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The equity method of fund accounting is used to pull profits and losses from lower–tier entities up to upper–tier entities. This way, unrealized gains and losses can be accurately reflected in quarterly statements and other reports, offering an accurate value of the investing company’s portfolio.
The equity method is a process used to value one company’s investment in another company. It’s often used when the investor has considerable influence in the investee, usually defined as an investment of between 20% and 50%, with representation on the board of directors, or both.
When using this method, profits and losses in the investee will affect the investor’s own balance sheet. As a result, P&L needs to be adjusted.
Equity pickup is the process of making this adjustment. To do so, the P&L from lower-tier entities is pulled up to the upper-tier ones in order to accurately reflect the latter’s value.
As an example, let’s say an investor (company ABC) owns a 30% stake in its investee (company XYZ). That share was purchased for $30 million.
If XYZ earns $10 million dollars over the course of the next year, ABC will need to show its percentage of that profit ($3 million) as a line item on its income statement.
ABC will also need to reflect this unrealized gain on its balance sheet for XYZ, adding $3 million to the historical cost basis of the purchase price, $30 million, for a total of $33 million.
Similarly, debits also must be accounted for. If, at the end of the year, XYZ pays out a dividend of $100,000, the investor would show its portion of this, $30,000, as a reduction on its investment account balance sheet and a line item on its income statement.
Like many fundamentals of private equity fund accounting, standalone instances like this are relatively straightforward to account for. But as fund structures become more complex, so do these sorts of calculations.
Consider, for example, the following fund structure:
Pulling P&L for a complicated fund structure like this, involving multiple currencies, quickly becomes a tedious and error-prone exercise. Trying to manage these workflows in legacy tools like Excel can simply exacerbate the issue and add operational risk.
Fund accounting teams need a better solution.
Allvue’s Fund Accounting software solution meaningfully streamlines workflows like the equity pickup process and equity method accounting. Our platform eliminates the need to manually key in GL entries for each entity during a financial close, saving teams a significant amount of time and reducing risk in the process.
Allvue is a fully integrated, end-to-end platform, so data is able to seamlessly flow across stages of the alternative investment life cycle and across processes and workflows. Consider, for example, the complicated fund structure listed above.
Because the entities are connected in the system through a capital call chain, creating a ledger activity at one level kicks off a single continuous and automated process that generates corresponding ledger activities at each level in the structure, based on correct ownership percentages.
When interest income comes in on the lowest level (the Albion Water debt investment example), Allvue’s solution can automatically create entries that need to be posted at each level of the structure for review and approval.
Additionally, Allvue allocates the income based on the correct currency – for example, listing the transaction generated at the AssetCo level in EUR, based on the GBP of the Albion Water holding – and provides full transparency into the target company at this level, which helps facilitate look-through reporting.
Equity method accounting doesn’t need to slow down your workflows or create added risk.
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