Advisers to private funds, usually rely on the audited financial statement method to satisfy the Custody Rule. The Chief Accountant’s Office of the Division of Investment Management released a “Dear CFO Letter” last week that raises issues about using combined financial statements to satisfy the custody rule.
You may have missed this possibly important compliance change because this is not a usual source for compliance. Frankly, it’s not easy to find on the SEC Website. Go to the Accounting Matters Bibliography and scroll to the bottom of the page. Let me know if you can otherwise find it on the SEC website.
Paragraph (b)(4) of the Custody Rule permits an adviser to comply with certain aspects of the Custody Rule if an account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) is subject to an annual audit and that audit is distributed to investors within120 days of fiscal year end.
Here is what seems to be the meat of the Dear CFO Letter:
“For purposes of compliance with the audit exception, however, we do not believe an investment adviser can prepare combined financial statements for multiple PIVs in reliance solely on the common management basis in ASC 810-10-55-1B. For example, in the staff’s view, if the economics of each PIV are different and not pro rata (e.g., certain PIVs only participate in certain investments or have differing fee arrangements or rights), the combined financial statements may provide less clarity about an investor’s ownership than if separate financial statements were provided to all limited partners (or members or other beneficial owners) in each PIV.
“The staff believes that if an investment adviser uses combined financial statements to rely on the audit exception, the investment adviser should consider whether:
- Each PIV has the same management;
- There is clear evidence of legal ownership of each investment individually with each PIV or there are contractual agreements which clearly show the assignment of investments held on a combined basis to each PIV;
- Investments and investment gains and losses, including income and expenses, are allocated pro rata to each PIV;
- Each PIV has the same management fee and performance fee structure (e.g., allocations work on a combined basis, calculated based on one hurdle on the combined basis, including combined fair values and contributions/distributions);
- The financial highlights are the same for each PIV; and
- The combined financial statements will
- Present a statement of changes for each PIV separately and a combined aggregate total; and
- Provide clear disclosure of each PIV’s pro rata percentage ownership of the combined basis, total commitments of each PIV, and aggregated commitments on a combined basis.”
I think this means that many private fund managers are going to have to revisit their custody analysis. This is going to add on some legal costs and audit costs.
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