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.

Private equity funds are akin to hedge funds in that they have similar payment structures. 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 longer game, and this affects its accounting. While hedge funds invest in anything and everything, most of these positions are highly liquid. They can be sold in seconds if the fund manager chooses. In contrast, private equity funds tend to be very illiquid.

In this way, they are like venture capital firms in that private equity funds invest directly in private companies and, depending on the investment, may not be able to touch their investments for years. In some cases, they may also intervene in a private company’s operations and coach the management into making the business profitable. This could end in an initial public offering (IPO) or culminate in the company merging with 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.

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 LPA, and there can be wide variance between firms. The exact structure impacts 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 also makes a big difference in both private equity fund structures 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. (For more, see: Understanding a Private Equity Fund's Structure).

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, actually financing a sort of 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

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 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, 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 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 may 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. (For more, see: DCF Analysis: Coming Up with a Fair Value).

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 statements, 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.