Fund accounting principles in private funds

What is fund accounting in private funds?

Fund accounting is a specialized accounting system used by private investment funds, like venture capital (VC) funds, private equity (PE) firms, and hedge funds, to handle the fund management on behalf of their investors. Unlike a typical business that tracks its own money to measure profit, a fund's primary goal is accountability. The system is designed to prove to investors, known as limited partners (LPs), that their money is being managed correctly according to the legal terms of the fund.

This focus on accountability is a core tenet of fund accounting. It means that every dollar an LP contributes is tracked from the moment it enters the fund until it is returned as a distribution. This provides a clear, auditable record of how the fund’s manager, or general partner (GP), is handling the capital entrusted to them.

Note that while the term fund accounting is also used for tax-exempt organizations, nonprofit organizations, and by local government agencies for governmental funds, this guide focuses strictly on private investment vehicles. In those other sectors, accountants track fund balance across types of funds such as special revenue funds, debt service funds, capital projects funds, permanent funds, designated funds, endowment funds, or the general fund, often using a statement of functional expenses.

How fund accounting differs from corporate accounting

If you are moving from a corporate finance role to a fund, the shift in perspective is fundamental. You are moving from managing one company’s finances to managing a complex partnership with many stakeholders and separate funds. Corporate financial reporting focuses on a company's own profitability, while fund accounting prioritizes accountability to external investors.

The reports and metrics you use will also differ significantly. A corporate accountant is focused on standard financial statements like income statements and balance sheets, whereas a fund accountant lives in a world of partner capital accounts and investment schedules.

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The core components of private fund accounting

Because fund accounting is about tracking financial resources that belong to many different partners, the fund accounting system must be broken down into a few key components. This structure provides the foundational architecture of a fund's financial world. It ensures every transaction is properly recorded and attributed to the correct parties.

The general ledger: Your fund's single source of truth

The general ledger (GL) is the central, official record of every transaction that occurs in the fund. Think of it as the fund's definitive financial diary, where each entry for every dollar in and every dollar out is a permanent part of the fund's history. The GL is organized by a chart of accounts that categorizes all financial activities.

Many firms struggle with using spreadsheets for their GL, which often lag behind real-time activity and are prone to error. An event-based GL provides a modern, fund accounting software system that updates instantly with each fund event. This creates a reliable single source of truth for all fund accounts, financial information, and fund forecasting.

Partner capital accounts

Each partner capital account is a sub-ledger that tracks that specific LP’s contributions, their share of profits and losses, and any distributions they receive, which are used to calculate metrics like distributions to paid-in (DPI), a percentage calculated by dividing total LP distributions by total capital called.

The schedule of investments (SOI)

The schedule of investments (SOI) is a key component of portfolio monitoring and is the detailed report that lists all the portfolio company investments the fund has made. It shows LPs exactly where their money is at work, detailing each entity the fund has backed.

Effective data collection is essential, as keeping the SOI accurate is a major challenge without a connected system, especially given the significant lag in fund reporting, which means positive market performance is often not reflected in VC fund marks in a timely manner.

The difficulty of marking portfolio companies has grown in recent years, and manually tracking these shifts makes timely, accurate reporting a constant struggle. For instance, in the year leading up to Q1 2024, the median 2018 vintage fund experienced a decline in total fund value of more than 11%. An integrated platform ensures the SOI always reflects the true state of the fund's portfolio.

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The fund accounting lifecycle: From capital call to distribution

The core components of fund accounting are brought to life through a series of operational workflows. This lifecycle walks you through the key events that drive all activity in a fund, from fundraising and collecting money from investors to returning profits to them—a process heavily influenced by market dynamics like the recent slight increase in exit activity.

Capital calls

A capital call is the process where the GP requests committed capital from LPs to make an investment or pay fund expenditures, such as management fees. When this happens, the basic accounting entry shows an increase in cash and a corresponding increase in the LP's capital contribution balance.

Operationally, managing capital calls with emails, spreadsheets, and manual tracking creates friction. As Jarred Morales-Mckinzie, director of finance at Base10, explained, this lack of direct access to data can be baffling and inefficient. An integrated platform with capital call workflows and banking integrations can digitize and streamline this entire process, from sending notices to reconciling the cash received.

Management fees

​​While capital calls bring money in, management fees are the primary recurring expense paid out by the fund. These are fees paid by the fund to the GP (or the manco entity) to cover the operational costs of running the firm, such as investment team salaries and office overhead.

Unlike standard business expenses, these are governed strictly by the limited partnership agreement. They are typically calculated as a percentage of committed capital (during the investment period) or invested capital (after the investment period). Automating the calculation and transfer of these fees is crucial, as manual errors here can directly impact the net returns reported to LPs.

Portfolio valuations and ASC 820

ASC 820 is part of Financial Accounting Standards Board’s (FASB) Generally Accepted Accounting Principles (GAAP) guidance that requires funds to report their private, illiquid investments at fair value. ASC 820 is a significant challenge because, unlike public stocks, private companies don't have a readily available market price. This requires companies to perform complex portfolio valuations to determine their fair market value, which can create significant administrative burdens in a volatile market.

