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What is Fund Accounting?
Fund accounting, in reference to alternative investments, refers to the methods of accounting used by investment funds. Some of the responsibilities of fund accounting in private equity overlap with traditional, corporate accounting – such as identifying income and expenses on an accrual basis and verifying accounting records against external sources – but others are unique to investment funds.
Every company – whether it’s a non-profit, pizza parlor, or private equity investment manager – must, in some way, track the financial inflows and outflows of their business. All businesses have to capture in some accounting ledger how many purchases they made, how much money came in, and other basic financial events.
What sets the accounting needs of private equity firms apart from other companies is that, while pizza parlors, for example, make purchases with their own funds, private equity firms make purchases with their investors’ funds.
This is what gives fund accounting its other name – partnership accounting. General partners, the fund managers, raise funds from limited partners, the investors, in order to make investments. What further complicates this distinction is that not all investors make the same investment into the fund.
This is true on two levels – one rather straightforward, the other more complex.
On the simplest level, LPs make different dollar amount commitments to a fund and thus own different percentages of the fund. Investor A might commit $200,000 to Fund I while Investor B commits $300,000. Accounting for these differences is straightforward; to calculate what each investor owes for an upcoming capital call is as simple as calculating their percentage of the fund.
But investors also might choose to not invest in certain investments. Investor A, for example, might be an endowment at a university and have ESG requirements. So when the fund notifies its investors that it will be making an investment in oil, Investor A might opt to sit that investment out.
This gets to one of the key differentiators of private equity fund accounting: Allocation.
In private equity fund accounting transactions need to be tracked at the partner level so they can be allocated correctly according to partner levels of ownership, function, and responsibility.
But not all accounting activity will be allocated according to a simple ownership percentage. One common example is fund expenses and management fees. In some cases, the LP who contributes the most into a fund may pay a lower management fee percentage than other LPs. The concept of an allocation rule emerges, then, to accommodate these more nuanced fund-level characteristics.
Similarly, distributing profits back to LPs after investments have been realized is more complex than a calculation based on a simple percentage-based commitment. As discussed further below, distribution waterfall calculations can take on dizzying complexity and eat up hours of an accountant’s time.
The unique characteristics of private equity fund accounting give rise to unique challenges – and make clear the need for fund accounting software designed specifically for the alternative investment market. Before discussing these specific challenges, though, it is worth examining the business-related processes that make up the bulk of fund accounting activities.
The business process related to private equity fund accounting can broadly be grouped into two buckets: investment activities and capital activities.
Investment activities, as the name suggests, concern those cash flows between the fund manager and their investments (e.g., portfolio companies, funds, real properties, land, etc.). Broadly speaking, these fall into two buckets, cash flows from the GP to the investments (funding purchase), and cash flow from the investments back to the GP (divestments, realizations, etc.).
|Security Conversion||Corporate Activity|
|Stock Split||Corporate Activity|
|Fund Operations||Generic Allocation|
|Elimination Entries||Generic Allocation|
|Interest Accrual||Interest Income|
|Interest Payment||Interest Income|
|Investee Commitment||Investee Commitment|
|Investee Cash Distribution||Purchase|
|Investment Write Off||Valuation|
Capital activities concern those cash flows between the fund manager (GP) and investors (LPs). Again, broadly speaking these fall into two buckets, cash flows from the LPs to the GP (capital calls, including management fee expenses), and cash flow from the GP to the LP (cash and stock distributions).
|Investor Capital Call||Capital Call/Distribution|
|Investor Cash Distribution||Capital Call/Distribution|
|Investor Unfunded Commitment Adjustment||Commitment|
|Management Fee Expense||Generic Allocation|
|Carry Allocation||Generic Allocation|
|Investor Transfer||Interest Transfer|
|Investor Reallocation||Investor Reallocation|
|Investor Sub Close P&L True Up||True Up|
The specific details for these different activities will vary, in some cases substantially, between types of funds, but they will all generally fall into these two categories.
