The Securities and Exchange Commission's recently finalized
The SEC's long-standing custody rule has required private funds to disclose much of this information, but there are new wrinkles and requirements. The new requirements will make these funds disclose more information about their fees, expenses and performance, and require annual financial statement audits for each fund they advise to be distributed to investors, in the hopes of safeguarding investors against the misappropriation of fund assets (
"Having the funds audited has been a widespread practice for the most part, primarily through the custody rule," said Chris Avellaneda, a partner at the law firm Schulte Roth & Zabel in New York. "There are some specific areas that are going to create some challenges, but overall having the funds audited as an official matter has been a very common practice in the private funds industry."
Major auditing firms have long been providing services to private equity firms and hedge funds.
"For firms like BDO and other big accounting firms, there's no change in the audit requirements," said Dale Thompson, national technical partner of asset management at Top 10 Firm BDO USA in New York. "What the SEC did in the final rule was to leave some of the existing requirements under the custody rules where the audit of the funds were used to satisfy the rules. They tie in things like auditor independence, which has to comply with SEC independence rules. That was already baked into the custody rule provisions, and the fact that the audit must be done in accordance with U.S. GAAS. The financial statements should be prepared in accordance with U.S. GAAP, and if it's not U.S. GAAP, then another comprehensive basis or widely accepted basis of accounting with a reconciliation of disclosures that would be required in accordance with U.S. GAAP to make sure that those are included in any other type of GAAP. There's really no change in terms of the financial statement requirement, the audit requirement and the independence requirement."
"From what I've seen, most of these funds were already getting audits," said Curtis Farrow, private equity practice leader at Centri Business Consulting in Philadelphia. "But where I see this going is the scrutiny over those audits is likely to increase over time, just as things do when you start with regulation, and then it evolves and goes from there. The scrutiny for the auditors is likely to increase, especially if at some point these end up being PCAOB-type audits, then that would drastically increase the amount of scrutiny and the level of involvement from the audit firms, the funds and then any providers like us at Centri that assist the management teams in getting through their audits."
"For most of the industry, this is business as usual," said Scott Beal, a partner in the private funds and asset management group of New York law firm Barnes & Thornburg. "Under the existing custody rule under the Investment Advisers Act, the most common way for managers to comply with the requirements has just been to do an annual audit, and for funds of a significant size, this is something that investors expect. The differences from the proposed to the final rule basically make sure that these provisions line up with the existing requirements under the custody rule."
The financial services industry nevertheless fought against the rule after the SEC proposed it, and the SEC removed some of the provisions that had been of concern, such as some involving liability. Nevertheless, several industry groups, including the Managed Funds Association, the National Association of Private Fund Managers, the National Venture Capital Association, the American Investment Council, the Alternative Investment Management Association, and Loan Syndications & Trading Association filed a
"Although it doesn't have quite as many of the features that were originally concerning to the industry, it will still be very significant, transformational and challenging," said Avellaneda.
The audit requirement will apply to subadvisors as well as primary advisors, he noted, and the audits would also have to either be GAAP or GAAP-reconciled. "You can imagine a circumstance where you are a registered investment advisor, subadvising a private fund that you don't control that is established and operated by a primary advisor outside the United States," said Avellaneda.
The audit requirements differ from the custody rule requirements because they're not tied to having custody, he noted, but instead to advising a private fund. Subadvisors will need to take reasonable steps to request financial statement audits be undertaken even when the subadvisor doesn't have custody.
Safekeeping rule changes
The SEC separately proposed in February some
"The custody rule requires registered private funds to obtain either a surprise audit, or they can do an annual audit, which is then distributed to their investors and their funds," said Jim Van Horn, senior counsel at the law firm Seyfarth Shaw. "Most private funds already do the annual audit. They'd rather not have to do a surprise audit, so the regular annual audit is the way they go. From that perspective, what's happening is they're encoding something that was already happening by choice with all the private funds."
