Limited partner financial reporting

Private equity and venture capital funds have long established practices for reporting financial results to their LP investors. Many of these practices result from the normal contractual negotiations between GPs and their LPs. This reporting has evolved with the growth and maturation of the industry, but the principles of this reporting have remained constant – consistent reporting of investment results, providing the transparency that builds trust over the life of the investment fund.

Investment company accounting, as detailed in the AICPA’s Accounting Audit and Accounting Guide: Investment Companies (‘Investment Companies Guide’), is the generally accepted accounting principles (GAAP) base upon which all LP financial reporting is built. These are the same standards that are used for financial reporting to investors across all investment vehicles, from money market mutual funds to bond mutual funds to index equity mutual funds. Investment company accounting requires that the investments and financial results of the fund be reported on a fair value basis. While determining fair value can be challenging, the requirement for fair value accounting is the critical component of investment company accounting and LP reporting.

Private equity and venture capital funds have a 10- to 20-year life cycle that begins with cash contributed by LPs to their GPs, followed by the acquisition of portfolio company investments, then the sale of the portfolio companies, and finally the distribution of cash to LPs. This long life cycle involving illiquid investments requires additional transparency that is provided by specialised investment reporting. Investment reporting typically covers the cumulative results for the fund over its lifetime, insights into the progress and current prospects of the fund’s portfolio companies, and other information often unique to the particular fund and its investment process.

One of the unique aspects of LP reporting for private equity and venture capital is that it covers privately held companies that may be developing market-changing drugs, technologies or business concepts. Being transparent with investors is a goal of financial reporting, but GPs need to consider the need for the confidentiality of the underlying portfolio company information to bring the investment to fruition as well.

Investment company accounting

An investment company, generally, is an entity that pools shareholders’ funds to provide the shareholders with professional investment management (FASB ASC 946-20-05-2 and the Investment Companies Guide). The objective of financial statements of investment companies is to present net assets, results of operations, changes in net assets and financial highlights resulting from investing activities. GAAP under investment company accounting categorises funds into registered and non-registered investment companies. Private equity and venture capital funds generally do not register with the Securities and Exchange Commission in the US.1 Therefore, GAAP considers them to be non-registered investment companies and requires them to present the following financial statements:

• A statement of assets and liabilities with a schedule of investments (or at least a condensed schedule of investments) as of the close of the latest period;
• A statement of operations for the latest period;
• A statement of cash flows for the latest period (assuming illiquid assets);
• A statement of changes in net assets for the latest period; and
• Financial highlights for the latest period consisting of required operating ratios and the cumulative internal rate of return (IRR) of the fund.

The above list differs primarily from a registered equity mutual fund in the inclusion of the statement of cash flows and the items included in the financial highlights. While there is not room here to address all the unique aspects of investment company accounting for private equity and venture capital funds, the following paragraphs attempt to list and describe the more important ones and also to describe why investors are interested in that information.

This partial chapter is one of 19 in The Investor Relations Manual: Creating and maintaining best-in-class private equity GP-LP relationships,a new book from PEI Media.