Private Equity Fund Audits: Capital Accounts, Carried Interest and Level 3 Valuation

A private equity fund audit looks nothing like an operating company audit. There is no inventory and little revenue. The financial statements are the portfolio at fair value, the partners' capital, and the allocation of profit between the limited partners and the general partner. Most of the risk sits in two places: the valuation of illiquid investments and the arithmetic of the partnership agreement.

This guide covers the accounting framework, the capital account and carried interest testing, and the PBC items to request.

Why the audit exists

Many funds are audited because the adviser relies on the audit alternative in the SEC custody rule. Under Rule 206(4)-2, a pooled vehicle that is subject to audit is deemed to comply with the annual verification requirement and is excused from the custodian notice and account statement requirements, provided the audit meets three conditions:

• The fund is audited at least annually and distributes audited financial statements to all limited partners within 120 days of fiscal year end.
• The statements are prepared under U.S. GAAP.
• The auditor is registered with, and subject to regular inspection by, the PCAOB, and the audit on liquidation is delivered promptly after it is completed.

That PCAOB registration and inspection condition matters at acceptance. A firm that is not registered cannot perform the audit if the adviser relies on the rule. Resolve it before signing the engagement letter.

Investment company status

Funds follow ASC 946. An entity is an investment company if it meets the fundamental characteristics in ASC 946-10-15: it obtains funds from investors and provides them with investment management services, its business purpose and only substantive activities are investing solely for returns from capital appreciation, investment income, or both, and neither it nor its affiliates obtain other benefits from investees. The same section adds typical characteristics: more than one investment, more than one investor, investors that are not related parties of the manager, ownership interests in the form of equity or partnership interests, and substantially all investments managed on a fair value basis. Missing a typical characteristic does not automatically disqualify the entity, but it requires judgment and documentation.

The consequence is large. An investment company reports its investments at fair value, including controlling interests in operating companies, rather than consolidating them or using the equity method. Document the status conclusion in the planning file and re-test it when the strategy changes. An entity that holds operating company interests for strategic or operating purposes, or whose affiliates obtain other benefits from investees, does not meet the fundamental characteristics. See the ASC 946 standards page.

Fair value of portfolio companies

Private equity investments in non-public companies are Level 3 in the fair value hierarchy under ASC 820 when significant inputs are unobservable. Management values them, sometimes with an outside valuation firm, using market multiples, discounted cash flows, or a recent transaction price. The auditor tests the process under AU-C 540 and evaluates management's specialist under AU-C 620. See ASC 820 fair value measurement.

Procedures that matter:

• Obtain the valuation memo for each significant investment and trace inputs (EBITDA, revenue, net debt) to the portfolio company's financial statements.
• Compare selected multiples to public comparables and to the entry multiple, and ask why any gap exists.
• Test for stale marks: an investment held at cost for several quarters while the company's results moved.

Management bias is a fraud risk factor to consider. Marks can affect fees, the carry, and fundraising for the next fund. Treat the valuation of the fund's largest holdings as a significant risk.

The capital account roll-forward

Each partner has a capital account. Under Treas. Reg. 1.704-1(b)(2)(iv), an account increases by money contributed, the fair market value of property contributed, and allocated income and gain, and decreases by money and property distributed and allocated loss and deduction. Liquidating distributions follow positive capital account balances. The financial statements present a statement of changes in partners' capital with the same roll-forward. See partners' capital accounts.

Test it this way:

1. Agree opening balances to the prior-year audited statements for each partner or class.
2. Agree contributions and distributions to capital call and distribution notices and to bank statements.
3. Recalculate the allocation of net increase in net assets by partner using the limited partnership agreement (LPA) formulas.
4. Foot the roll-forward, and tie the sum of partner capital to net assets on the statement of assets and liabilities.

Carried interest and the waterfall

Carried interest is the general partner's share of profit above the investors' return, usually after a preferred return. In the financial statements it appears as an incentive allocation to the general partner's capital account, calculated as if the fund liquidated at fair value on the reporting date (a hypothetical liquidation). The audit has to prove the number against the LPA, not against the sponsor's spreadsheet.

Worked example (illustrative numbers). An LPA gives limited partners return of capital, then an 8% preferred return, then a full catch-up to the general partner, then 80/20. Limited partners contributed $100M. At year end, net assets before carry are $160M. Under a hypothetical liquidation:

The general partner's $12M equals 20% of the $60M of profit, which confirms the catch-up completed. The auditor recalculates each tier, agrees the preferred return to the days outstanding for each contribution, and checks that the LP capital accounts end at $148M. A mistake in the compounding convention for the preferred return flows straight into the carry.

Then test the exposures around it:

• Clawback. If interim carry was distributed on early exits and later marks fall, the GP owes money back. Obtain the clawback calculation and test whether a liability or a receivable restriction is needed.
• Whole-fund versus deal-by-deal. The LPA terms decide how losses on later deals offset earlier gains. Read the exact wording.
• Tax distributions to the GP that are advances against carry.

For tax reporting, the holding period requirement in IRC Section 1061 applies to carried interests held in connection with services: net long-term capital gain on an applicable partnership interest is recharacterized as short-term to the extent it exceeds the amount computed with a 3-year holding period. Fund tax allocations and K-1 data should reflect it.

Other audit areas

Obtain confirmations of investments from portfolio companies, transfer agents, or custodians, and of subscription line balances and covenants. Review fee arrangements with the manager and affiliates as related party transactions. Read subsequent events for distributions, capital calls, and deal closings that change the carry.

Red flags

• Marks that never decline, or that move in lockstep with the sponsor's fundraising calendar.
• Carry calculated outside the fund administrator's system.
• Capital account totals that need a plug to tie to net assets.
• Distributions that exceed capital account balances without an LPA basis.

PBC items to request

• Executed LPA and side letters
• Fund administrator's capital account statements by partner
• Capital call and distribution notices with bank support
• Valuation memos, third-party valuation reports, and board materials
• Waterfall and clawback calculations at year end
• Portfolio company financial statements and covenant certificates
• Subscription line agreement and balance confirmation
• Management representation letter

See the PBC list guide for how to structure the request.

Sources

• SEC, 17 CFR 275.206(4)-2, Custody of Funds or Securities of Clients by Investment Advisers, paragraph (b)(4), via Cornell Legal Information Institute
• FASB, ASU 2013-08, Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements
• 26 CFR 1.704-1(b)(2)(iv), Capital Account Maintenance, via Cornell Legal Information Institute
• 26 U.S.C. 1061, Partnership Interests Held in Connection with Performance of Services, via Cornell Legal Information Institute
• AICPA, Investment Companies Audit and Accounting Guide, publication description
• AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures; AU-C Section 620, Using the Work of an Auditor's Specialist

CORAA prepares ready-to-review audit files for US CPA firms; see /us.

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error