One of the changes in the private advisor rule could essentially end the practice of doing surprise audits or examinations for the private funds.
"There's no more ability if you're a manager of a private fund, or you're covered by this, to do surprise audits, or surprise examinations," said Barnes & Thornburg's Beal. "This would be a situation where the accounting firm will show up at some point during the year unannounced or with very little notice to do a surprise examination, which is much less intrusive and involved than an actual audit that involves verification of the assets, etc. In addition to a surprise audit, a manager can comply with the custody rule by doing that in conjunction with the delivery of account statements to investors. This is a practice that's only used with a minority of funds, which tend to be smaller funds, like a registered advisor who is launching a new strategy that's going to be mostly for friends and family and wants to avoid the expense of a full audit as it's getting off the ground, so it's going the surprise audit route for year one or the first couple of years. That's a practice that happens on occasion. But now that's completely closed off. That's probably the biggest change from an audit standpoint."
Quarterly reports
Auditors will also be working with their private fund manager clients to address other issues under the rule, he noted, including the reporting of expenses that are passed along to funds in the quarterly statements, as well as the performance reporting.
"There are greater requirements to, on a quarterly basis, disclose expenses and fees borne by the fund and the impact on performance," said Avellaneda. "It's a more prescriptive disclosure requirement that didn't exist previously."
One of the key changes in the final rule from the proposal was that the SEC, instead of prohibiting advisors from passing along certain expenses to the funds, said the expenses could be passed along but required them to be disclosed in the quarterly statements. However, the level of detail in the disclosures is still unclear, Avellaneda noted, and there will be some questions about how that's interpreted in practice.
Funds will need to start providing more details in their quarterly reports.
"The quarterly report rule that was adopted basically requires certain levels of detail that I don't think every fund was putting out there," said Van Horn. "The SEC is basically requiring certain types of fees and expenses, both at the fund level and at the portfolio level, where those fees and expenses are actually being paid to the advisor, or to an affiliate of the advisor."
Performance reporting disclosures will need to be more detailed.
"The advisors now will need to make disclosures regarding the fund's performance, as well as fees and expenses that the funds incur," said BDO's Thompson. "The quarterly statements need to be done and provided to investors within 45 days from the end of the quarter. That's definitely going to be an additional burden on advisors. Some advisors, especially hedge fund advisors, do provide their investors with some information already on a quarterly basis, primarily the year-to-date performance. This statement requirement will just add more information in terms of performance. It's not just the year-to-date performance, but also information about performance for the last 10 years on an annual basis, and then average performance in a one-, five- and 10-year period. They need to provide more information and a breakdown of the fund's fees and expenses as well."
Third-party fund administrators will probably aid in this process. "Most of these advisors have a third-party fund administrator, so presumably the administrator would be able to streamline the data requirements and calculations that are necessary for this statement," said Thompson. "They will probably do a test run, but I think after they do a walkthrough on the first go, it should be on autopilot and streamlined by these fund administrators."
Real estate-oriented private funds will probably need to disclose more details.
"For example, with a real estate fund, you will often have an affiliate property manager or something of the advisor of the sponsor of the fund that's getting paid a fee for managing the property or a monitoring fee or something like that," said Van Horn. "That will now have to be expressly included in these quarterly reports. That's a little more detail than most funds have been doing in the past. That's going to be something that both the funds and their accountants are going to have to get used to and work out basically how to put this together. The industry eventually will develop standards around this, and I'm confident that will happen relatively quickly. We're going to have to really start working out how to put these quarterly reports together in a way that satisfies these requirements. Even if we think the information is already there, it may have to be broken down in a way that's more applicable to the rule."
More details will need to be disclosed on methodologies on the quarterly and annual reports.
"They're going to require a statement with respect to the methodologies for the calculations, fees, allocations of fees, payments and valuations," said Van Horn. "That's a detail that hasn't been required in the past. There's always footnotes and certain explanations and audited financials, but having to put down your allocation methodology and valuation methodology — in my experience, those things didn't usually go in the quarterly reports. That's something that now the SEC is saying, 'No, we want to see them in the quarterly reports. We want to see these descriptions and calculations.'"
