Bookkeeping for private equity
Accounting and bookkeeping come in all forms and types. There is general business accounting, tax accounting, real estate accounting, and countless other forms. Private Equity accounting is no different, as some special circumstances and rules will only apply to private equity funds and firms. Since private equity is a unique structure, with many assets but relatively lower overhead, normal accounting statements may look more skewed than traditional statements. These special circumstances and the structure of the private equity fund are one of the main reasons private equity accounting and bookkeeping must be highly detailed. Even though most private equity investors are experienced and sophisticated investors, the laws governing private equity demand that bookkeeping is excellent.
Principles of Private Equity Accounting
In general, accounting processes should always be the same. It is merely adding up the revenues and subtracting the expenses to arrive at a profit or loss. However, in investment accounting, whether it be real estate or investments in other assets, the accounting is tracking the values of the investment rather than revenues. Private equity does have expenses and like any business will have to track expenses to ensure that all operational bills are met. Unlike businesses though, and even rental real estate investments, in private equity the expenses are usually very small when compared to the total value of the investment. For private equity, the principle issues will be based on values, amounts invested, appreciation of equity, and tracking of investor investments.
One major point to understand is that not all investors in private equity are equal. Most private equity firms are partnerships. As such, the allocation or amount of the investment from each investor may vary greatly. Normally in a private equity fund, the fund itself is managed by a general partner, with the other investors in the fund being classified as limited partners. Under this type of structure, investments by the fund will have more flexibility. Limited partners can choose to invest in certain assets by the fund while withholding investments in other assets. Even general partners will have the ability to choose which investment they may participate in or not invest in. This is one of the main reasons why private equity forms partnerships, as it allows this investment flexibility.
However, this flexibility creates one of the major concerns for bookkeeping in private equity- accounting for and tracking these differences in investments and amounts. Thus, of paramount concern for bookkeeping or accounting in private equity is to ensure that each investment is tracked and the valuation is properly allocated to the correct investor. It would be highly unusual for a novice investor would invest with a private equity fund. This is because most of the funds are developed for high-net-worth individuals who will be very savvy in their investment knowledge. Thus, most of these investors will have their lawyers and accountants to watch over investments and understand the exact breakdown of the investment, appreciation, and related expenses. However, much of the law that is developed regarding private equity investments is meant to ensure that this accounting is beyond reproach. This is the reason bookkeeping in private equity must be precise without ambiguity, adding another layer of protection to the investor.
Allocating Investments and Valuation
Since investments by a private equity fund can affect different classes of partners in the partnership, the accounting and bookkeeping will always need to track these variations.
For example, if a fund is investing $30 million into a company, the investment will have to state the exact amount and nature of the investment. The general partners may control 50% of the investment but only be given a 25% controlling interest in the asset. The limited partners might have a smaller allocation in the investment, based on how much they contribute, and might have no control over the interest in the asset, with the original owner retaining the other 50% control and 75% interest.
From this example, it is easy to see that these investments tend to be complex and very detailed. So, the bookkeeping will need to account for all these variations in the structure of the deal to ensure that the investment is accurately reported.
However, that is only one part of the concern. Most of the investments by a private equity firm will be in assets that are not of solid value. The assets will normally be businesses, real estate, or items where the value of the asset will fluctuate with the market price. The concern here is that the valuation might increase or decrease, and this will in turn affect the value of the investment. Thus, the valuation must be accurate. To be accurate the valuation needs to follow the rules set up by the accounting standard boards to ensure that it is properly accounted for in the end. In the $30 million investment above, there will be several variations on how to place a value on that company. The assets of the business might only total $10 million, but the firm might have sales of $70 million per year. So, what is the fair valuation of that business? That is the issue and why valuations will play a major part in the bookkeeping of a private equity fund. Besides setting the valuation at a set point, the valuation process needs to be the same, so that the accounting is comparing "apples to apples." This means that if the fund invested in an asset 20 years ago, using a valuation based on an appraised value at the time, the valuation now must remain at the appraised value or if a new valuation is used it must describe why and how the value has changed. A good example of this is the real estate crisis of 2008- many buildings had a high appraised value based on the market price of the building before the crisis. Then just after the crisis hit, when buildings couldn’t be given away, the market price value might not be accurate.
Summing it up
Private equity funds and investments are normally very complex investment structures and require detailed accounting or bookkeeping standards. Not all investors or partners in a private equity fund are the same or equal. The investments that are made by private equity into a vehicle, such as a building or business, can be developed to give various parties in the deal different amounts of ownership, control, or returns. Because of this flexibility in the structure of the deal, the bookkeeping must properly account for these differences and properly report these differences with as much clarity as possible. Add in that most of the investments made by private equity funds are in illiquid investments, the valuations of the investment are not as clear. To manage these issues the accounting regulators have had to develop very precise rules on how investments need to be reported and accounted in statements. The following links are provided to offer more insight into bookkeeping in private equity:
https://www.nasdaq.com/articles/understanding-private-equity-fund-accounting
https://www.allvuesystems.com/resources/understanding-private-equity-fund-accounting/
