4.3 Fund accounting and valuation basics

Behind every performance figure in lesson 4.2 sits a set of accounts. Someone has to record each capital call and distribution, value the companies the fund still owns, and split the results between dozens or hundreds of LPs. That is the job of fund accounting, done by the GP's finance team, a third-party fund administrator, or both.

If you work in fund operations or investor relations, this is your daily work. If you are an LP analyst, it is where your numbers come from. This lesson covers the basics: capital accounts, NAV, how unlisted companies are valued each quarter, and what LPs receive.

Capital accounts

Each LP has a capital account: a running record of its share of the fund. Money paid in increases it. Distributions reduce it. The LP's share of the fund's gains, losses, income and expenses, including management fees, moves it up or down.

A fund keeps the key commitment figures alongside:

• Commitment: the total the LP has agreed to invest over the fund's life.
• Contributions to date (paid-in capital): what it has actually paid in response to capital calls.
• Unfunded commitment: commitment minus contributions, the amount the GP can still call. Some LPAs allow certain distributions to be recallable, meaning they can be called again, which adds back to the unfunded amount.

Take an LP in Ashcombe Capital Fund I with a $10m commitment, 10% of the fund. At the end of year 5, its illustrative capital account statement looks like this:

These are exactly 10% of the fund-level figures from lesson 4.2: $85m paid in, $35m distributed and NAV of $90m.

How does $8.5m in and $3.5m out become a balance of $9.0m? The capital account can be rolled forward:

The $4.0m line includes unrealized gains: increases in the estimated value of companies not yet sold. So the balance is only as reliable as the valuations behind it. The LP's own multiples match the fund's: DPI = 3.5 ÷ 8.5 = 0.41x and TVPI = (3.5 + 9.0) ÷ 8.5 = 1.47x.

Real statements add more detail, such as separate lines for management fees, fund expenses and any carried interest allocated to the GP. The structure is the same.

NAV

A fund's net asset value (NAV) is the value of everything it owns, mainly its portfolio companies, plus cash, less its liabilities, such as any borrowing and accrued expenses. The sum of all LPs' capital account balances, plus any amount allocated to the GP, equals the NAV.

For a private equity fund, nearly all of the NAV is the estimated value of unlisted companies. So the key question is how those estimates are made.

Valuing unlisted companies each quarter

Private equity funds report investments at fair value: the price that would be received to sell an asset in an orderly transaction between market participants on the valuation date. The rules come from ASC 820 in the US and IFRS 13 in countries that use IFRS. Both apply the same idea.

Because there is no market price, fair value has to be estimated. Common approaches include:

• Market multiples. Apply a multiple, usually of EBITDA or revenue, taken from comparable listed companies or recent sales of similar businesses. If similar companies are valued at around 10x EBITDA, that is a starting point, adjusted for differences in size, growth and risk.
• Discounted cash flows (DCF). Forecast the company's future cash flows and discount them back to today at a rate that reflects the risk.
• Recent transactions. If the company has recently raised money or received a firm offer, that price is strong evidence of value.

Most funds use more than one approach and weigh up the results. They also follow industry valuation guidelines, such as the IPEV Guidelines, which set out accepted practice.

Under both standards, investments valued mainly with unobservable inputs, such as a GP's forecasts or its choice of multiple, fall into Level 3 of the fair value hierarchy. Almost all unlisted private equity holdings are Level 3, just like the private loans described in PC101 4.2. The same concerns apply:

• Judgement. Reasonable people can pick different multiples and reach different values.
• Lag. Valuations rely on company financial results that arrive weeks after quarter-end, so reports come out later still and may trail market moves.
• Smoothing. Marks tend to move more gradually than listed share prices, so reported returns can look steadier than the underlying risk.
• Conflicts. The GP prepares the values, and fees, fundraising and interim performance can all be influenced by them.

To manage this, GPs typically have a valuation policy, a valuation committee, and sometimes third-party valuation firms that prepare or review marks.

Audit and reporting to LPs

The fund's annual financial statements are audited by an independent audit firm. The auditor tests, among other things, whether the valuations are supported and follow the fund's policy and the accounting rules. Quarterly figures are usually not audited.

LPs typically receive:

Many LPs also receive tax documents, and some ask for reporting in a standard industry template. Later operations courses go deeper into fund accounting, valuation and investor reporting.

Key terms

• Fund administrator: a firm that keeps a fund's books and records and prepares investor statements, often on the GP's behalf.
• Capital account: an LP's running balance in the fund: contributions, less distributions, plus its share of gains, income and expenses.
• Unfunded commitment: the part of an LP's commitment not yet called.
• Recallable distribution: a distribution that the LPA allows the GP to call back, which adds to the unfunded commitment.
• Fair value: the price that would be received to sell an asset in an orderly transaction between market participants.
• Level 3: the fair value category for assets valued mainly with unobservable inputs.
• Capital call notice: a request for LPs to pay in part of their commitment by a set date.

Key takeaways

• Each LP's capital account tracks contributions, distributions and its share of results; together the accounts add up to the fund's NAV.
• The example LP has $8.5m in, $3.5m out, $1.5m still to be called and a $9.0m balance, 10% of the fund's figures.
• Unlisted companies are marked to fair value each quarter using multiples, DCF and recent transactions, guided by ASC 820 or IFRS 13 and industry valuation guidelines.
• These are Level 3 values, based on judgement, so they can lag and smooth reality; annual audits test them.
• LPs receive call and distribution notices, capital account statements, quarterly reports and audited annual accounts.