"Especially for the illiquid funds, they're going to have to provide something that is a basis for the methodology for determining, say, the waterfall distributions, carried interest and management fee offsets," he continued. "How are those being allocated where some expenses are paid out at the fund level, but they're allocated to all of the different portfolio investments? Those little details are going to have to get worked out pretty soon. It's an 18-month effective date, but in my mind, those are the kinds of things that accountants are going to have to really kind of dig into the weeds of this and work with their clients on how we make sure that we're basically complying with this."
The new rules could have an impact on how the funds are structured.
"The additional reporting and disclosures around their fund expenses, and any side letter agreements and things of that nature are probably going to be more impactful and may cause some funds to restructure and reallocate how they do those expenses," said Farrow.
New services for firms
Audit firms may be able to provide extra services thanks to the new rule.
"There's certainly potential for auditors to find ways to be helpful in addressing some of these points," said Avellaneda of Schulte Roth & Zabel. "There's going to be a desire to be consistent where possible, with financial reporting practices that are already well established and undertaken throughout the industry. But these are new challenges that are going to require some thinking by the industry about how to address these."
Auditors may help with reconciling the quarterly and annual statements provided by the funds.
"I could see where potentially as time evolves, the auditors may reconcile the quarterly fee information that's sent to the investors to the fees and expenses in the annual financial statements," said Thompson. "I can see that evolution over time, just to make sure that what's communicated to the investors is consistent with the sum of the quarters that shows up on the [annual] financial statements. There's no obligation by the auditors to review the quarterly statements."
The new rule is likely to expand the number of funds that are audited, but firms will probably need to have experience already with private equity and hedge fund clients to be hired.
"If you've already engaged with private funds to provide audit or other services, there's a chance to expand the services that you provide," said Beal. "Maybe you'll pick up some new coverages again, if there was a fund that was doing a surprise audit before and now they're doing a full audit. But I would guess it's more about providing ancillary services with your existing customers."
"I don't know that there are a lot more firms out there that aren't currently doing that would get more involved in the space," said Van Horn. "They might, but they're going to have to make an effort. There are a lot of firms out there in the mid space, as well as the smaller accounting firms and regional accounting firms doing it. It's not just the Big Four." He pointed to firms such as EisnerAmper, Anchin, Marcum, Weaver and Cherry Bekaert.
Firms need to be registered with the Public Company Accounting Oversight Board to do the audits. "That excludes some of the smaller accounting firms out there," said Van Horn.
"The mandatory audit requirement now is going to require that the audit firm should be SEC independent, but also that they should be registered with the PCAOB and be subject to inspections," said Thompson. "The latter could be challenging because to be subject to PCAOB inspection, you have to audit a public company or a broker-dealer. Some of the smaller firms may not have a client that meets those two buckets."
But given the complexity of the information that will be required, more firms may get involved with providing the information needed for the quarterly reports.
The rule has a variable implementation period. "For firms that have over $1.5 billion in private fund assets, it's a 12-month implementation period from the publication in the Federal Register, which typically is a month or two from when it's actually put out," said Avellaneda. "For firms with less than $1.5 billion, they have an 18-month implementation period. That is a tight timeframe overall for this magnitude of changes, but we're going to see how this shakes out, going forward."
"Smaller advisors are given a bit more leeway with 18 months, but larger advisors have 12 months," said Thompson.
Asset managers may need more help from accounting firms to comply with the new requirements. "This increases the operational and compliance burden on managers pretty materially, having to put out this type of reporting, both the reporting of performance information and fees, in addition to the side letter transparency," said Beal. "In a lot of cases, the managers who don't have the in-house resources currently to do this will look to external vendors that have reporting solutions in place to help with the process. In the past, a number of accounting firms have offered services in similar situations. I could see that happening here as managers looking to kind of outsource more of this."
