Audit Considerations for Private Credit Funds

Annual audits of private credit funds involve specialized considerations that reflect the complexities of loan portfolio accounting. Auditors examine fair value measurements for illiquid credit positions, evaluate credit loss methodologies, and assess income recognition practices that may differ from equity-focused funds. Understanding these audit focus areas helps managers prepare effectively and supports efficient audit execution.

Audit Focus Areas for Private Credit

While audits of private credit funds address standard matters common to all investment funds, several areas receive heightened attention due to the nature of credit investing. Managers should anticipate substantive audit procedures in these areas and prepare supporting documentation accordingly.

• Loan Valuation: Fair value measurements for private loans typically involve significant judgment because active markets rarely exist for these positions. Auditors examine valuation methodologies, test key inputs, and evaluate whether conclusions are reasonable given market conditions.
• Credit Loss Provisioning: For funds that establish credit loss allowances, auditors assess whether methodologies comply with applicable accounting standards and whether estimates are supported by relevant data and analysis.
• Interest Income Recognition: The timing and measurement of interest income, including treatment of OID, deferred fees, and PIK interest, requires consistent application of accounting policies. Auditors test income recognition calculations and evaluate policy appropriateness.
• Impairment Assessment: Determining when loans are impaired and measuring impairment losses involves judgment about collectibility and recovery. Auditors examine the basis for impairment conclusions and test related calculations.

Valuation Audit Procedures

Loan valuation typically represents the most significant audit area for private credit funds. Auditors may perform several types of procedures to evaluate fair value conclusions:

Methodology Review: Auditors assess whether valuation methodologies are appropriate for the types of loans held and consistent with fair value measurement principles. Common methodologies include discounted cash flow analysis, market comparables, and enterprise value analysis for loans with equity-like characteristics.

Input Testing: For each valuation approach, auditors test key inputs against supporting evidence. This may include verifying borrower financial information used in models, assessing discount rate assumptions against market data, and testing mathematical accuracy of calculations.

Third-Party Valuation Review: Many private credit funds engage independent valuation firms to support fair value conclusions. Auditors evaluate the qualifications of these firms, understand their methodologies, and assess whether management appropriately considered their conclusions.

Sensitivity Analysis: Auditors may perform or request sensitivity analysis to understand how changes in key assumptions would affect valuation conclusions. This helps assess whether valuations are reasonable within a range of possible outcomes.

Credit Loss Methodology

Funds applying Current Expected Credit Loss (CECL) standards face audit scrutiny of their loss estimation methodologies. Auditors examine whether the methodology considers relevant factors including historical loss experience, current conditions, and reasonable and supportable forecasts. Documentation of methodology choices and key judgments helps support audit conclusions.

For funds not subject to CECL, auditors still assess whether impairment indicators are identified and whether impairment losses are measured appropriately when loans become impaired. The distinction between temporary declines in value and other-than-temporary impairments requires judgment that auditors evaluate.

Income Recognition Testing

Auditors test interest income recognition through procedures such as:

• Recalculation: Independently calculating interest income for a sample of loans to verify accuracy, including proper application of day count conventions and rate reset mechanisms.
• OID Amortization: Testing that original issue discount is amortized appropriately over the loan term using the effective interest method.
• Fee Recognition: Evaluating whether fees are recognized in appropriate periods based on their economic substance, with deferred fees amortized over the relevant service period.
• Non-Accrual Assessment: For loans placed on non-accrual status, testing that income recognition ceased at the appropriate point and that any previously accrued but uncollected interest was reversed.

Preparing for the Audit

Effective audit preparation reduces engagement duration and supports favorable outcomes:

• Valuation Documentation: Compile supporting materials for each position including borrower financials, valuation models, third-party reports, and documentation of key judgments. Organized valuation files accelerate auditor testing.
• Policy Documentation: Ensure accounting policies for income recognition, impairment, and fair value measurement are clearly documented and consistently applied.
• Reconciliations: Prepare reconciliations between loan servicing records, accounting systems, and administrator records. Auditors test these reconciliations as part of control evaluation.
• Management Representations: Anticipate representation letter requests and ensure appropriate personnel can provide required representations about valuations, contingencies, and other matters.

Auditor Selection Considerations

Selecting an audit firm with private credit experience improves audit efficiency and quality. Relevant experience includes familiarity with loan accounting, understanding of credit valuation methodologies, and experience with the fund's specific accounting framework (U.S. GAAP, IFRS, or other).

Larger private credit funds may benefit from audit firms with dedicated financial services practices and valuation specialists who can evaluate complex credit positions. The audit team should include personnel familiar with investment fund structures and investor reporting requirements.

Questions to Ask When Preparing for Audit

• What valuation documentation does the auditor expect for each position, and when should it be provided?
• How will the auditor evaluate third-party valuation reports, and what additional testing may be required?
• What credit loss methodology documentation will the auditor need to review?
• How will the auditor test interest income calculations, including OID and fee amortization?
• What is the expected audit timeline, and what deliverables are needed at each stage?
• How will audit fees be affected by portfolio complexity and the extent of valuation testing?