Because of its unique properties, private equity fund accounting also comes with a number of unique challenges. These include:
Waterfall calculations are one of the most notoriously complex aspects of fund accounting. Customized LP agreements often lead to a wide variety of waterfall structures, and the calculating of distributions becomes even more complicated once one factors in tiers, catch-up calculations, and other one-off subtleties – eating up valuable hours and opening the door for errors.
The solution seems simple: automate the process. But the complexity of waterfalls has long made it a challenge to do so, especially in any way that would add true value.
Now, though, true automated waterfall calculations are a reality.
Subsequent closings – that is, any closing that happens after the initial closing date, most often to accommodate a new investor – are similar to other fund accounting challenges: the concept itself is straightforward but it’s in the details that things can become dizzyingly complex.
Tracking subsequent closings and calculating equalizations and equalization interest can quickly become challenging, especially as accountants accommodate multiple capital calls and closings across multiple funds. The right technology, though, can help simplify and de-risk the process.
Equity method accounting is used to pull profits and losses up from lower tier entities into upper tier ones. Doing so allows one to properly reflect unrealized gains and losses in quarterly statements and other reports – and, thus, to show the accurate value of one’s portfolio.
Unfortunately, many systems aren’t built to handle this methodology. Accountants are too often forced to manually key GL entries for each entity during a financial close, adding a significant amount of time and risk to the process. With Allvue, though, it’s possible to significantly streamline equity method accounting processes.
Fund accounting, like much of private equity, is constantly evolving and changing. One of the key drivers of that change is advances in fund accounting software.
“We’re expecting to see more automation, especially more automated responses through equity allocation and waterfalls to investors,” predicts Travis Broad, Manager at Lionpoint Group. As automation streamlines more processes, it should free up teams for higher value work.
“There will be a shift towards more analytical-minded considerations once people have this freedom to not worry about data inputs,” Broad predicts.
To outsource or not to outsource – that’s often the perennial question for fund managers when considering back-office operations like fund accounting. Each option comes with its own list of pros and cons:
There is a third option – co-sourcing – which has been gaining more popularity recently. With co-sourcing, your administrator enters and updates your fund’s financial activities directly on your fund accounting system.
There are a number of benefits to the co-sourcing model, for both fund managers and administrators:
Co-sourcing benefits for Fund Managers
Co-sourcing benefits for Fund Administrators
|Keep it together |
With your key back-office data now back in your domain, co-sourcing enables you to share relevant performance data with your deal team to aid in follow-on investment decisions, with your IR team and externally with LPs when fundraising.
|Less is more |
Simplify by de-leveraging your technology and vendor risk – no more playing middleman between your client and your technology vendor, being blamed for things you can’t control. With co-sourcing you can focus on what you do best, servicing your client’s needs.
|Golden record |
A single golden record, with no need to maintain your own shadow copy, forever trying to stay in sync with your admin. With co–sourcing your record is the very same one your admin accesses and keeps up-to-date in real-time.
|You can sleep at night |
Managed costs and improved performance – co-sourcing mitigates the need to add additional client assets onto your own technology instance.
|Better safe than sorry |
Control your risk and reputation. With co–sourcing you’re both working off the exact same secure system, protected and out of reach from bad actors.
|Go Beyond |
Giving your client the choice of where their fund and investor financial data resides means that with co-sourcing you can differentiate your offering based on your exemplary service, while your competitors continue to cling to the traditional model.
Allvue Systems offers fund managers true general ledger fund accounting software designed specifically for the needs of the alternatives market. Built to handle the most complex fund structures and partnership accounting requirements, Allvue’s Fund Accounting software solution combines into one fully-integrated platform:
Download our Fund Accounting brochure to discover how our cloud-based solution, built within Microsoft’s enterprise framework, can help empower superior investment decisions.
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