Annual audit obligations, auditor selection, and the audit process for hedge fund managers
Annual financial statement audits are a fundamental requirement for most hedge funds, providing independent verification that supports investor confidence and regulatory compliance. SEC-registered investment advisers managing private funds must generally have those funds audited annually by an independent auditor registered with the PCAOB. Beyond regulatory requirements, institutional investors typically require audited financial statements as a condition of investment, and fund documents often mandate annual audits regardless of regulatory status.
The SEC's custody rule creates the primary regulatory driver for hedge fund audits. Registered investment advisers with custody of client assets must either undergo an annual surprise examination or have the private funds they manage audited annually. Most hedge fund managers choose the audit path, as it aligns with investor expectations and provides more comprehensive verification.
The audit must be conducted by an independent public accountant registered with the Public Company Accounting Oversight Board. The auditor must issue an opinion on the fund's financial statements and deliver audited financials to investors within 120 days of fiscal year-end. Failure to meet these requirements can result in regulatory action against the adviser.
Even exempt reporting advisers who do not register with the SEC often face audit requirements through fund documentation or LP demands. Institutional investors generally expect audited financials regardless of the manager's regulatory status.
Choosing an auditor involves balancing multiple considerations. Experience with hedge funds specifically matters—the valuation challenges, trading volumes, and fee structures differ from other fund types. An auditor familiar with hedge fund accounting will conduct the engagement more efficiently and identify issues more effectively.
The major accounting firms offer deep resources and institutional credibility that some LPs prefer. Mid-sized and specialized firms may provide more personalized service and competitive pricing while still meeting LP expectations. The appropriate choice depends on fund complexity, LP requirements, and service priorities.
Independence requirements constrain auditor selection. Auditors providing certain non-audit services or having relationships with the fund, manager, or key service providers may face independence concerns. Evaluating independence early in selection prevents problems during the engagement.
Several aspects of hedge fund operations receive particular audit attention.
Valuation represents the most significant audit focus area. Hedge funds hold diverse instruments—some trading on exchanges with observable prices, others requiring significant judgment to value. Auditors test the fund's valuation policies, examine pricing sources, evaluate broker quotes, and assess whether fair value conclusions are reasonable. Level 2 and Level 3 fair value measurements under ASC 820 receive heightened scrutiny.
Trading activity and transaction testing involves sampling trades for accuracy, proper recording, and settlement. High-volume trading creates audit challenges—auditors cannot test every transaction but must achieve reasonable assurance about accuracy. Organized records and reconciled systems facilitate efficient testing.
Performance fee calculations receive careful audit attention given their complexity. Auditors verify high water mark tracking, hurdle rate applications, and crystallization mechanics. Errors in performance fees directly affect investor returns and manager compensation, making accuracy essential.
Annual audits typically follow a structured timeline:
Efficient audits require coordination among the manager, administrator, prime broker, and auditor. The administrator typically prepares draft financial statements and trial balances. The manager provides valuation support, transaction documentation, and management representations. Prime brokers confirm positions and provide transaction records.
Organizing documentation throughout the year supports audit efficiency. Valuation memos explaining pricing decisions, reconciliations tying to service provider records, and organized transaction files reduce auditor requests and accelerate the process.
Communication during the audit helps address issues promptly. Regular status calls, clear escalation paths for questions, and responsive document production keep the engagement on schedule.