The GP LedgerSubscribe
  • 12dQ3 LP reports Nov 14
  • 59dQuarter end Dec 31
  • 133dK-1s Mar 15
  • 179dAudit Apr 30
Guide

Choosing an auditor for a first fund: 5 things to check before you sign the engagement letter

Checked against our editorial standards6 min read
An old book opened on a white surface
Quick answer

Start with the PCAOB's registered-firm database and confirm the firm is both registered and inspected. Check independence under Regulation S-X Rule 2-01 before signing anything. Ask for references from funds of your size and strategy, because ASC 820 fair value work is where audits go long. Expect $25,000 to $60,000 for a $20M to $50M venture fund with 10 to 20 positions. Sign the engagement letter before December 31; a firm engaged in February audits in April.

Before you start

Your LPA almost certainly requires an annual audit. Read the reporting clause: it names the deadline (usually 120 days after fiscal year end), whether the auditor must be PCAOB-registered, and whether the opinion covers the capital accounts or only the fund-level statements. Most LPAs copy the custody rule's language verbatim, which means GAAP financial statements audited by an independent public accountant registered with and inspected by the PCAOB, delivered to all limited partners within 120 days of fiscal year end.

If the manager is a registered investment adviser, the custody rule makes that requirement law. If the manager is an exempt reporting adviser, the custody rule does not apply, but the LPA and your LPs' expectations do. Institutional allocators will ask for the auditor's name, its PCAOB registration number, and the date of its last inspection before they wire the subscription. Do not treat auditor selection as an accounting decision. It is a fundraising one.

The year-end audit preparation guide covers how to run the audit once the auditor is engaged. This guide covers how to choose the firm.

The selection process, start to signature

Begin six months before year end. The engagement letter must be signed before December 31 or the firm joins the back of the queue.

  1. 1Read the LPA's audit clauseDeadline, PCAOB requirement, opinion scope
  2. 2Search the PCAOB registered-firm databaseConfirm registration and last inspection date
  3. 3Request three proposalsScope, team, fees, timeline, references
  4. 4Check independence under Regulation S-XNo prohibited relationships or services
  5. 5Call two fund-manager referencesValuation process, responsiveness, surprises
  6. 6Sign the engagement letterBefore December 31; agree the PBC list at the same time
Figure 1The GP Ledger

Step 1: Confirm PCAOB registration and inspection

Open the PCAOB's registered-firm database and search by firm name. The entry shows whether the firm is currently registered and when it was last inspected. Both matter. A firm that is registered but has never been inspected, or was last inspected five years ago, does not meet the custody rule's requirement that the auditor be "subject to regular inspection" at the start of the engagement and at each calendar year end.

Sarbanes-Oxley Section 104 sets the inspection cycle. Firms that audit more than 100 public-company issuers are inspected annually. Firms with 100 or fewer are inspected at least every three years. Nearly every fund auditor falls in the triennial category, because fund audits are not issuer audits. A three-year gap between inspections is normal for a boutique fund practice. A six-year gap is not.

Step 2: Check independence before you talk fees

Regulation S-X Rule 2-01 defines what makes an auditor independent. The rule is longer than most fund managers read, but three areas matter for a first fund.

Financial relationships. No partner or professional in the engagement team may hold an interest in the fund, its portfolio companies, or the management company. This includes indirect interests through a spouse or dependent.

Non-audit services. The auditor may prepare the partnership tax return and the K-1s under the compliance safe harbour, but it may not provide bookkeeping, appraisal or valuation services for amounts that are material to the financial statements, or act as a broker-dealer, or serve in a management role. If you plan to hire the same firm for tax, confirm in the engagement letter that the tax work stays within the permitted scope.

Portfolio company relationships. If the auditor also audits a portfolio company, or provides consulting services to one, the relationship may impair independence with respect to the fund. Ask the firm to run its own independence check across its client list before you sign.

Step 3: Ask about fund audit experience

A PCAOB-registered firm that audits restaurants is registered and inspected. It is not the right firm. The questions that matter are about the work the fund audit actually involves.

ASC 820 fair value. Every venture position above cost is a Level 3 measurement under the fair value hierarchy. The auditor must test the method, the inputs, and the support. Ask how many venture or PE funds the firm audits, what percentage of their audit hours go to valuation work, and whether they use a valuation specialist on the engagement.

ASC 946 (investment companies). The fund's financial statements follow FASB's investment company guidance. The auditor should know the partners' capital presentation, the schedule of investments, the financial highlights, and the specific disclosures the standard requires.

