Understanding Private Equity Fund Accounting

The Invaluable Insights and Understandings of Private Equity Fund Accounting

Jun 07, 2022

| Blog | Fund Structure | Private Funds | Technology and Innovation

Private equity fund accounting is quite complex to other investment vehicles. What separates fund accounting from general accounting is that, while small businesses, for example, make purchases with their own funds, private equity firms make purchases with their investors’ funds. Fund accounting, refers to the methods of accounting used by investment funds. Some of the responsibilities of fund accounting in private equity overlap with traditional, general accounting – such as identifying income and expenses on an accrual basis and verifying accounting records against external sources – but others are unique to investment funds. This is what gives fund accounting its second name – partnership accounting. General Partners, the fund managers, raise funds from Limited Partners, the investors, in order to make investments. However, private equity accounting is subjected to best practices to ensure investor transparency and minimal tax implications. And the complexities arise mainly because private equity investments are highly illiquid and are designed to provide dividends in the distant future.

Understanding Private Equity Funds

Private equity is a form of financing where money, or capital, is invested into a company. Typically, private equity investments are made into mature businesses in traditional industries in exchange for equity, or ownership stake. Private equity is a major subset of a larger, more complex piece of the financial landscape known as the private markets.

Private equity is an alternative asset class alongside real estate, venture capital, distressed securities and more. Alternative asset classes are considered less traditional equity investments, which means they are not as easily accessed as stocks and bonds in the public markets. A private equity fund is a closed-end fund run as a limited partnership by general partners.

Private equity funds invest in promising private businesses with a goal of increasing their value over time before eventually selling the company at a profit. Private equity funds may utilize various strategies to improve a company, including improving operational efficiency, changing the management, or expanding the company’s product lines. Private equity firms usually have majority ownership of multiple companies at once. A firm’s array of companies is called its portfolio, and the businesses themselves, portfolio companies. The ultimate goal of a private equity fund is to make the company as valuable as possible so the general partners can sell the investment for a higher profit.

Private Equity Funds vs. Hedge Funds

Both private equity funds and hedge funds are investment products that appeal to accredited high-net-worth individuals. Both are traditionally structured as limited partnerships and involve paying a percentage of profits and basic management fees to the managing partners. However, the biggest difference between private equity funds and hedge funds are fund structure and investment targets – Private equity funds focus on private companies, while hedge funds operate in the public markets, investing in publicly traded companies.
Private equity funds are also closed-ended, implying that new money cannot be invested after the initial period has expired. Whereas hedge funds are open-ended, meaning that investors can continue to add or redeem their shares in the fund at any time.

A private equity fund focuses on a long-term strategy to maximize profits and returns by partly owning a private company. In comparison, a hedge fund focuses more on earning the maximum possible return in the shortest time frame. And thus, the portfolio allocation of a hedge fund includes highly liquid assets that can be generated to cash. In contrast, investments in a private equity fund need to be held for longer, sometimes ten years or longer. The short-term focus of hedge funds also makes it likely to involve higher risk.

Private Equity Funds vs. Venture Capital Firms

Private equity funds are also somewhat similar to venture capital funds, as both invest in private sector companies and exit by selling the investments in equity financing. However, there are considerable differences between them regarding investment and conducting business.

Private equity funds mainly invest in mature companies that are already established but fail to make profits due to inefficiency. In comparison, venture capital firms invest mainly in startups with good growth potential. Private equity firms generally acquire 100% ownership of the invested companies. In contrast, venture capital firms only invest 50% or less of the companies’ equity. Most venture capital firms also prefer spreading out the risk and investing in many different startups so that the fund is not affected substantially if one startup fails.

Fund Structure

Private equity firms are structured as partnerships with one General Partner making the investments and several Limited Partners investing capital. Generally, when a private equity fund is launched, the General Partner assumes responsibility for managing the fund and identifying investments. Limited Partners are investors who contribute capital, but do not necessarily have discretion over the choice of investments.

Performance incentives give the General Partner motivation to aim for strong performance, which, if successful, benefits both the General Partners and Limited Partners. All investors of the fund will agree on set terms laid out in a Limited Partnership Agreement (LPA). The key terms generally found in an LPA include the duration of the fund, the percentage of the management fee (typically 2% annually), how profits will be divided and paid out, rights and obligations of the institutional partners, and restrictions imposed on the General Partner (including industry, size, or geography of investments and any diversification requirements).

A successful private equity firm will manage several funds (i.e., a family of funds) and generally try to raise a new fund every few years. They then use this capital to invest in or buy subsequent companies, which become portfolio companies.

The Limited Partners generally just provide capital. They do not have a hand in deciding on which companies to invest in. The General Partners decide that. However, if the Limited Partners are unimpressed with the returns generated by the General Partner, they may choose not to invest with the private equity fund again.

