Private Equity Fund Accounting - Subsequent Closings & Equalisation

This is the fourth in a series of posts on private equity fund accounting.

For the third post, Drawdowns, click here.

This post considers what happens when there is a subsequent closing and, in particular, what is meant by equalisation (the ‘true-up').

Continuing our example of the DesTek Fund, there is another round of financing and so a subsequent closing. The GP has attracted a further $90 million from 3 new investors, LPs 6,7 & 8. These subsequent investors are coming into the fund at this 2nd closing on 30th June 2014.

LPs 6,7 and 8 need to pay cash to the fund straight away on 30th June. The amount of cash they are required to pay is determined by their % ownership of the fund based on commitment amounts after this 2nd closing. For example, based on the commitment of $30 million, LP8 owns 8.08% of the fund. So he is required to pay 8.08% of something, but of what? 8.08% of Drawdown A; that is, 8.08% of $50 million.

The new investors make the following payments to the fund:

LP6 - $2,020,202

LP7 - $3,030,303

LP8 - $4,040404

This ‘true-up’, has the effect of putting all investors on an equal footing and it’s called equalisation. Look what happens.

The total amount required from LPs 6,7 and 8, is apportioned across the original investors based on their % holding after the initial closing. Effectively, the original investors are credited as compensation for having their % holding diluted.

The outcome should be that, having re-balanced contributed capital, the amount of uncalled capital for each partner is consistent with the % ownership of each partner after this, the 2nd, closing.

Note that, so far, it appears that the fund does not receive cash on 30th June; the net effect of the cash flows shown is zero as the flows simply re-balanced the investor’s capital.

In reality, it is likely that, in addition to attracting these new investors, the GP issues a Capital Call Notice to all investors for a drawdown at this 2nd closing on 30th June. So there is actually no cash payout to the original investors as a result of the re-balancing. They would be paying cash at this Drawdown B but proportionally less than the new investors. Let’s imagine the DesTek Fund draws down $30 million at the same time as the 2nd closing. The following table outlines the situation.

So LP1 should ‘receive’ $1,795,735 for re-balancing and ‘pay’ $5,656,566 for the drawdown. In effect, he receives a capital call notice requesting that he pay the difference, $3,860,831.

As in the example shown here, the outcome should still be that the amount of uncalled capital for each partner, after the 2nd closing, is consistent with the % ownership of each partner.

Now let’s reconsider the first drawdown, drawdown A. The fund needed $50 million in cash by 31st January. We said this cash was needed to fund portfolio investments or pay fund expenses. In reality, accounting must know exactly what it’s for. Our spreadsheet showed one amount of $50 million. In practice this would be broken down across portfolio investments, organizational fund expenses or management fee. The result is, at partner level, accounting can then reflect proper allocations of expenses, gains and losses.

A basic premise in the treatment of subsequent closings is that subsequent investors should be treated as if they had invested at the beginning.  Consequently, they share in the income and expenses, gains and losses of the fund as if they had invested at the initial closing. This means, for example, LPs 6,7 and 8 are charged a management fee for the period beginning at the first closing even though they didn’t get into the fund until the second closing.

A basic premise in the treatment of subsequent closings is that subsequent investors should be treated as if they had invested at the beginning.

So, having properly reflected the true-up or equalisation, or what many refer to as re-balancing, what else must be considered regarding 2nd and subsequent closings?

Other considerations include an interest compensation charge. And I’ll address that in my next post.