Private Investment Fund Audits: Surprise Examination vs. Annual Audit

As a matter of accountability to investors, private investment funds are generally subject to annual financial statement audits. This audit requirement may be self-imposed by fund management or may exist under federal or state investment advisor regulations.  Where a fund does not have a legally imposed requirement for audited financial statements, a surprise custody examination may be an option. A private investment fund, by definition, will always have “custody” of investor funds and thus subject to the terms of the SEC Custody Rule. Investor reporting requirements are frequently addressed in the organization or offering documents of the fund, and it is important to consider the fund’s specific circumstances, benefits, and costs of both options before proceeding. Both examinations and audits are required to be completed within an SEC-prescribed timeframe for registered advisers, but there are important differences to consider, such as with structure and objective, financial cost, and the requirements of and benefits to investors.

Overview of Options

A surprise custody examination is an attest service and is limited in scope and nature compared to a financial statement audit. An examination requires the auditor to evaluate and report to the SEC on matters relevant to the adviser’s compliance with certain provisions of the Act, which consists primarily of the following:

  • The Adviser must maintain all cash and securities of the fund with a qualified custodian; and
  • The Adviser must maintain accurate records and support for all cash and security positions and transactions in the fund related to both investors and operations.

The evaluation of compliance with these provisions is largely accomplished through the testing of certain fund transactions and direct confirmation of funds and securities balances as of the exam date with investors and the qualified custodian(s). As a result, the procedures are mostly simple and straightforward.

In contrast to a surprise examination, financial statement audits are broader in scope and have the objective of forming an auditor’s opinion on the fairness of a fund’s reported financial information and required disclosures as of the end of year.  Accordingly, an audit includes gaining an understanding of the fund’s operating cycles and internal controls as well as performing substantive testing of the transactions and year-end balances of the fund as a whole. While not necessarily more complex, an audit is more labor-intensive and thus typically more costly than a surprise examination.  However, it is important to note for funds managed by SEC-registered advisers, if the fund does not complete and distribute its audited financial statements within the SEC-prescribed timeframe (120 days or 180 days, depending), the surprise examination will be required in addition to the audit.

Practical Considerations

In evaluating these two reporting options, there are several scenarios and circumstances specific to each fund that are important for an adviser to consider:

  • If the adviser and/or fund is registered with an offshore regulatory agency, and an annual audit of the financial statements is already required, a surprise examination would be unnecessary. In this instance, the annual audit required by the foreign agency will likely satisfy the SEC Custody Rule requirements.
  • An internal control report is required by the SEC for surprise examinations when the adviser or one of its related parties is the custodian for the fund’s investments. The requirement is not applicable to funds receiving an annual audit, although additional work may be required during an audit when the custodian does not issue an annual internal controls report.
  • Surprise examinations may be most efficient for funds trading only listed securities with independent qualified custodians, and a small number of investors, which typically translates into less time and cost to the adviser.
  • Annual audits may be most efficient for funds . Alternatively, a surprise examination would require engaging a qualified third-party custodian willing to maintain privately offered securities which is often difficult to do.
  • A liquidating fund with a lengthy wind down process, or which is only holding cash to pay expenses, may particularly find switching from an audit to a surprise examination to be efficient due to the decrease in scope and nature.
  • The surprise examination route will require that each investor in a fund receive an account statement of the overall fund directly from the qualified custodian on at least a quarterly basis. This creates a great deal of transparency around trading activity, which may be undesirable for funds that invest in liquid securities, but inconsequential for funds with privately offered securities.
  • An adviser that has custody of both a private fund(s) and separately managed accounts can only satisfy the custody rule with an annual financial statement audit for the fund(s) and would still need a surprise examination on the managed accounts. An adviser in this circumstance may simplify compliance with the SEC and find efficiencies by having a surprise examination covering both the private fund and the separately managed accounts, depending on the nature of the portfolio.
  • An adviser that has custody of multiple private funds with different structures or investment objectives may find efficiencies by having annual audits for some funds, and surprise examinations for others.
We Can Help

If you need more information or assistance with annual financial statement audits of private investment funds, please contact a member our Alternative Investment Funds team.

The information provided in this communication is of a general nature and should not be considered professional advice.  You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change as a result of rapidly evolving legislative developments and government guidance.