Private funds, which include hedge funds, private equity firms, and other investment entities, operate within a complex regulatory framework in the United States. The U.S. Securities and Exchange Commission (“SEC”) is the primary overseer, with rules drawn from legislation such as the Investment Company Act of 1940. This article sheds light on the stringent requirements that the SEC imposes on the auditors of private funds to ensure accuracy, fairness, and transparency in the financial markets.
The New Private Fund Audit Rule
Effective November 13, 2023, Rule 206(4)-10 requires a registered private fund adviser to obtain an annual audit of the financial statements of any private fund it manages and to distribute them to investors in the private fund promptly after completion of the audit. Rule 206(4)-10 requires:
(1) The audit must be performed by an independent public accountant that meets the standards of independence in 17 CFR 210.2-01 also noted as rule 2-01(b) and (c) of Regulation S-X). The auditor must also be registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (“PCAOB”) in accordance with the PCAOB’s rules;
(2) The audit must meet the definition of audit in 17 CFR 210.1-02(d) also noted as rule 1-02(d) of Regulation S-X;
(3) Audited financial statements must be prepared in accordance with generally accepted accounting principles (“GAAP”); and
(4) Annually within 120 days of the private fund’s fiscal year-end and promptly upon liquidation, the private fund’s audited financial statements must be delivered to investors in the private fund.
Background: Private Funds and the SEC
Private funds typically pool capital from various investors to invest according to a specific strategy with the intent of a return on investment that exceeds the capital invested into the fund. Most private funds are not required to register under the Investment Company Act of 1940, provided they meet certain exemptions. However, the managers of these funds may be required to register as investment advisers under the Investment Advisers Act of 1940. Advisers to these private funds likely will avail themselves to the jurisdiction of the SEC as a registered investment adviser. As an SEC registrant the fund manager will have additional rules and regulations regarding their activities—auditors should specifically be aware of the inherent conflicts of interest between the fund manager(s) and the fund’s investors as the fund manager(s).
The Importance of Audit in Private Funds
In its final rule release the SEC took specific action to address the need for independent audits of private funds. The SEC stated that audits provide an independent verification of a fund’s financial statements, ensuring that they fairly represent the financial position and performance of the fund. The SEC also noted that independent audits would add a layer of protection for investors in that the audit would provide transparency to the value of fund assets, particularly illiquid assets. Similarly, given that private funds handle significant assets and cater to sophisticated investors, a high standard of transparency and reliability is expected. The SEC’s rules and regulations, therefore, emphasize the role of competent auditors in ensuring that these standards are met. Through the Private Fund Audit Rule, the SEC seeks to increase investor confidence and protection.
Requirements for Auditors
A. Independence
Independence is paramount. Auditors must not have any financial, managerial, or other relationships with the private fund that could compromise their impartiality. This means the auditor should not have any direct or material indirect business relationship with the fund, its management, or its affiliates. In its final rule the SEC noted that auditor independence is a bedrock principle.
B. Expertise in U.S. GAAP or IFRS
The SEC expects auditors of private funds to be proficient in U.S. Generally Accepted Accounting Principles (U.S. GAAP) or International Financial Reporting Standards (IFRS). Given the complexities associated with valuing investment portfolios, such expertise ensures accurate financial reporting.
C. Registration with PCAOB
Auditors of private funds, whose securities are owned by investors that are not considered “accredited investors,” must be registered with the Public Company Accounting Oversight Board (PCAOB) and subject to its oversight.
D. Compliance with Audit Standards
Auditors must conduct their audits in accordance with PCAOB standards. This requirement ensures that audits are conducted under a uniform set of high-quality standards.
E. Custody Rule and Audit Implications
One of the crucial rules governing private fund advisers is the Custody Rule (Rule 206(4)-2 under the Investment Advisers Act). If a fund adviser has custody of client funds or securities, they are subject to specific requirements to protect investors.
A significant provision under the Custody Rule is the requirement for an annual surprise examination by an independent public accountant to verify client assets. This examination ensures that the fund’s assets exist and confirms that the fund holds them.
F. Disclosures and Reporting
Auditors play a pivotal role in ensuring that private funds meet their disclosure and reporting obligations under Form PF (Private Fund Reporting Form). Form PF requires certain registered investment advisers to report information about the private funds they manage to assist the Financial Stability Oversight Council in its assessment of systemic risks in the U.S. financial system.
Challenges and Considerations
The role of auditors in private funds’ regulatory framework is not without challenges:
– Valuation of Illiquid Assets: Many private funds invest in illiquid assets, which are hard to value. Auditors must navigate these complexities, ensuring the valuations are accurate and fair.
– Global Operations: Many private funds operate globally, requiring auditors to understand and work within multiple regulatory and accounting regimes.
Conclusion
The SEC’s rules and regulations for the auditors of private funds aim to instill investor confidence by ensuring transparency, accuracy, and fairness in financial reporting. Auditors shoulder significant responsibility in this framework, and their role cannot be understated. As private funds continue to play a pivotal role in the financial landscape, the SEC’s emphasis on robust auditing standards remains crucial to the health and stability of the broader financial markets.
For more information on how JLG can assist with your SEC investment adviser examination preparations, please contact us at (619) 298-2880.
Author: Jeremiah Baba Pagano, Esq. LLM; Editor: Michelle L. Jacko, Managing Partner of Jacko Law Group, PC (“JLG”). JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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