Financial statement audits, internal controls, and auditor selection
Annual financial statement audits are a fundamental requirement for private equity funds, typically mandated by Limited Partnership Agreements and expected by institutional investors. The audit provides independent verification of fund financial statements, including the critical fair value determinations for portfolio company investments. Beyond compliance, the audit process offers an opportunity to strengthen financial controls and demonstrate operational integrity to investors. Understanding audit requirements, processes, and firm selection helps managers navigate this essential function effectively.
Most PE fund LPAs require annual audited financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles. Registered investment advisers face additional requirements under the SEC's custody rule, which mandates annual audits of pooled investment vehicles by independent public accountants registered with the PCAOB. These audits must be completed within 120 days of fiscal year end, with financial statements distributed to investors.
PE fund financial statements typically include a statement of assets and liabilities, statement of operations, statement of changes in partners' capital, statement of cash flows, and accompanying notes. The notes disclose significant accounting policies, fair value measurement methodologies, related party transactions, and commitments and contingencies. Schedule of investments provides detailed information about each portfolio holding.
Portfolio company valuations represent the most significant audit area for PE funds. Under ASC 820, investments are valued at fair value using a hierarchy that prioritizes observable market inputs. Most PE holdings qualify as Level 3 assets, requiring valuation techniques based on unobservable inputs such as comparable company multiples, discounted cash flow analyses, or recent transaction prices.
Auditors evaluate the appropriateness of valuation methodologies, reasonableness of assumptions, and consistency of application across periods and investments. This evaluation often involves testing management's analysis, evaluating third-party valuation reports, and considering alternative methodologies. Valuation audit procedures have intensified following regulatory focus on fair value practices at PE funds.
Documentation supporting valuations should be comprehensive and contemporaneous. Auditors expect to see evidence of the valuation process, including data sources, methodology selection rationale, sensitivity analyses, and approval documentation. Building robust valuation files throughout the year, rather than reconstructing documentation at audit time, improves audit efficiency and reduces findings risk.
While PE funds are not typically subject to SOC reporting requirements, establishing strong internal controls supports audit efficiency, reduces error risk, and demonstrates operational maturity to investors. Key control areas include authorization procedures for capital calls and distributions, segregation of duties in cash handling, valuation governance processes, and financial reporting review procedures.
Documenting control procedures and testing their effectiveness helps identify weaknesses before they result in errors or audit findings. Many managers implement control self-assessment processes or engage internal audit resources to evaluate control design and operating effectiveness. The level of formality depends on firm size and complexity, but even smaller managers benefit from documented procedures and periodic control evaluation.
Selecting an audit firm involves balancing expertise, capacity, service approach, and fee considerations. Factors to evaluate include the firm's PE practice depth, engagement team experience, service reputation among peers, and geographic coverage for portfolio companies. Larger firms offer brand recognition and deep technical resources but may present capacity constraints during peak audit season. Mid-sized and regional firms can provide strong PE expertise with potentially greater partner attention and fee flexibility.
Effective auditor relationships develop through clear communication, timely information provision, and constructive engagement on technical matters. Providing auditors with access to information, explanations of unusual transactions, and reasonable response times for requests supports efficient audit completion. Building relationships during planning phases allows early identification and resolution of potential issues.
Audit timing requires careful planning, particularly for funds with December fiscal year ends competing for auditor resources. Early planning meetings, interim audit procedures, and accelerated closing processes can help meet filing deadlines. Funds with K-1 delivery commitments face additional pressure to complete audits in time for partner tax filings.
Multi-entity audit coordination becomes relevant for managers with multiple fund vintages, co-investment vehicles, and management company entities. Coordinating audit timing, addressing intercompany transactions, and ensuring consistent accounting policies across entities requires advance planning and clear communication with audit teams.