Most business owners are familiar with the concept of an audit. It’s essentially a systematic examination of your financial statements and operations. But in the context of private equity portfolio companies, audits are crucial for transparency, accuracy, performance monitoring and risk management.
But there’s another essential reason for private equity (PE) audits – regulatory compliance. After all, in 2023, the Securities and Exchange Commission (SEC) adopted new rules for the regulation of all registered investment advisers. This includes conducting an annual audit for each private fund.
In this blog, we’ll guide you through the challenges of the PE audit process, from what you should expect, to what happens afterwards.
The Importance of Private Equity Audits
By ensuring financial transparency, PE audits can boost investor confidence. They provide investors with assurance that their funds are being managed properly, and help with due diligence during acquisition and exit phases. In fact, one of the reasons for the SEC’s new suit rules for PE firms is to add a layer of protection for investors through transparency.
Audits can also provide you with a snapshot of any inefficiencies or areas that need to be improved within your portfolio. That way, you can ensure effective and streamlined operations, and strategic investment decisions. For example, they can highlight which revenue opportunities should be maximized or where costs can be cut. That way, you can conduct continuous monitoring and improvement.
Another vital component of audits is risk management. The process helps to identify financial or operational risks like inaccuracies in your financial statements, undisclosed liabilities, or inadequate internal controls.
An audit can ensure that your firm strengthens its internal controls to prevent errors and fraud. This, in turn, helps to improve your financial processes while ensuring compliance with regulations such as those imposed by the SEC. These include:
- Audits must be conducted by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB).
- Audited financial statements must be prepared in accordance with generally accepted accounting principles (GAAP).
- Every year, within 120 days of the fund’s fiscal year-end, the fund’s audited financial statements must be delivered to investors.
However, despite the importance of audits, there are a few challenges unique to the private equity industry.
Unique Challenges in Portfolio Company Audits
Private equity firms usually buy companies and overhaul them to earn a profit when the business is sold again. This could lead to frequent changes and transformations as a result of mergers and acquisitions, in a financial and operational sense. Also, capital for these acquisitions often comes from outside investors in the private equity funds the firms establish and manage.
Firstly, this means it’s often hard to establish accurate valuations and equity for funds. As a result, portfolios are usually under intense scrutiny from multiple stakeholders.
Moreover, portfolios can have complex financial and ownership structures. They could include holding companies, or other entity layers, making it tough to consolidate financial statements, especially if these include debt arrangements.
This is further complicated if your portfolio makes use of intercompany transfers. Likewise, including companies from a number of different industries means each has its own accounting standards and regulations.
Because of this, many PE portfolios lack standardized financial and operational processes. This means that simple tasks like data collection and analysis can be complicated, which will have a knock-on effect on widespread management and compliance.
To mitigate these challenges, it’s essential to have an audit preparation strategy in place.
Preparing for a Private Equity Audit
Under the SEC rules, annual audits of PE portfolios are unavoidable. However, with preparation and planning, you can reduce the stress of the process.
To begin with, you’ll need to prepare internally. This encompasses:
- Organizing financial documents: Ensure that the financial statements and records for all your different funds are accurate and up to date. That includes supporting documentation like invoices, bank statements, operating agreements, and contracts.
- Reviewing processes and internal controls: Assess how effective your current practices are across funds, to identify where improvements are needed. Conducting internal audits and establishing standard operating procedures (SOPs) across funds can help standardize processes across your portfolio.
- Account reconciliation. Reconcile your bank accounts and chart of accounts to ensure that all transactions are up to date.
- Training staff. Employees need to be aware of the latest industry developments, as well as relevant financial management and troubleshooting practices.
In addition to these measures, you’ll also need to know exactly what’s expected during an audit.
Understanding auditor expectations
Knowing what auditors look for can help you prepare for a PE audit. Obviously, one of the first things they’ll examine is the accuracy and completeness of your financial statements and record keeping. This information helps to determine your portfolio’s overall financial position.