Accounting Standards

Fund accounting refers to the maintenance of the financial records of an investment fund. Accounting records must be kept for the investor activity, the portfolio activity, the income earned and the expenses incurred by the fund.

Generally Accepted Accounting Principles (GAAP) are a collection of commonly-followed accounting rules and standards for financial reporting. The specifications of GAAP, which is the standard adopted by the U.S. Securities and Exchange Commission (SEC), include definitions of concepts and principles, as well as industry-specific rules. The purpose of GAAP is to ensure that financial reporting is transparent and consistent from one organization to another.

A private equity fund’s accounting standard also impacts how partner capital is treated. Under U.S. GAAP, partner capital is considered as equity unless the partners come into an agreement that enables them to redeem their investment at a particular time.

Financial Statements

The financial statements which are prepared for investors in a private equity fund also vary depending on the accounting standard. Private equity funds that adhere to the U.S. GAAP follow the framework outlined in the American Institute of Certified Public Accountants (AICPA) Audit and Accounting Guide. This mandates that the financial statement must include a cash flow statement, a statement of assets and liabilities, a schedule of investments, a statement of operations, notes to the financial statements, and a separate listing of financial highlights. In contrast, the International Financial Reporting Standards (IFRS) requires an income statement, balance sheet, and cash flow statement, as well as applicable notes and an account of any changes in the net assets attributable to the fund partners.

Challenges of Private Equity Fund Accounting

Due to the unique attributes of private equity funds, investment fund managers and their accountants may face several challenges during private equity fund accounting, including:

  • Distribution waterfall calculations – Investing in private equity funds can be financially beneficial, especially when Limited Partners benefit from dividing capital gains or investment returns between all participants, including the General Partners, also known as the private equity waterfall model. Private equity waterfall models define all the rules for distributing profits within the private equity agreement.Furthermore, a waterfall model is a structure designed to ensure that the interests of General Partners and Limited Partners align in a way that adequately compensates everyone involved in an investment. Ideally, waterfall models ensure that everyone receives the correct incentives. In addition, waterfalls can be difficult to model or explain in partnership agreements; therefore, they should be done carefully and approved by third-party professionals with years of private equity industry experience.
  • Increasing Fund Complexities –Experience shows that fund managers face significant increases in the complexity of their operations, resulting from expanding their product offerings into non-traditional private equity and real estate investments (e.g., credit, middle-market, infrastructure) and increasing regulatory reporting requirements. Private Equity funds have evolved from simple, stand-alone limited partnerships to highly complex structures. Creating multiple vehicles within each structure also means complicated allocations and fee calculations. While these complex calculations may be handled in spreadsheets, that carries risk and is a warning flag to larger institutional investors who may want to invest in the fund.

The largest investors have become more demanding in terms of fund reporting. Investors routinely request more detailed quarterly reports with extensive capital account statements, to be delivered within days after the quarter ends. The result is less standardization and far more customization. For managers, meeting these challenges is time consuming, expensive, and difficult.

  • Evolving Technology – The ability to meet the current and future needs of you and your investors requires a proven, substantive platform with the level of automation, scale, control, and security expected in an industry leading solution. It must deliver transparency and efficiency to you and to the investor experience. Using a secure, sophisticated platform provides a more controlled and reliable environment for data input and outputs. It mitigates the risk inherent in using spreadsheets, and allows for transparent and secure reporting. State-of-the-art investor portals allow fund managers, General Partners and Limited Partners to access online, real-time data and reporting.

The cost of investigating, implementing, and maintaining relevant technology can be expensive and overwhelming for individual managers. Partnering with a fund administrator who already invests in these platforms allows fund managers access to advanced technology while avoiding much of the cost, process and time commitment of in-house implementation and ongoing maintenance.

Private equity fund accounting is constantly changing and evolving. As funds grow and their complexities multiply, the impact of having to hire, train and retain staff to support a back-office functions also becomes greater. Gain economies of scale with a qualified Fund Administrator such as Ultimus LeverPoint. With an effective co-sourcing model, the responsibility for attracting and retaining skilled talent falls on the administrator, who can pool resources across a broad client base, reducing the fund manager’s skills-related risk.

Ultimus LeverPoint leverages both technology and a flexible servicing model that enable General Partners to adapt to the new environment and enhance the investor experience. A robust architecture allows Ultimus LeverPoint to deliver quality services and increase productivity to meet the needs of our clients. Our responsive service model focuses only on the core activities of fund administration. Since we are an independent service provider, our dedicated teams and services won’t be disrupted by the budget cuts, service reductions, downsizing, offshoring and outsourcing.

ULP 15083675 05/26/2022

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