Auditing and Corporate Governance

What Are the SEC Private Fund Audit Requirements?

The SEC's private fund audit rule creates a compliance framework for advisers, setting key standards for financial reporting to ensure investor transparency.

The Securities and Exchange Commission (SEC) regulates private funds, such as hedge funds and private equity funds, as part of its oversight of financial markets. These investment vehicles are available to a limited range of investors and are not publicly traded. To enhance transparency and protect investors, the SEC has established rules for the investment advisers who manage them. A component of this framework involves rules for advisers with custody of fund assets, with the annual independent audit serving as a common method for satisfying these obligations.

On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit vacated a set of new rules and amendments known as the “Private Fund Advisers” rules. Therefore, the information in this article reflects the requirements that were in place under the Custody Rule, which have historically governed audit practices. Advisers should monitor for further developments from the SEC.

Applicability of the Audit Rule

The requirement for a private fund audit stems from the SEC’s Custody Rule, which applies to registered investment advisers who have custody of client funds or securities. The rule is designed to protect client assets from being lost, misused, or misappropriated. Its primary mandate is that such advisers undergo an annual surprise examination by an independent public accountant to verify the existence of client assets.

However, the rule provides an alternative for advisers to private funds. An adviser can satisfy its obligation under the Custody Rule by having the fund obtain an annual financial statement audit and delivering the audited statements to investors within a specific timeframe. Because this option is often more practical for a pooled investment vehicle than a surprise examination, it has become the standard compliance method for most private funds.

This framework does acknowledge some nuances. For instance, advisers who are considered “exempt reporting advisers” because they fall under certain exemptions from full SEC registration may not be subject to the Custody Rule. There are also considerations for advisers who do not have full control over a fund. In such cases, the adviser must take all reasonable steps to cause the fund to undergo an audit to comply with the rule.

Core Audit and Financial Statement Requirements

Financial Statement Preparation

The foundation of the audit is the preparation of financial statements in accordance with U.S. Generally Accepted Accounting Principles (U.S. GAAP). For private funds, this means that all financial data, including the valuation of complex and often illiquid investments, must adhere to these established standards. A key element of this is the application of fair value accounting, where investments are reported at their current market value, providing investors with a more accurate representation of the fund’s financial position. In some circumstances, financial statements may be prepared under another comprehensive body of accounting standards, but they must include a reconciliation of any material differences from U.S. GAAP.

Audit Scope

The audit must be comprehensive, covering the fund’s complete set of financial statements. This includes the balance sheet, statement of operations, statement of cash flows, and statement of changes in partners’ or members’ capital. The audit must be conducted on a consolidated basis, encompassing the fund and all of its subsidiary entities. This consolidation prevents an adviser from obscuring performance or financial issues by holding certain assets in separate, unaudited entities.

Auditor Qualifications

The audit must be performed by an independent public accountant. Independence is a fundamental principle, meaning the auditor must not have any financial or managerial relationships with the fund or its adviser that could compromise their impartiality. The auditor must also be registered with the Public Company Accounting Oversight Board (PCAOB) and be subject to its regular inspection process. The PCAOB’s oversight of private fund auditors provides an additional layer of assurance regarding audit quality.

Audit Opinion

The culmination of the audit process is the issuance of an audit report, which contains the auditor’s opinion on the financial statements. This report must be included with the distributed financial statements. The opinion states whether the financial statements are presented fairly, in all material respects, in accordance with U.S. GAAP. An “unqualified” or “clean” opinion indicates that the auditor has found no material misstatements. This independent verification helps protect investors against the misrepresentation of performance or misappropriation of assets.

Investor Delivery and Timing Obligations

An adviser must ensure that the audited financial statements are promptly delivered to all fund investors. The primary deadline for this distribution is within 120 days of the private fund’s fiscal year-end. This timeframe is designed to provide investors with timely, verified information about their investment. Delivery can be accomplished through various means, including secure electronic portals or physical mail, but the adviser is responsible for ensuring it reaches every investor.

An extended deadline is provided for a “fund of funds,” which is an investment vehicle that invests in other funds rather than directly in individual securities. Because these funds need to wait for the audited financials from the underlying funds in which they are invested, the SEC allows for a longer delivery period. Advisers to funds of funds must deliver the audited financial statements to their investors within 180 days of the fund’s fiscal year-end.

When a private fund is in the process of liquidating, the adviser is required to obtain a final audit of the fund upon its liquidation. The resulting audited financial statements must then be distributed to the fund’s investors promptly after the liquidation is complete. This final audit provides a concluding, verified accounting of the fund’s activities and the distribution of its remaining assets to investors.

Adviser Recordkeeping Duties

Following the completion of the annual audit, the investment adviser has an ongoing duty to maintain specific records to demonstrate compliance with SEC rules, as detailed in the Advisers Act, or Books and Records Rule. The primary record to be kept is a complete copy of the audited financial statements for each private fund the adviser manages for each fiscal year. These records serve as the foundational evidence that the annual audit was completed.

The adviser must also maintain documentation that proves the audited financial statements were delivered to all fund investors by the required deadline. The adviser must be able to show regulators during an examination that the distribution obligation was met. Adequate proof could include electronic delivery records, such as email logs with timestamps, or certified mail receipts for physical deliveries.

Under the Books and Records Rule, advisers are required to keep these records for a period of five years, with the first two years in an easily accessible place. This retention period allows the SEC’s examination staff to review an adviser’s historical compliance with the audit and delivery rules. Maintaining an organized system for these records is a core component of an adviser’s compliance program.

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