The process of gathering the necessary data to perform these valuations can be tedious and manual. As discussed during Carta’s Unlocking ASC 820 Valuations for Funds webinar, a key part of this process is calibration, which involves looking at a company's valuation from the last financing round and adjusting it based on what has changed since. A fund's valuation policy dictates this process, which requires considering company milestones, industry trends, and the overall economy to arrive at a defensible fair value.

Portfolio valuations solutions can streamline this process by connecting directly to portfolio company cap tables and market data to produce audit-defensible valuations.

Waterfall calculations and distributions

When your fund exits an investment at a profit, the proceeds must be distributed according to a specific formula. This process involves several key concepts that you need to understand.

• Distribution waterfall: This is the formula in your fund’s legal agreement that dictates how cash is split between the LPs and the GP, which requires precise waterfall modeling.

• Carried interest: This is the GP's share of the fund's profits, often called carry.

• Hurdle rate: This is the minimum rate of return your LPs must earn before you are eligible to receive carried interest.

The waterfall analysis is one of the most complex calculations in investment fund accounting. Because its output, DPI, can be seen as the "metric that rules them all” for LPs, performing this calculation in a spreadsheet is a major source of risk. Automated waterfall and distribution tools ensure accuracy and compliance with your fund's agreements, reducing the chance of costly errors.

Key financial reports for LPs

The output of your entire fund accounting process is a set of clear, accurate, and timely reports that build and maintain LP trust. These documents provide your investors with a comprehensive view of the fund's activities and performance.

The essential reports your LPs receive each quarter include:

• Partner capital account statement (PCAP): The LP's individual "report card" for the quarter, summarizing their contributions, profit and loss allocations, distributions, and final capital balance, which represents their share of the fund's net asset value.

• Schedule of investments (SOI): A detailed list of the fund's portfolio companies, showing LPs where their capital is invested.

• Balance sheet: A statement of financial position and provides a snapshot of the fund's assets and liabilities at a specific point in time and is a key input for many fund performance metrics.

• Statement of cash flows: Summarizes all cash movements into and out of the fund during the reporting period.

• Statement of operations: Similar to a corporate income statement, this report details the fund's investment income (interest, dividends), fund expenses (management fees, professional fees), and, most importantly, the net realized and unrealized gains or losses on investments during the reporting period.

A modern fund administration platform automates the creation of these reports. Providing your LPs with a secure, self-service portal to access their documents enhances the investor experience and reduces your administrative burden.

Achieving audit and tax readiness

For any fund CFO, the most stressful times of the year are the annual fund audit and navigating the complexities of private fund tax treatment. The key to a smooth audit is having a clean, complete audit trail for every single transaction, from capital calls to expense payments.

Manually gathering evidence from emails, bank statements, and disconnected files is a significant pain point that can lead to delays and errors, especially during a valuations audit. An integrated platform provides auditors with secure, permissioned access to fund data, which can dramatically speed up the process. As Brian Montgomery, CFO of Legalist, noted, accuracy and consistency are paramount: "With Carta, if your inputs are correct, your outcomes are consistent. If we catch something in Carta, it’s extremely quick to fix. In a manual system, it can take days."

Similarly, combining fund administration and fund tax preparation on one platform streamlines the creation of K-1s and other tax documents for the IRS.

Building an institutional-grade back office with Carta

While the principles of fund accounting can be learned, managing a fund effectively at scale requires moving beyond manual processes and spreadsheets. The complexity of allocations, valuations, and reporting requirements demands a system built for accuracy and speed.

An integrated platform provides the fund management software and services to run a professional, institutional-grade back office.

By automating routine tasks and centralizing all fund data, you can ensure your operations are efficient, compliant, and transparent, ultimately protecting the fund’s financial health.

See how you can empower your finance team to focus on strategic work instead of manual data entry and reconciliation when you request a demo of Carta's all-in-one platform.

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Frequently asked questions about fund accounting

What is the difference between a fund accountant and a corporate accountant?

A fund accountant specializes in accounting for investment vehicles, focusing on capital accounts and investor allocations that form the basis of the fund's track record, while a corporate accountant manages the finances of an operating company’s business.

What are the primary expenses in a private fund?

Unlike a corporation with payroll and rent, a fund’s primary expenses are management fees (paid to the GP to run the firm) and professional fees (costs for third-party audits, tax preparation, and legal counsel). LPs monitor these closely to ensure they are not eroding the fund's net return on investment.

What is IRR and why does it matter to LPs?

Internal rate of return (IRR) is a performance metric used to estimate the profitability of potential investments. For LPs, it represents the time-weighted annualized effective compounded return rate. It answers the question: "For the time my money was locked up in this fund, what annual percentage rate did it earn?"

How does a platform like Carta help with management fees? 

Management fees involve complex calculations based on committed vs. invested capital that can change over the fund's life. An integrated platform streamlines this by automating the fee calculation based on the limited partnership agreement and facilitating the transfer of funds from the fund entity to the manco, creating an instant audit trail.

How is carried interest accounted for?

Carried interest is the GP’s share of profits, and it is recorded on the GL only after the fund's waterfall calculation confirms it has been earned according to the legal agreement, which often requires exceeding a target internal rate of return.

What is a partner capital account statement (PCAP)?

A PCAP is a standard quarterly report for an LP that summarizes their capital contributions, share of profits or losses, any distributions received, and their final capital balance.