Private equity fund accounting includes compliance methods for reporting revenue. In this guide, pop the lid on corporate accounting, to have a stronghold in your next finance meeting.
In this article:
- What is private equity?
- Different types of private equity investments
- Private equity fund accounting
- Historical cost vs Mark-to-Market (MTM)
- The difference between equity method accounting, cost method, fair value method, and the consolidated method
- How to calculate distribution waterfalls
What Is Private Equity?
Private equity is an investment not traded on a public market. It goes to the purchase of all or part of a business. For instance, investments are made directly in private enterprises or go to a buyout of a publicly-traded company, leading to the delisting of public stock. After a holding period, the businesses are sold, with investors hoping to generate revenue and see a profitable return.
Different Types Of Private Equity Investments
Private equity funds go to established organizations and late stage startups. Here are different types of private equity investments, ranging from the most common—least:
Buyouts: buying a company and administering IPO through debt minimization and management restructuring.
Venture Capital: investment in startups to help them further compete in a market.
Real Estate: purchases of land deals, commercial buildings, or other tangible assets on behalf of a company.
Distressed or Vulture Financing: an injection of funding with aims to overhaul a business via a reorganization of management or consolidation/sale of assets like real estate, patents, brands, etc.
Hedge Funds or Mutual Funds: aligning with other funds to extend portfolio income.
Private Equity vs Venture Investment
Venture capital is one of the most popular types of private equity. There are key features that set it apart from its private equity counterparts. Most private equity investments go to established companies that show high rates of return. On the contrary, venture investment fuels startup companies that pose high risks of loss. Return on interest (ROI) happens with profit distributions or a return of capital at the next venture round.
Venture investments have a holding period of 3-5 years. In private equity investments, there is a longer holding period because there is significant ownership interest. This comes with more influence in management and finances. Venture capitalists are available for mentorship to a startup, or they will arrange a passive role for self-sufficient startups.
Private Equity Fund Accounting
This is corporate accounting for private equity firms. The general ledger plays less of a role in accounting than investments and capital. Largely because private equity firms do NOT manufacture products, sell goods or services, or carry out other commercial operations. Instead, they construct corporate groupings by owning controlling shares or membership interests in other businesses. That is why they are often called a holding/parent company of a subsidiary or affiliate company.
For Example: LVMH is a holding company of 60+ subsidiaries like Christian Dior, Givenchy, Sephora, etc, in addition to backing the L Catterton private equity firm. L Catterton funds brands like Nature’s Variety, Zarbees, Peloton, Freetrade, and more.
Quick Definitions
Parent-Subsidiary: When an investor has complete authority over the company it invests in. The investee is a subsidiary of the investing firm.
Affiliate: A company is an affiliate if the parent company has less than 50% interest. Also when multiple subsidiary companies are owned by the same parent company, they are affiliates.
Private equity firms are structured as a corporation or LLC. They consist of high net worth partners, endowments, pension funds, and other incorporated groups. There is a general partner (GP) that will perform management duties for the fund, and limited partners (LPs) that contribute to capital. LPs will pay a portion of the generated profit, to the GP, as a management fee.
SEC And GAAP Regulations For Private Equity Firms
The complexity of this business setup requires adherence to regulations and reporting procedures. The Securities and Exchange Commission (SEC) is a federal regulatory organization charged with safeguarding investors. They do this by monitoring participants in the securities sector, such as exchanges, dealers, advisors, funds, and rating agencies. Thus, they are the watchdog of private equity firms with security investments.
These are the fundamental principles that the SEC adheres to:
- Investors should have access to all relevant information regarding an asset.
- Companies who sell and trade securities must prioritize the interests of investors and serve them justly. They must provide detailed and reliable information about operations, securities they sell, and any risks associated with the investment.
Private equity firms often will appoint a member of the fund to their subsidiary and affiliate companies. Acting as a point of consultation on the board of directors, the member influences company growth. There is nothing inherently wrong with this appointment, but it is a corruptible position via insider trading.
Quick Definition
Insider Trading: the disclosure of non-public information that influences security trading.
Therefore, the SEC prevents insider trading by instituting accounting regulations for parent companies. Specific accounting methods are controlled by another agency called the Financial Accounting Standards Board, who oversees generally accepted accounting principles (GAAP).
