonomous smaller entities (from a systems perspective, anyway).

    Sure, there are now ERPs, but there are so many times where, in the rollout, it becomes clear that certain markets / offices / brands are not “worth” brining on to the new system because of the level of effort to implement vs. relatively scale. This means that even if 60-70% of the total business in now on Oracle, the consolidated corporate “rollup” is done through a separate system not all that dissimilar of the one described above.

    The “automation” being sold is really to the central corporate team that *they* don’t have to do much because they push all the work down to their underlings. Also important is the “one source of the truth” bit because the “submission process” becomes iron clad with an “official copy” with a date/time stamp and everyone knows where it is.

    I’m not defending iLevel or PE firms; I’m just stating that it’s no different than the rest of our corporate oligarchy / kleptocracy where financial accuracy has zero currency and spin is the name of the game. And it’s always nice to force the act of fudging the numbers down lower into the organization for the sake of plausible deniability and future scapegoating.

    In a perfect world all major companies would have powerful, integrated accounting systems that would roll things up at the push of a button. Unfortunately, there’s too much money to be made everywhere by keeping things constantly in a state of change.

    CEOs love it because they like to be the wheeler-dealers in charge and playing the game with M&A banks is much more fun than focusing on the core business; plus the larger they can build the empire the more they get paid. Of course, eventually, bad performance needs to be blamed on something and that’s when the line becomes “divesting of non-core lines if business” and now they become the sellers.

    CFOs love it because it helps to obscure results and make everything into a series of asterisks on the accounting statements. I worked for one client on various projects for around 10 years, and of those 10 years they had a major acquisition/divestiture in all but 3 of the years, making year-over-year comparisons all but meaningless.

    Consultants love it because it keeps them in business. Wall Street talking heads loves the game because it gives them something exciting to talk BS about.

    In the end, however, structural instability in the corporate world makes accurate and automated financial reporting next to impossible.

    1. s spade

      Excellent comment. I have suspected all this for twenty odd years, and for this reason have never bothered analyzing company financial statements. About the only thing an investor can trust these days is a trend, which of course can end at any time. I am thinking of going back to dart throwing monkeys.

      1. mcmike

        The only safe way to trade is to be in the exact same place as the banks at the exact same microsecond.

        Everything else is playing in traffic.

    2. Mcmike


      I would add that there is not just more fun for wall street in the churn, but more fee money too.

      The incessant churn of deals is not necessarily motivated merely to obscure what is really going on; that is more of a colateral benefit.

      The churn is the point. Lots of money flying around to be skimmed as it flows by. The underlying business is initally just a cash source, then a trading platform, then a front.

      We are entering the stage of simulacra where the business pretense is dropped, Wall Street has gone direct: buying metal warehousing for instance, with no pretense of being interested in metal warehousing, but simply brazenly using it to fix markets and skim some gravy, literally at the expense of the underlying business, which will be discarded like a used snot rag once the con dries up.

      Accounting reporting systems are low priority here. But you can be sure they spend a lot more time and money tracking the con itself.

  6. Ishmael

    Well if you really want to be automated you could pull information on a SQL basis direcly from the database and load this automatically.

    A far better system would be using Hyperion and exclude excel totally.

    However, having been a controller and CFO for a multibillion dollar corporation I would say this is much too do about nothing. Let me assure you before these reports are filed, earnings are discussed with the PE firm (or the portfolio company knows what numbers the PE firm is expecting) and any required entries to correct the earnings are booked at the portfolio company level. Trust me. I have been there and lost my job because I refused to do this.

    1. Ishmael

      I use that term correct in a rather sarcastic manner such as the PE firm plans on or wants certain numbers. Actual results differ and then pressure is put on the portfolio company to “correct” the actual results to better reflect what the PE firm is looking for.

      No way are numbers entered into this system before they are reviewed with the appropriate partner at the PE firm.

  7. Peter Brown

    Everything is being fiddled. Over one quadrillion dollars worth of ‘off balance sheet’ derivatives. How many times global GDP is that? It’s impossible to audit that little lot…even if they wanted to there aren’t enough auditors in the world and they probably wouldn’t want to even try because they would lose the audit. So who can verify principal solvency, counter-party solvency. It’s all a joke. What we have is over one quadrillion dollars worth of unregulated and unaudited weapons of financial destruction out there. But who gives a rat’s ass? Nobody.

  8. readerOfTeaLeaves

    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.”

    Of all the phenomenal posts that I’ve read at NC over the past few years, I have to say this is in my “Top 10” for sheer gut-wrenching shock-value.

    The extent of the charlatanism is truly breathtaking.
    I doubt even Orwell or the old USSR could top this for sheer propaganda – in this case, economic propaganda.

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