Waterfall and carry testing. The auditor recomputes the management fee by LP, the accrued carry, and the waterfall against the LPA. If the firm has never tested a distribution waterfall with side-letter discounts, the first engagement is slower and more expensive.

Ask for the names and phone numbers of two fund-manager clients with a fund of similar size and strategy. Call them. Ask what went wrong in the first year.

What to evaluate in a fund auditor

Registration is the floor. Experience with fair value and fund structures is what separates a smooth first audit from one that runs past the deadline.

  1. 1PCAOB registration and inspectionConfirm both on the PCAOB database; check the last inspection date
  2. 2Independence under Regulation S-XNo prohibited financial, employment or service relationships
  3. 3ASC 820 fair value experienceLevel 3 measurements, valuation specialist on the team
  4. 4ASC 946 investment company reportingPartners' capital, schedule of investments, financial highlights
  5. 5Waterfall and carry testingManagement fee, accrued carry, side-letter discounts
  6. 6References from similar fundsTwo fund managers with a fund of your size and strategy
Figure 2The GP Ledger

Step 4: Compare proposals on scope, not just fees

Request proposals from three firms. The letter should name the scope (fund-level statements, capital account statements, the financial highlights), the team (a partner who signs and a manager who runs the fieldwork), the fee, the timeline, and what the firm expects from you (the PBC list and its deadlines).

Fees for a first venture fund of $20M to $50M with 10 to 20 positions typically run $25,000 to $60,000 in the first year. The first year costs more because the auditor builds its understanding of the fund, the LPA, the valuation policy, and the administrator's records from scratch. Year two is usually 10% to 20% lower if the fund's operations are stable.

Three things raise the fee: a large number of positions (each one requires valuation testing), complex structures (a feeder, a co-invest vehicle, side pockets), and books that arrive late or do not reconcile. The cheapest proposal from a firm that has never audited a fund is not cheaper when it takes twice as many hours.

Step 5: Sign the engagement letter before year end

The engagement letter is a contract. It names the parties, the scope, the fee, the representations the manager will make, the timeline, and the conditions under which the auditor can withdraw. Read the indemnification clause; some firms ask the fund to indemnify the auditor for third-party claims arising from the audit, which counsel should review.

Sign it before December 31. The auditor needs a planning call before year end: what investments the fund holds, how the valuations are supported, whether any distributions have been made, what the administrator delivers and what the manager delivers. The PBC list should be agreed at the same call and assigned by owner and date, so the 120 days start with the work already organized.

A firm engaged after year end joins the back of the queue. Every week the engagement slips past January pushes the delivery date further into April, and a delivery that misses the 120-day deadline is a default under most LPAs.

What goes wrong

  • Picking a firm on price alone. A low fee from a firm with no fund experience costs more in hours when the engagement runs over, and the opinion carries less weight with LPs.
  • Skipping the independence check. A conflict discovered during fieldwork forces the firm to withdraw, and the fund starts over with a new auditor and a missed deadline.
  • Engaging in February. The firm's schedule is set. The fund's audit lands in the last week of April, and the 120-day deadline is April 30 for a December year end.
  • Assuming the administrator handles the auditor. The administrator delivers the PBC list and answers questions about the books. The manager owns the valuations, the representations letter, the related-party disclosures, and the sign-off.
  • Using the auditor for valuation work. An auditor that sets the marks cannot also test them. If you need a third-party valuation agent, it must be a separate firm.

Frequently asked questions

Does a first fund need a PCAOB-registered auditor?
If the manager is a registered investment adviser relying on the custody rule's audit route, yes: Rule 206(4)-2 requires financial statements audited by an independent public accountant registered with, and subject to regular inspection by, the PCAOB. An exempt reporting adviser is outside the custody rule, but most LPAs require the same standard, and institutional LPs will not accept an opinion from an unregistered firm.
How much does a first fund audit cost?
For a venture fund of $20M to $50M with 10 to 20 portfolio positions, expect $25,000 to $60,000 for the first year. Fees rise with the number of positions, the complexity of the structures (side pockets, co-invest vehicles, a feeder), and the state of the books. A fund that delivers the PBC list late or has unsupported valuations pays more in hours.
Can the same firm do the fund's tax return and the audit?
Regulation S-X Rule 2-01 does not prohibit tax compliance work for the audit client, but it prohibits aggressive tax positions and certain tax advisory services that go beyond compliance. Many small fund auditors prepare the partnership return and the K-1s as a separate engagement. Confirm in writing that the tax work stays within the safe harbour before you sign both letters.
What is the difference between PCAOB and AICPA standards for a private fund audit?
A private fund audit is conducted under generally accepted auditing standards (GAAS), issued by the AICPA's Auditing Standards Board. The auditor must also be registered with the PCAOB and subject to its inspection programme. The PCAOB sets its own auditing standards for public-company audits, but for a private fund the engagement follows GAAS. The PCAOB registration is a regulatory requirement under the custody rule, not a standard-setting one.
When should I start looking for an auditor?
Six months before fiscal year end. Audit firms plan their busy season in the autumn, and a first engagement requires a planning call, a review of the LPA and the valuation policy, and an agreed PBC list. A firm engaged in the second half of December can still make the 120-day deadline. A firm engaged in February usually cannot.
What if the auditor finds a problem with my valuations?
The auditor does not set your marks. It tests whether the marks follow the fund's valuation policy and ASC 820. If a position's support is missing or the method does not match the policy, the auditor asks you to fix it. If you disagree, the finding may become a qualification or a scope limitation in the opinion. Fix valuation issues before the draft, not during it.

