2019 saw $450 billion in private equity deals, and the year ended with a record level of almost $1.5 trillion in unspent capital, primarily spurred by underperforming hedge funds. Accountants working in private equity undoubtedly are busier than ever.
Private equity accounting is quite complex, however. This complexity arises as private equity investments are highly illiquid and designed to provide dividends in the far-flung future. Private equity structure can also be complicated in that the structure is designed to reduce a fund’s taxes.
Further complicating this web is that the Generally Accepted Accounting Principles (GAAP) were not written with such complex investment structures in mind. However, private equity accounting is also subject to best practices that an experienced accountant can help implement to ensure all reporting is transparent and tax implications are minimized.
Let’s examine how to wrangle the complicated beast that is private equity accounting.
Unraveling Private Equity Fund Structure
A private equity fund is a closed-end investment vehicle that is run as a limited partnership by one or two general partners, who also are typically the fund manager(s). The minimum investment level generally is as high as $200k.
The fund manager will typically be looking for opportunities to become a controlling interest in private companies via debt or equity investments and use the fund’s resources to guide them towards an IPO or M&A. Fund managers will be looking for:
A struggling private company that needs R&D or strategic support, or;
Taking control of a company with operational issues and righting the ship.
Funds are subject to a Limited Partner Agreement, in which investors agree to criteria in which the GP will be operating, as well as the duration of the fund. Limited Partners are not involved in the decision making process for investments.
The duration of a fund is traditionally around ten years, but can be longer due to an extended exit period:
Years 1-2: Formation and Fund-raising
Years 3-6: Investing
Years 6+: Exiting of investments via IPOs, secondary markets, or trades
The management fee for limited partners typically sits around 2%, while the performance fee, contingent on being successful, can be as high as 20% of the gross profit. A fund manager, therefore, has to work hard for the investors to earn that hefty fee for the fund.
In terms of risk, limited partners are only liable to the amount of their initial investment. In contrast, general partners are fully accountable to the market and any of the fund’s debts or obligations. Private equity has traditionally been less regulated than other investment structures, due to the net worth of the typical private equity LP.
Private Equity Accounting Considerations
Private equity funds have been under increased scrutiny across the U.S. during the COVID-19 era, and Limited Partners are demanding more transparency.
It is a sobering fact that the Securities and Exchange Commission (SEC) filed over 100 misconduct cases against funds between 2010 and 2012. While many of these cases are related to outright fraud, funds have also been held accountable for omitting or fudging information to investors about investing strategies, performance, fees, or conflicts of interest.
It is, therefore, incumbent on the fund to be transparent when communicating with LPs.
Accounting standards and Valuation
While private equity is expected to adhere to GAAP, there is an understanding that the application of these standards in reporting is slightly different for private equity. This is due to the various terms that are specific to each company the fund has been invested in, which would make it difficult to be consistent across the board in terms of reporting. There are also times where confidential, non-public information can not be communicated until such time it goes public.
Regardless, it is critical that your reporting is as transparent as possible. U.S. GAAP policy ASC 820, Fair Value Measurements and Disclosures, requires fair value measurements or disclosures and provides a single framework for measuring fair value and related disclosures. ASC 820 defines various terms, such as the seller’s perspective, market participant, and orderly transactions, to help private equity operators address fair value issues.
It helps to have the assistance of a private equity fund accountant when structuring your fund and planning investment terms for an optimal tax outcome.
The two primary tax structures for private equity are Flow-Through and C Corporation, which both have pros and cons:
Flow-through structure: Income is subject to a single layer of tax at the owner level versus a corporate taxpayer. However, foreign and/or tax-exempt investors are subject to U.S. tax withholding or taxes on unrelated business taxable income (UBTI).
C Corporation: Relatively low tax rate, and shields foreign investors and tax-exempt investors from having to recognize income from the operations of the enterprise. The downside is that The corporation pays corporate income tax on its taxable income, and its shareholders are subject to income taxes on any dividends from corporate earnings and profits and sales of the corporate stock.
An accountant can help choose the best system for your fund and ensure the best outcome in taxation by assisting with tasks like these:
Payment reconciliation for investments made with both debt and equity
Accurately separating and accounting for distributions
Handling deductions for pass-through income
Identifying dividend deductions when dealing with foreign corporations.
Financial Statements and Their Importance
Trust between General Partners and Limited Partners provides tangible dividends as well, and a large part of communicating trust is through comprehensive financial reports. A study by investment software company eFront reveals that funds that offer more transparency to their LPs are also the highest performing. Funds that utilize standardized templates provide 70% more info to their LPs, including the number of investment professionals and exposure to geographies and sectors, and a breakdown of both fees and portfolio companies.
This chart from eFront emphasizes information that most quarterly reports should include as a Fund and Portfolio Company level:
Funds that want to ensure their reporting is above board (and that their portfolios are sound) would do well to bring in an independent analyst to audit their investments and processes. As new regulations come into place, you’ll want an expert in your corner who can make sure you’re staying ahead of the competition.
Benefit from the financial lessons we’ve learned from working with leading Silicon Valley VCs
Private Equity vs. Venture Capital
Both private equity and venture capital funds invest in the private sector and are similar in many ways. The primary difference is that VC focuses entirely on high-growth potential startups early in their life cycle rather than mature companies. Private equity also tends to buy 100% ownership of a core group of investment companies, vs. Venture Capital’s 50% or less stake spread across a larger pool of companies.
As venture funds continue to get larger and larger, however, venture and private equity are beginning to clash more and more on the investment front. Private equity is starting to invest earlier into high-growth companies, that they do not deem as “startups.” However, venture funds are not stepping aside and allowing private equity firms to invade their space.
Therefore, you will continue to see more and more battles on the investment front. For this reason, we recommend that high-growth companies explore both venture and private equity options when raising capital at the later stages. When an investment opportunity is de-risked, the possibilities for different investor groups increase on both the venture and private equity fronts. For now, we recommend you grab some popcorn and watch on the sidelines as these two industries continue to battle it out.
Private Equity Accounting Requires Experienced CPAs
If your fund needs assistance in optimizing the fund structure for an optimal outcome, determining and reporting valuations to stakeholders, or designing fully transparent reporting systems – Greenough Group is here to help.
More than 200 Venture Capital and Top Private Equity Firms have found that our back-end accounting, administrative and private equity CFO services save them time and money by providing the high-level executive insight they demand but don’t need as a full-time employee.
Contact us today for a free consultation and learn how we can support the health and expansion of your business.