Around the books in 80 days

by Matthias Plötz 31 July 2023

Every job includes duties that make one appreciate all its other aspects. For private equity operational leaders, the annual audit seems to fulfil this function. Ever vigilant in our quest to inform operational excellence, The Drawdown takes a look at whether even this process can add value to a GP’s operations.

One industry veteran, who has been in the game well over two decades, recalls a time when audits “consisted of a stack of paper and differently coloured pens”. Today, they have become rigid, a combination of harsh auditing standards and machine learning.

As the audit process has evolved from pen and paper to digital and data, so has the role of the GP’s audit partner. One operational leader tells us how in their eyes, “the real value of an audit lies in the commercial discussion with the audit partner”.

While their remit may be easily dismissed as one of following a set standard and ensuring files stack up to review, in the course of their duties, audit partners gain deep insight into private equity firms. This makes them an excellent source of information on best practices and a good sparring partner. Audits are ultimately a test for good business practices, and a commercially minded auditor who is able to set the regulatory standards into commercial reality is a vital asset, according to several CFOs we spoke to.

Private equity is a people business and auditing is no exception. The process is rigorous and causes tensions between a GP and their auditing partner. However, as several CFOs remind us, private equity firms need to be aware of the information asymmetry. While they might know everything about their firm, the external auditor certainly will not. And grunt work will often be carried out by juniors with limited experience.

Therefore, the keys to a smooth process lie in frequent and regular communication that keeps in mind the disparity in knowledge about the GP and its dealings. Further, this is key should anything go sour and crisis situations arise.

Travellers’ insurance
While audits may not appear particularly risky, they have their pitfalls. There is a strict timeline, any delays to which will jeopardise the GP. This is dictated by two external documents – the FCA’s Chapter 16, which sets the time of completion to 80 days after the accounting reference date; and the LPA and its provisions on when accounts need to be published.

Preparation is paramount. Smaller teams where individuals juggle multiple responsibilities particularly rely on good preparation and a timely transmission of requests for information. Further, defining the exact scope of the audit is important. As an audit encompasses a firm’s own bookkeeping and to some degree the activities of its external service providers, it is likely that in the beginning ‘you don’t know what you don’t know’.

According to seasoned CFOs and auditing partners alike, this statement remains true throughout the process.

The main risk of an audit is the valuation of the portfolio. Especially so in times of high market volatility and the rise of reporting metrics that are harder to quantify, such as ESG. Portfolios that include smaller companies, particularly around the pre-seed or series-A stages, face the additional challenges that these companies will likely be poorly prepared and require more assistance than others.

Consensus puts external events as the most impactful on a smooth auditing process. A common horror story told to The Drawdown by several respondents is the possibility of investors pulling out of a fund halfway through an audit. Less scary but nevertheless impactful are closings or restructurings at the fund level, as these will significantly impact the scope of the audit. Several CFOs we spoke to warned about this, particularly in times of high volatility that are likely to cause greater need for restructuring of one’s portfolio. In turn, this makes it harder to calculate valuations properly. Alongside preparation, all of them stressed the importance of a meticulous paper trail and documentation to combat this.

Any significant delays or shakeups to a firm's process are likely to throw them off the timeline, causing problems with both the regulator and the LPs. Therefore, an open channel of communication, conducted regularly, will grease the wheels – even on problematic pavement.

Something to write home about
While an LP pulling out of a fund is hopefully just a story used to scare operational juniors, The Drawdown had conversations with seniors to discuss the role of the audit in fundraising.

An audit provides hard data on a GP’s track record, a form of security that set standards were adhered to. However, the CFOs warn us that they set a commercial bar that is not high enough for fundraising. Over time, LPs have become increasingly sophisticated in their own internal operations and outward expectations of GPs. The bar raised by an audit will not be high enough to reach them, is the consensus.

An exception to this rule are young firms. Voluntary audits provide the possibility to demonstrate they have nothing to hide, as well as showing that alongside the focus on transactions and portfolio management, they have robust internal operations as well as high quality service providers.

For established players, internal auditing processes that collect information on their investment team, such as relevant press coverage and financial information, are much more preferable, says one investor relations professional.

We have yet to meet an operational leader in private equity who has audits at the top of their list of duties they enjoy about their position. However, the process does warrant necessity. While regulation is a pain point, it gives recognition and legitimacy to an industry and its practices. In turn, this provides a basis for the legislator to take players’ considerations into account when forming frameworks and cater to their interests.

On the ground however, it does remain a necessary unpleasantry. A good auditing partner who GPs communicate with openly and regularly, and extensive preparation, however, can help smooth the sails during choppier parts of the journey. And the record of one’s travels might even be of some use when approaching LPs for more travelling budget the next time around.

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