Keeping up with capital accounts is a discipline in fund administration that maintains the economic interest of each limited partner in the fund on a per-unit, per-transaction basis, from fund inception through final liquidation. When done right, capital account maintenance sets the foundation for limited partner (LP) trust, facilitates audit-readiness and executes the waterfall accurately. When done wrong, it is the origin of most limited partner disputes in private equity and venture capital. Here is what capital account maintenance entails. Capital accounts in a private equity or venture capital fund is maintaining the full ledger of what each LP has contributed, the income or losses that have been allocated to the LP, distributions received, and what is left in the LP's unfunded commitment on a continuous and audit-ready basis throughout the life of the fund, updated after each capital transaction. It is not just a periodic snapshot but a living record that is reconciled to the fund's general ledger at all times.
A general partner's capital account maintenance responsibility begins at the first closing of a fund and continues until the last capital call and distribution is made and capital accounts are reconciled to zero. In a 10-year traditional closed-end fund, for example, this responsibility requires accuracy on each capital call and distribution from the first closing to the final close, typically 40 to 80 capital transactions, from 20 to 150 LPs. Each transaction requires a capital account reconciliation. Each reconciliation introduces opportunity for error. Capital accounts in a PE or VC fund is three things in total (1) capital contributed minus return of capital; (2) net income or loss allocated from the fund's portfolio activity; (3) net distributions. Total these three figures and adjust for management fees and general fund expenses, and this is what is referred to as an LP's capital account. A mid-market buyout fund with 45 LPs in a 5-year fund life can easily require over 200 individual transactions, each of which requires capital account reconciliation with a documented trail, in the runup to a distribution of proceeds from fund exits or harvest, which is why most general partners and their third-party administrator partners use partnership accounting software as it is infeasible to maintain the capital accounts of multiple LPs via manual spreadsheet.
There are three main ways for general partners to allocate income or loss to the capital accounts of limited partners in a PE or VC fund: the pro-rata method, the layering or tranche allocation method, and the targeted allocation method. Each LP fund has a specific allocation methodology mandated by its documents (i.e., limited partnership agreement), which will have material tax and economic implications for LPs. The pro-rata method is to allocate income or loss from the fund pro-rata among all LPs on a percentage of their interest in the fund. While pro-rata income and loss allocation is a very straightforward accounting method and easy to audit from an LP perspective, it does not recognize the difference in timing when LPs participate in a fund at different closings and the associated returns or losses attributable to those investments. The layered or tranche method is income or loss from the fund is segregated and assigned according to the tranches in the transaction.
If an LP invested in one transaction (via a tranche of capital call), that LP receives income or loss assigned only to that capital transaction. While this is more accurate to the capital contribution, it is a very complex accounting method to maintain. The targeted allocation method (aka book-up method) is more commonly used for funds with a complex waterfall. Unlike mechanical income allocation, targeted allocation starts from the outcome. Under a targeted allocation, each LP’s capital account is maintained at a level such that, were the fund liquidated today, at what was deemed the current fair value, any proceeds in hand would be distributed according to the terms of the Waterfall. The biggest complaint I encountered during 22 years in the industry was less about how the allocation was being executed, but rather than what was actually being executed was not what was described to be executed in the LPA.
The reality is that GPs are often negotiating favorable provisions for the LPs at closing, and are not briefing their fund administrator about the accounting ramifications of such provisions. When those provisions are discovered (more often than not on the first audit), there are multiple periods that have to be restated. The distribution waterfall is the order in which fund proceeds flow to the LPs and then to the GP. It cannot be executed unless capital accounts are maintained accurately, and capital accounts must be updated immediately upon the completion of each distribution. The waterfall cannot be calculated unless capital accounts are updated. A PE fund typically follows an American style waterfall, which is comprised of four levels. The first four are (i) return to LPs of all contributed capital; (ii) return to LPs of all 8% preferred annual return on contributed capital; (iii) return to the GP of the catch up amount so that it has collected 20% of total profits; and (iv) return of the remaining profits in a 80% and 20% ratio to the LPs and GP, respectively.
