Graham Phillips, partner, Asset Management, PricewaterhouseCoopers

Key accounting steps for new fund launches

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Interview with Graham Phillips - There are a host of different variables that a new manager must consider when embarking on the launch of a new fund. In today’s “institutionalised” environment, the barriers to entry are considerably greater than they were five years ago. This is because investors are taking far more interest in the fund’s structure. They expect a manager to demonstrate robustness in every area, and using third party administrators to value assets (particularly OTC derivatives), to maintain first-rate accounts that are error-free is now de rigueur. Nobody in the industry wants a repeat of the Madoff incident. 

From day one, the pressure is on new fund managers to ensure that their fund’s accounts (and indeed those of their management company) are objectively produced. Another cost burden admittedly, but an unavoidable one.

Choosing the right fund administrator is a key stage in fund formation. For many, doing the rounds and meeting different providers is often necessary. “Once they’ve decided who they’re going to use they need to do their due diligence on that fund administrator and negotiate fees. In particular, they need to be satisfied that the administrator can keep accurate books and records for the fund,” explains PricewaterhouseCoopers partner, Asset Management, Graham Phillips.
 
The quicker a new manager gets his mind thinking about due diligence, the better able he’s going to be at adapting to the new demands of fund management. Getting the right administrator that you know can maintain the books accurately is an essential spoke in the start-up wheel.
 
Phillips says that the first part of doing due diligence centres on the proper recording of subscriptions and redemptions, and the proper recording of various transactions of the fund. “Thereafter, you’ve got to ensure that the systems and processes are sufficiently robust such that the portfolio and other assets/liabilities are properly valued to“cut” the NAV. It is the NAV that is the key component of the subscription/ redemption price,” Phillips explains.
 
Another area to be aware of is ‘equalisation’. This is an adjustment made by the fund administrator to attribute the cost of incentive fees fairly amongst investors to allow for their different subscription and redemption dates. Athough the administrator prepares the exact calculations a good understanding of the different methodologies that can be used is recommended in Phillips’ opinion.
 
Typically, a manager might go out to Luxembourg or Dublin to meet with PwC to discuss their shortlist of potential fund administrators, assuming, that is, that PwC are being considered as the fund’s auditors. This is always an advisable option as it gives the manager constructive feedback and allows them to discuss any potential issues before moving forward with a particular fund administrator.
 
To recap: due diligence should be performed on the process for keeping the books and records, on cutting the valuation, and on producing the actual accounts. Timely, accurate accounts will help a year one manager avoid having sleepless nights.
 
There are currently two main frameworks used in accounting: US GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards). However, a large-scale project is now underway to converge both frameworks. Fund managers should be aware of both.
 
US GAAP, according to Phillips, has a specific carve-out for investment funds and how you report on them, but this is not presently true of IFRS, although a standard is being developed. “The level of disclosure of a US GAAP set of accounts is not as great as an IFRS set of accounts at this precise moment,” comments Phillips.
 
Start-up managers should be mindful, therefore, that their chosen administrator can produce fund accounts in either framework. Deciding on which regime is best suited to the fund will depend on two things: Firstly, where are the majority of your investors likely to be located? US-based investors are likely going to want to see reports in the US GAAP format. Secondly, what kind of strategy are you going to be running?
 
“If it’s a l/s equity fund investing in liquid stocks then either US GAAP or IFRS will suffice,” says Phillips. “But if it’s something more complex like a distressed debt fund then the disclosures currently required by IFRS can also be complex. You’ve got to discuss the strategy with the administrator and think ‘will there be any particular accountancy issues or any disclosure issues?’”
 
Actually producing a clean set of accounts and good pro formas that comply with all the standards is complex work for administrators. “We train administrators on new standards and keep them up-to-date on issues. A new fund manager has to make sure that his chosen administrator is getting that sort of input,” says Phillips.
 
Another challenging area is dealing with tax, particularly with respect to FIN 48 that deals with the provision and disclosure of tax. An administrator has to understand whether there might be a potential tax liability, either capital gains or withholding tax, in relation to a particular portfolio holding. If the risk is more likely than not, then the accounts should include an estimate of that liability. The problem with this is its subjectivity. “It depends on the strategy and how well a manager has set up control processes to monitor either withholding tax or CGT issues. Tax regimes change all the time,” explains Phillips.
 
Year one is often the hardest, from an accounting perspective, because a manager is faced with having to create a set of financial statements from scratch. They have no reference point. At least, come year two, they have a pro forma to work from. Phillips believes that one of the challenges of setting up a new fund is that managers tend to misjudge how long this process will take.
 
“There tends to be an underestimation of the time taken to review the accounts before sending them out to investors, which may be two months after year-end, which leads to a bit of a last minute panic,” comments Phillips. “Like all things, it’s first time round the track.”
 
Were a manager to launch his fund today, the first set of audited accounts wouldn’t be produced until December 2012. Given that this is a long time for investors to wait, managers tend to release interim financials in an unaudited format. If you do this, Phillips says that you should have early discussions with your auditor “to agree the accounting framework and any difficult accounting policies. You don’t want to put out unaudited information containing errors.”
 
A fund’s first year accounts are what a new manager is measured against (in addition to fund performance) in the eyes of his investors. The document needs to be easy to read and communicate everything clearly. In that sense it’s an important document because it gets independently reviewed by auditors like PwC. “You’re displaying your wares and it shows that for this bit of your infrastructure, you’re doing it well and getting it out on time,” asserts Phillips.
 
Another issue that comes up frequently in discussions that Phillips has with start- up managers is the treatment of upfront costs. Within the accounting frameworks, all set-up costs have to be written off immediately regardless of whether you use US GAAP or IFRS. However, offering memorandums often state that the set-up costs as a whole will be spread over, say, a five year period to avoid initial investors only bearing such costs.
 
This fund non–GAAP NAV is then calculated and used for the purposes of subscription and redemption prices. This creates two NAVs: one calculated officially using relevant GAAP, the other calculated in accordance with the offering memorandum. “If your fund didn’t raise as much assets as you’d have liked and there’s a material difference in the two NAVs, you could get a technical qualification that says you’re not following GAAP,” adds Phillips.
 
Lastly, start-up managers need to determine who will keep the books and records of the management company; often this is outsourced. For UK managers regulated by the FSA, annual statutory accounts have to be filed with the FSA within 80 business days of the period end – much faster than the 9 month deadline for filing with Companies House. So an outsourcer than can produce statutory accounts that are fully compliant with UK GAAP or IFRS is essential.
 
In addition, each FSA entity has to meet the FSA capital resources requirement 24/7; monitoring and projecting capital requirements is something that can be easily overlooked. “If you’re incurring costs in year one in excess of management fees because you haven’t raised your target assets, you may need to inject more capital. Doing projections of how much you’re going to spend, your likely management fees and how much you need to keep in your FSA regulated vehicle to meet FSA capital requirements is pretty key in the early years,” explains Phillips.
 
Regulation like the AIFMD is introducing widespread changes to the industry which can be quite daunting for new managers to take in. Phillips concludes by saying that, although the level 2 consultation proposals have only just been published and implementation is still a way off, managers should nevertheless think about the disclosure-type issues and stay abreast of developments.
 
“They need to get up to speed and think about what additional information might be required in the accounts and the nature of such disclosures. It’s not just about your track record anymore. You’ve got to demonstrate your business’s operational resilience to these new challenges as well.”
 
Graham Phillips is partner, Asset Management, PricewaterhouseCoopers



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