Next, they’ll look at your firm’s financial ratios and key performance indicators (KPIs), to see if your funds are on track.
Similarly, they’ll go over your procedures for revenue recognition. Importantly, they’ll check that all processes are compliant with accounting standards like ASC 606, and occur in the correct periods.
Your expense management will also be scrutinized. Auditors will double-check everything from recording expenses to how liabilities and accruals are reported.
Asset valuation is also part of the process. This refers to both your inventory and fixed assets, and all depreciation calculations.
Finally, an auditor will review your firm’s internal controls to establish whether they’re effective.
Conducting the Audit
As mentioned above, key focus areas for PE audits include revenue recognition and asset valuation.
Your firm will need to demonstrate that it complies with revenue recognition accounting standards. Auditors will check that you use the correct cut-off procedures, documentation, and controls. They might also review investor contracts to ensure that funds meet performance obligations and payment terms.
In addition to verifying that your inventory and fixed assets are valued correctly, auditors will check how your firm values intangible assets. This includes whether you’ve properly determined the fair market value for assets and liabilities.
Another important aspect that will be reviewed is how your firm deals with complex transactions.
Handling complex transactions
Because many portfolios include mergers and acquisitions (M&A), auditors will review how your funds allocate purchase prices among the acquired assets and liabilities, and the fair value adjustments made to these.
They’ll also check to see that all financial statements are consolidated after acquisitions, and test for potential goodwill impairment (especially if an acquisition does not perform as well as expected).
In the event of any discontinued operations, auditors will verify that the financial results are classified correctly, along with your calculations regarding losses or gains during the sale of assets.
Also, if your portfolio includes derivatives or hedge funds, their valuation and accounting treatment will be examined.
Note that all auditors will conduct a detailed review of your financial documentation, along with substantive testing, to verify the results.
Best Practices for Effective PE Audits
To make the process as painless as possible, it’s important to embrace communication. This includes confirming the audit scope and timeline from the auditors, and requesting regular updates. From your side, it’s important to be transparent in all interactions with auditors, which means giving them quick access to whatever information they request.
Not only will this build trust with the auditors and stakeholders, but it will help you identify issues from the get-go, for improved efficiency.
To make this easier, accounting software like QuickBooks or NetSuite can automate your data collection and financial reporting. The right software solution can also help you continuously monitor your funds and manage documentation, for real-time insights and the ability to spot and rectify any issues as they arise.
Post-Audit Actions
So what happens when your PE audit has been completed? Firstly, you’ll receive an audit report, which lists all the auditor’s findings. It’s important to review this carefully so you understand exactly what the findings are, and how to remedy any issues. If anything is unclear, reach out to the auditors as soon as possible for clarification.
Then, you need to prepare a response. This should detail the root cause of each finding, with a proposal of how your firm plans to rectify the issue. You can even include an action plan that clearly outlines the steps your firm will take to implement the necessary changes. If necessary, a business mentor can help you with this.
Any changes you make to your portfolio must be communicated with your investors and relevant stakeholders, for the sake of transparency.
Then, you can focus on continuous improvement to prevent needing to make adjustments after future audits. Consider establishing an audit committee, and conducting regular internal audits to review your internal controls, documentation, and reconciliation practices.
Integrating audit findings into investment strategy
The findings of your PE audit can actually help with investment decisions and strategy going forward, especially for IPOs and exit strategies.
You’ll be able to determine your portfolio’s overall financial health, identify risks, and evaluate its performance. This can help you to improve portfolio management and drive improvement. Also, by ensuring that your portfolio is always compliant with legal and accounting regulations and best practices, you can further improve investor trust.
If you need assistance with managing the finances for your private equity portfolio, to minimize the stress of an audit, schedule a Discovery Call with one of our CPAs. We can help you streamline your accounting and keep your records in order.
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