How to Grasp the Accounting of Private Equity Funds
Private equity fund accounting is unlike that of other investment vehicles because private equity funds are not like other types of investments. They are one part hedge fund, one part venture capital firm, and one part something all their own, and it is evident in their accounting. The same accounting rules you see in other companies still apply, but they often have to be modified to accommodate privately held companies.
Key Takeaways
- Although accounting rules for typical companies apply, these rules can be modified somewhat for private equity companies.
- Private equity fund accounting may also be affected by the amount of control the fund has over an entity.
- Valuation methodologies are a critical element when analyzing private equity accounting.
Understanding Private Equity Funds
Private equity funds typically invest in companies directly. Private equity funds often purchase private companies and can sometimes buy the stock shares of publicly-traded companies as well.
Private equity funds seek to acquire a controlling interest in a private company. Once a company has been acquired, experts are signed to the company to improve and guide management and implement improvements. Private equity funds employ various strategies to improve a company, including a change of management, improving operational efficiency, expanding the company, or its product lines. The goal of a private equity fund is to make the company as profitable as possible within the intent of selling their controlling interest for a profit once a company becomes more valuable.
The result could also end in an initial public offering (IPO), which is when a private company issues equity shares to the public to raise capital or funds. Private equity firms also have a hand in helping companies merge with one another. In either case, there is a period of years during which a precise value of the private equity fund’s investments is not objectively defined.
Private Equity Funds vs. Hedge Funds
Private equity funds are akin to hedge funds in that they have similar payment structures. Hedge funds are an investment containing pooled funds that invest in various securities and assets to achieve returns for investors. Typically, a hedge fund’s goal is to earn as much return in the shortest time frame. The portfolio allocation can include commodities, options, stocks, bonds, derivatives, and futures contracts. Leverage–or borrowed funds–is often employed to magnify returns.
Private equity funds are different than hedge funds because private equity is focused more on a long-term strategy to maximize profits and investor returns by partly-owning the companies directly. Investors can liquidate their hedge fund holding when needed while an investment in a private equity fund usually needs to be held for a longer period of time, sometimes ten years or longer.
However, there are similarities between the two funds. Investors pay management fees and a percentage of the profits earned. Both types of funds maintain portfolios of different investments, but they have very different focuses. Private equity has a long-term outlook, and this affects its accounting. While hedge funds invest in anything and everything, most of these positions are highly liquid, meaning the positions can be readily sold to generate cash. Conversely, private equity funds tend to be very illiquid.
Private equity funds are akin to venture capital firms, which are funds that invest in private companies with high-growth potential. Venture capital funds often involve investing in start-ups. Private equity funds also invest directly in private companies and, depending on the investment, may not be able to touch their investments for years.
Fund Structure
Private equity funds tend to be structured as limited partnership agreements (LPAs) with several classes of partners. There is often a founder partner (FP) class, as well as a general partner (GP) class and a limited partner (LP) class. Fund expenses and distributions have to be allocated across these partner classes. The rules for this are to be stipulated in the limited partnership agreement (LPA), and there can be wide variance between firms. The type of private equity fund structure can impact how the accounting information for each investment and that of the company as a whole are recorded. The level of analysis the private equity fund uses may also be affected by the structure.
The country of jurisdiction can also impact both the private equity fund structure and accounting. Most U.S. private equity funds are in Delaware, but private equity funds may also go offshore, as in a Cayman Limited Partnership, or they may be based in another country. For instance, in Europe, an English Limited Partnership is very common, even for funds not based in the United Kingdom.
Private Equity Investments
Also, keep in mind that many private equity funds create complex investment structures to limit the tax burdens of their investments, which vary depending on the state or country of jurisdiction, and that complicates the accounting. Controls may be put in place, or need to be put in place, to reduce tax risk, and some structures may need to be adjusted as time goes on depending on changing legislation or the accepted interpretation of tax legislation.
Further, the agreements that private equity funds have with the companies in which they invest also make a difference. For example, some private equity funds invest in a business through both equity and debt, which acts as a loan for the business. If so, interest payments have to be reconciled. In other cases, the company may have an agreement to pay dividends to the private equity fund, and the distribution of those profits has to be handled.
Accounting Standards
Private equity firms must adhere to the standards issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). For the most part, accounting standards were not written with private equity in mind, so the format for private equity fund accounting has to be modified to illustrate clearly the operations and financial situation of the private equity fund. There is also variance in the terms the private equity fund has with each company in which it invests, the purpose of the private equity fund’s activities and the needs of its investors as far as financial statements are concerned.
Private equity fund accounting may also be affected by the amount of control the fund has over an entity. For instance, under the U.K. generally accepted accounting principles (GAAP), equity accounting is necessary if the investment gives the fund an influential minority (20 to 50%) stake in the company and is not held as part of a larger portfolio, while U.S. GAAP does not require equity accounting for influential minority positions. In contrast, the International Financial Reporting Standards (IFRS) requires equity accounting for influential minority positions when they are not valued fairly through a profit and loss.
The accounting standard that a private equity fund adopts also affects how partner capital is treated. Under U.S. GAAP, partner capital is treated as equity unless the partners have an agreement that allows them to redeem their investment at a particular time. In contrast, the U.K. GAAP and IFRS treat partner capital as debt that has a finite life.
Valuation Methodologies
When looking at private equity accounting, valuation is a critical element. The choice of accounting standards impacts how investments are valued. While all accounting standards require investments to be listed at fair value, the definition of fair value differs considerably between standards. In certain cases, a private equity fund might be able to discount the value of an investment by claiming there is a contractual or regulatory restriction that affects the market price. In other cases, investments are listed at what the fund paid for them minus any provisions or are valued at the sale price of the investment if it were put on the market.
Financial Statements
The financial statements prepared for investors also vary depending on the accounting standard. Private equity funds under U.S. GAAP follow the framework outlined in the American Institute of Certified Public Accountants (AICPA) Audit and Accounting Guide. This includes 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 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. U.K. GAAP asks for a profit and loss statement, a balance sheet, a cash flow statement, a statement of the gains and losses the fund recognizes, as well as any notes.
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