Assessing whether your fund is an investment company is just the beginning of the journey to ensure complete and accurate financial reporting for your fund.

A key, but often overlooked component of running a direct lending fund is fully understanding what your investors and relevant regulatory bodies expect and require in terms of financial reporting.

Allocating insufficient resources can result in investors entering and exiting your fund at the wrong price, material compliance issues, your auditors providing a non-clean opinion on your financials, or confusing and incomplete reporting for your investors.

The requirements and guidelines discussed in this article are based on Generally Accepted Accounting Principles (GAAP), the predominant accounting standards required in the U.S.

As fund manager, you must first understand whether you are required to keep GAAP financial statements. Generally, for private funds, the operating agreement your investors signed, facility agreements with banks, and other legal agreements with various stakeholders will stipulate whether GAAP reporting is required or not. Once answered, you are ready to consider the investment company framework.

An Investment Company or Not?

If your fund is a GAAP reporting entity, you must determine whether it meets the definition of an investment company as defined by the Financial Accounting Standards Board Accounting Standards Codification Topic 946 “Financial Services-Investment Companies” (ASC 946), which will in turn dictate the specific reporting requirements and rules to use in your reporting.

Note: An investment company under ASC 946 is not the same as being an investment company under the Investment Company Act of 1940 (although it is worth noting that if you are an investment company under the 1940 act, you do automatically meet the criterion for being an investment company under ASC 946—just not the other way around).

GAAP requires you to perform an assessment to make such a determination. If some characteristics of an investment company are met but others are not, apply your judgment. The AICPA Investment Company Guide provides the following guidance on characteristics of an investment company, per ASC 946-10-15:

1. It is an entity that does both of the following:

1. Obtains funds from one or more investors and provides the investor(s) with investment management services
2. Commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both

2. The entity or its affiliates do not obtain or have the objective of obtaining returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests or that are other than capital appreciation or investment income.

Further, the fund should assess whether it has the following:

1. More than one investment
2. More than one investor
3. Investors that are not related parties of the parent entity (if there is a parent) or the investment manager
4. Ownership interests in the form of equity or partnership interests
5. Substantially all of its investments are managed on a fair value basis

Specific Guidance for ASC 946 Assessment

If your debt fund is originating loans, there are additional specific considerations you must address when performing the previously discussed assessment (specifically relating to item 1b). The American Institute of Certified Public Accountants (AICPA) released “Q&A Section 6910: Investment Companies: Determining Whether Loan Origination is a Substantive Activity When Assessing Whether an Entity is an Investment Company” (the Q&A) in response to the growing number of inquiries regarding treatment of debt funds.

The Q&A says that as a debt fund manager, you specifically need to analyze the qualitative and quantitative materiality of the fund’s income from loan originations (i.e., origination fees), as GAAP does not consider origination income to be capital appreciation or investment income (a key component of being an investment company).

Quantitative analysis. You must look at the amount of expected origination income in your fund over a relevant period of time (i.e., the average life of a loan) compared to all income in your fund. If the origination income is a significant portion of the income of the fund, it’s one indicator the fund may have business operations that are less indicative of an investment company.

Qualitative analysis. You should look at your specific fund’s situation when making the determination. The Q&A lists the following as examples to consider:

Investing Activity // Compare sales of originated loans to non-originated loans.

Regulatory considerations // Looking at specific fund regulations may provide indicators.

Ownership and management // Ownership of an investment advisor is more indicative of an investment company; ownership by a bank is less indicative.

Customization // Customizing loans specifically for borrowers is generally indicative of an investment company.

Loan retention // Selling loans shortly after origination as opposed to holding them is less indicative of an investment company.

Embedded Features // Loan features that indicate the loan is more like equity than debt is generally indicative of an investment company.

The Q&A recognizes that making the assessment may require significant judgment and that the above analysis should not be considered all-inclusive. Ultimately, the key for fund managers is to go through the steps to understand where you are for each criterion and then document the rationale for where you landed. Be sure to work with your fund administrator and auditor to ensure your conclusions and documentation are appropriate.

Now What?

Let’s assume that after running through the above analysis with your fund administrator and auditor, you’ve concluded your debt fund is an investment company under ASC 946. What does this mean for your fund and its stakeholders?

It means you are required to follow specific accounting principles under ASC 946 that somewhat differ from operating companies.

The AICPA has a comprehensive guide that provides an accounting and auditing framework for investment companies. Here are some of the key differences between investment company accounting and GAAP historical cost accounting generally implemented by operating companies.

Investment companies are “fair value” funds. You may hear people use “fair value fund,” “investment company,” and “ASC 946 fund” interchangeably. One of the core components of being an investment company is holding your assets and liabilities at fair value. In other words, the net asset value (NAV), or your assets minus your liabilities, of your fund at any given reporting period should represent the estimated value of the fund if it were to hypothetically liquidate on that day.

Fair value is an important, ever-changing, and widely discussed topic in the fund management and accounting world. It is also imperative to get it right for open-ended funds that allow investors in and out periodically. Although many fund managers in the direct lending space assume that the fair value of their debt investments can be held at par, it’s crucial that you have a policy in place that is agreed upon with your auditors, fund administrators, and valuation experts.

Investment companies have special reporting requirements on the face of the financial statements. Familiar statement names such as balance sheet and income statement become statement of assets and liabilities and statement of operations, with a slightly different presentation to better highlight important line items and metrics for investment companies. A schedule of investments is also added to summarize key investment metrics, exposure, and concentration.

Investment companies have special reporting requirements in the footnotes of the financial statements. The footnotes of your financials at year-end will specifically call out that your fund is an investment company under ASC 946. Further, there are a number of required reporting requirements that you should understand and work with your fund administrator and auditor to implement. While not all-inclusive, these requirements include a discussion surrounding valuation policies, details on the observability of inputs used in determining fair value (discussed as levels, with Level 1 being unadjusted quoted prices in an active market, Level 3 being illiquid markets being valued with unobservable inputs, and Level 2 being in between), and specific financial highlights breaking out the performance of the fund to its investors (e.g., total returns and expense ratios).

Summing It Up

Bringing investors in and out of your fund at the right value, staying on top of compliance requirements, receiving a clean audit opinion, and having useful reporting for your investors is key to your fund’s success. Making a thoughtful assessment about whether your fund is an investment company is just the beginning of the journey to ensure complete and accurate financial reporting for your fund, but it’s an important and often-overlooked component. Laying the groundwork early to apply the correct reporting framework will allow you to get the right resources in place to provide your investors and stakeholders with accurate information using industry requirements. Doing so is a critical step in gaining and maintaining trust from your investors.