Each tier must be completed fully before the next tier is begun. In an American style PE fund, the waterfall is calculated as a separate calculation at the fund level. Capital account records are critical to the correct calculation of the waterfall. VC funds more commonly follow a European style waterfall, under which the GP does not receive any carry until all LPs’ contributed capital is returned in aggregate in the entire fund. While 65% of institutional PE funds follow an American style waterfall, the majority of VC funds follow a European style waterfall. Clawback provisions, which require a GP to return previously received carry if subsequent losses reduce LP returns below the preferred return hurdle, are directly calculated from capital account records. A GP with sloppy capital account records is in very hot water if a clawback calculation is needed to be made. Capital account reconciliation is the process of confirming that the total LP capital accounts equal total partners’ capital as stated in the general ledger.
Reconciliation must be done after each capital event. It should not be done annually or quarterly but after every call and every distribution. The capital account reconciliation is an important part of the annual audit. The standard audit for private funds includes, a set of financial statements prepared under US GAAP (ASC 946); a schedule showing the opening balance, additions, deductions and closing balance for each LP; the waterfall used to calculate any distributions made; and supporting documentation for all fair value measurements under ASC 820. Emerging managers often underestimate the support required to sustain a valuation. All of the fund’s investments classified as a Level 3 must be supported with the methodology used to value the investment, a comparable market analysis and a memo describing any changes to the valuation methodology since the prior period. For funds that have 50 or more LPs, a capital account confirmation process should be performed on a regular, but at least annual basis.
Under a capital account confirmation process, the GP or fund administrator sends each LP a capital account confirmation statement (showing their beginning balance, activity and end balance) which requires the LP to confirm the accuracy of the statement by signing and returning it to the GP or fund administrator. It flags data entry mistakes, out-of-date LP bank details, and incorrect percent interest, thus averting the need for future adjustments in audit findings. Typical GP Liability Errors Capital account errors include (1) arithmetic errors, (2) methodology errors, and (3) documentation errors. Of the three types, (1) is the easiest to fix. (2) includes using the incorrect allocation method or getting the compounding basis of the preferred return incorrect; (2) is more difficult to find. (3) cannot be fixed at a later time because documentation was missing to begin with; (3) is the most serious type of error. Errors occur most often in funds that were running without institutional record keeping.
There are three specific errors that we see frequently: (1) the management fee offset was not taken out of the capital account when calculating the capital accounts. (2) the preferred return hurdle was not compounded; simple return vs. compounded return can be a large difference over time, for example 8% simple vs. 8% compound return is greater than $800,000 for an $50mm LP commitment over 5 years. (3) recycled capital was not handled properly; when a fund realizes early-exit proceeds and then calls the money back, we must keep track of this recycled capital as a separate line item to avoid double-counting. Frequently Asked Questions: Capital Accounts How often should the capital accounts be updated? Capital accounts should be updated after each capital event (meaning, each capital call, each distribution, and each quarterly income and loss allocation). As a general practice, institutional fund administrators will update capital accounts within 5 business days from each event.
What is the difference between a capital account and an LP's NAV? Capital accounts are GAAP-basis accounting records of an LP's economic interest. NAV is the fair value of the fund's portfolio attributable to each LP in accordance with ASC 820. In some early stage funds, where most portfolio holdings are at cost, a capital account's balance can be close to NAV; in later stage funds, where a portfolio has significant unrealized gains, capital accounts and NAV can diverge significantly. Who is responsible for capital account accuracy, the GP or the fund administrator? The answer is ultimately the GP. Although the fund administrator is prepared and maintained capital accounts as a service provider, the GP still signs off on the financial statements, and the LP capital account statements. If the fund administrator makes a mistake and the GP does not discover it prior to sending capital account statements to LPs, then the mistake is the GP's mistake in any legal or regulatory dispute.
How does a subsequent close affect existing LP capital accounts? The newly committed LPs are responsible for a "catch-up" contribution in the amount of pro-rata portion of capital already called for the funds plus some form of interest (commonly the preferred return). This catch-up contribution is paid to the existing LPs in their capital accounts (credited as either a distribution or fee reduction as specified in the LPA). Incorrectly calculating the "catch-up" in subsequent close funds is one of the most common errors in LP capital accounts for subsequent close funds. What documentation should a GP retain to verify LP capital account balance and transactions? A GP should retain: (1) a full set of signed subscription agreements from all LPs; (2) all capital call and distribution notices and wire confirmations, (3) quarterly allocation workpapers; (4) fair value documentation supporting each level 3 portfolio investment; (5) annual capital account confirmation letters to all LPs.
These documents are the same as the documents that the SEC would ask for during an exam, and are to be kept for at least 5 years following the termination of the fund.