Sources

  1. Rule 206(4)-2, custody of client funds or securities (Cornell LII)www.law.cornell.edu/cfr/text/17/275.206(4)-2
  2. PCAOB registered firms databasepcaobus.org/oversight/registration
  3. PCAOB basics of inspectionspcaobus.org/oversight/inspections/basics-of-inspections
  4. SEC final rule on qualifications of accountants (Rule 2-01 amendments, 2020)www.sec.gov/files/rules/final/2020/33-10876.pdf
  5. AICPA Audit and Accounting Guide: Investment Companies (ASC 946)www.aicpa.org/resources/download/aicpa-audit-and-accounting-guide-investment-companies
  6. Sarbanes-Oxley Act Section 104, inspections of registered public accounting firmspcaobus.org/oversight/inspections/inspection-procedures

Terms used in this article

  • Fund audit A fund audit is the annual examination of a private fund's financial statements by an independent accounting firm, which issues an opinion on whether the statements, including the schedule of investments at fair value and the partners' capital, are fairly presented.
  • Custody rule The custody rule is Advisers Act Rule 206(4)-2, which requires a registered adviser with custody of client assets to keep them with a qualified custodian and submit to independent checks.
  • Valuation policy A valuation policy is the written document, adopted by the general partner and usually referenced in the LPA, that sets out how a fund determines the fair value of each investment at each reporting date: the methods used, the inputs and their hierarchy, who prepares and approves the marks, how often they are reviewed and how conflicts of interest are handled.
  • Fair value Fair value is the price that would be received to sell an investment in an orderly transaction between market participants at the measurement date.
  • Capital account A capital account is the running balance of a single partner's economic interest in a fund: contributions in, allocations of income, gains and losses, less distributions out.
  • Partners' capital Partners' capital is the equity of a limited partnership fund, the sum of every limited and general partner's capital account, equal to total assets less liabilities.
  • Schedule K-1 Schedule K-1 (Form 1065) is the annual IRS form on which a partnership, including a fund organised as a limited partnership, reports to each partner their share of the partnership's income, gains, losses, deductions and credits for the tax year, so that the partner can report those items on their own return.
  • Fund administrator A fund administrator is the firm, or the software operated in-house, that maintains a private fund's books: partner capital accounts, capital call and distribution processing, fee and waterfall calculations, NAV, investor statements and audit support.
  • Form ADV Form ADV is the uniform form that investment advisers, including most venture and private equity fund managers above the exempt reporting threshold, file with the SEC to register or report, disclosing their business, ownership, conflicts and, in Schedule D Section 7.B, each private fund they advise along with its auditor, administrator and prime broker.
  • Exempt reporting adviser (ERA) An exempt reporting adviser (ERA) is an investment adviser that relies on the Advisers Act venture capital fund exemption or the private fund adviser exemption, for advisers solely to private funds with under $150 million in US regulatory assets under management, and therefore files a reduced Form ADV with the SEC instead of registering as an investment adviser.
  • Side letter A side letter is a bilateral agreement between a fund and a single limited partner that grants that LP terms beyond the limited partnership agreement, such as a management fee discount, most-favoured-nation rights, co-investment rights, excuse rights or additional reporting, and must be tracked and honoured in every subsequent calculation and notice.
  • LPA (limited partnership agreement) An LPA, limited partnership agreement, is the contract between a fund's general partner and its limited partners that establishes the partnership and sets its terms: commitments and capital calls, management fee, carried interest and the distribution waterfall, term and extensions, investment restrictions, reporting obligations, key person and GP removal provisions.
Quarter End

For people actually running a fund

One operating problem a week: capital calls, K-1s, LP reporting, waterfall math, onboarding. Every Tuesday. Free.