GAAP Regulations
GAAP is a collection of accounting rules and accepted reporting methods for corporations. They are used to standardize the presentation of financial data and promote transparent corporate accounting. For compliance, when a company has significant influence over another, the investor must add the results of the investee’s activities to its financial statements.
What Is Considered Significant Influence For A Holding Company?
Significant influence dictates how a holding company will report investment earnings. But, the definition of significant influence is not always a black and white figure. A company that doesn’t hold substantial shares can still have significant influence over the subsidiary. So, these items clarify what significant influence over an investee is:
- Percentage of ownership
- Appointment to the board of directors
- Executive appointment to the investee company
- Voting and policy-making participation
- Exchanges of assets or working capital
Historical Cost vs Mark-to-Market Asset Valuation
How much a parent company owns determines income reporting and taxation. When a holding company owns shares in a sub-tiered business it must value those shares according to different accounting methods.
These valuation methods don’t always show actual profits and losses. Instead, they help a private equity firm visualize investment holdings, and allow governing agencies to monitor trading of private securities.
What is historical cost?
Historical cost uses the original purchase price to report gains or losses on the investment. This is the most common method for share valuation.
Historical Cost Example: A company makes a 5% investment in another company, for $1 million, the historical cost of the shares is valued at $1 million.
What is Mark-to-Market (MTM)?
Private equity fund accounting will often use the Mark-to-Market valuation of assets. This uses the current market value of an asset to report investment earnings on financial statements.
Mark-to-Market (MTM) Example: A company makes a 10% investment in another company for $5 million. When they go to report unrealized gains they value the shares at $7 million because that is the current market value.
There are a couple of different accounting techniques that private equity funds will use with the above valuations: the cost method, the equity method, the fair value method, and the consolidated method.
The Cost Method
Minor influence in other companies will report using the cost method of accounting. It is implemented when the investment does not result in a considerable level of control, or under 20% holdings.
The stock acquired is documented as a non-current asset on a balance sheet at the purchase cost. It does not change unless the shares are sold or more shares are purchased. Dividends are noted as revenue and are taxed as gains or losses on the initial purchase price.
Example: Company A makes a 5% investment in Company B for $1 million, the historical cost of the shares are valued at $1 million. With the cost method, you base income off this price regardless of current worth. Company A’s dividend income increases by $10,000 when Company B pays them $10,000 in quarterly dividends on shares.
What Is The Equity Method Of Accounting?
The equity method in accounting tracks influential company interests. When a business buys 20-50% of a firm’s stock, it becomes an owner of the affiliate company. If this many voting shares are held in an investee, GAAP considers you have considerable sway in the company. Yet a firm can utilize the equity method if it holds less than 20% of shares, provided it can establish significant influence i.e. having representation on the board of directors.
Under the cost method, a company would only report dividends from shares as portfolio income. However, with the equity method, reporting dividend income doesn’t show the true value of income/loss for the holding company. Instead the total percentage of earnings from the affiliate will be reported as revenue. The purchase price of shares are modified by net income and losses from investment, NOT dividends.
Equity Method Example: Company A buys a 40% investment in Company B for $20 million. The initial $20 million purchase cost is recorded in the same manner as the cost method. But, when Company B generates $5 million net income, 40% of that figure, $2 million is added to Company A’s original purchase price and reported as revenue NOT dividends.
Note: The equity method will generally utilizes the historical cost of the investment for balance sheets. However they can elect to use the fair value method/mark to market to value shares.
Benefits Of The Equity Method For Firms And Affiliates
Take a look at why the equity method is beneficial to private equity firms and their affiliate companies.
Firms
Dealing with large figures that require accuracy
Appropriately represents the profit and loss of the investee.
Clearly track returns on investment (ROI)
Simplifies reporting for influential stakes in multiple companies
Affiliates
Liberation of some financial liability
Prevents the investment firm from misreporting a profit from dividends, when the affiliate is actually taking a loss by distributing dividends
The Fair Value Method Election
If you are accounting under the equity method, you can elect to report assets with the fair value method. This lets you update share price according to current market value. The initial cost of the shares is considered to construct a non-current asset. When reporting quarterly earnings the asset is revalued at current share price. The fair value method helps investors see the worth of their investment in real time.
The Consolidated Method
The consolidated method is used when a company has a controlling share of another company. All items of income are reported by the parent company this includes revenue, expenses, and tax deductions or credits. Additionally, the consolidated method will lump any minority shares owned by other investors, and subtract that figure out of total earnings. This differs from: the equity method, where only profit or loss is reported; the cost method where only dividends are reported.
What Is A Distribution Waterfall?
In private equity fund accounting, distribution waterfalls allocate returns on investment or profits on a sale. It is a pay structure that prioritizes investors in private equity funds according to their participation. There are two different distribution waterfall methods in fund accounting. Both follow the same basic structure, the only difference is who gets paid first:
- European Waterfall: favors LPs over the GP, and will allocate their return first.
- American Waterfall: favors the GP by allocating their interest and management fees first.
There are downsides to both models because each favors one party over the other. Not all investments are going to be profitable, so there is a risk that the party paid second may not get paid at all.
The European model pays general managers later, that could result in the GP losing interest and performing poorly while managing the fund. In the American model, investors could lose interest. Since investors are a critical component of private equity funds, a clawback provision helps thwart bad trading.
What is a clawback provision in a private equity firm?
In the case of fund accounting, clawback refers to the general partner relinquishing money that was previously paid out from an investment. This provision is made at inception and protects investors from mismanagement, poor performance, or liquidation. If any of these events come to fruition investors get to clawback all or a portion of their contributions.
How To Calculate Distribution Waterfalls
The waterfall structure is split into 4 parts: the return of capital, preferred return, catch-up, and carried interest of remaining distributions. When an investment pays out, the earnings are distributed to partners depending on their distribution model.
The 1st waterfall is a payout of the initial investment plus fund fees. Jump down the 2nd waterfall for a payout of the agreed-upon ROI (anywhere from 8-10% of the initial investment). The 3rd waterfall is the catchup, this party is entitled to a slice of the distributions until they reach a certain percentage. The 4th waterfall is a split of any remaining earnings.
European Waterfall Distribution Example
A private equity firm invests $20 million in a company. They double their return and earn $40 million for distributions. The preferred rate of return for the limited partners is 10% over a 5 year holding period. Then an 80/20 split of distributions, after the return of capital, between investors and the general partner.
1st Waterfall
A return of capital equal of $20 million is received, with $20 million remaining for distribution.
Total Earnings – Initial Investment = 2nd Distribution
$40M-$20M = $20M
2nd Waterfall
The preferred rate of return over 5 years (10% each year on the principal—22M, 24.2M, 26.62M, 29.282M, and $32,210,200M respectively) is received. With $7,789,800M remaining for distribution.
Total Earnings – (Return of Capital + Preferred Rate of Return) = 3rd Distribution
$40M – $32,210,200M = $7,789,800M
3rd Waterfall
Catch-up for the GP follows an 80 / 20 split of remaining distributions, starting with the 2nd Waterfall. When there is enough spread for a catchup, the PRR is not paid in full right away. So, the GP gets a catchup distribution of $3,052,550M. This reflects that 80% of the 2nd Waterfall was distributed to the LPs, and the GP got the remainder.
(Total Preferred Rate of Return/80%) – Total Preferred Rate of Return = GP Catch-up Distribution
($12,210,200M/80%) – $12,210,200M = $3,052,550M
With a remaining $4,737,250M for distribution.
Total Earnings – (Return of Capital + Preferred Rate of Return) – Catch-up = 4th Distribution
$40M – ($20M + $12,210,200M) – $3,052,550M = $4,737,250M
4th Waterfall
This is an 80/20 split of the remaining earnings.
(Remaining Distribution)(20%) = $947,450M to the GP
(Remaining Distribution) (80%) = $3,789,800M to the LPs
Note: At the end of the day these distributions are also subject to taxes. It is always best to consult with your tax accountant before accepting a distribution.
Private Equity Fund Accounting Solved
As an accountant this isn’t everyday practice, private equity fund accounting is needed for a very specific niche. However, if you are part of a holding company it is good to understand compliance measures for earned revenue from investments in affiliate or subsidiary companies.
