The custody rule is one of the most consequential compliance obligations for private fund managers. If you have custody of client assets, you must either submit to surprise examinations by an independent accountant or undergo an annual audit of each fund. Most private fund managers satisfy the rule through the audit approach.
What Counts as Custody
Under the SEC's custody rule, an adviser has custody whenever it holds client funds or securities, or has any authority to obtain possession of them. For private fund managers, this definition captures nearly every standard fund arrangement.
If you serve as the general partner of a limited partnership or the managing member of an LLC, you almost certainly have custody. The ability to deduct management fees from fund assets, make capital calls, or control distributions all constitute custody. Virtually every private fund manager triggers the custody rule, regardless of whether you physically hold investor money in your own accounts.
The Audit Exception
The custody rule offers two paths for compliance. The first is a surprise examination by an independent public accountant, conducted without prior notice. The second, and far more common approach for fund managers, is the annual audit exception.
Under the audit exception, each fund must undergo an annual audit by a PCAOB-registered independent accounting firm. The audited financial statements must be distributed to all investors within 120 days of the fund's fiscal year-end. For fund-of-funds structures, the deadline extends to 180 days. Meeting this requirement eliminates the need for a surprise examination.
The audit exception is the standard approach for private fund managers because it aligns with what institutional LPs already expect. Most LPs require audited financials as a condition of investment, so the custody rule audit serves double duty.
What the Audit Must Cover
The annual audit must be conducted in accordance with generally accepted auditing standards (GAAS) by a firm registered with the Public Company Accounting Oversight Board (PCAOB). The audit covers several critical areas:
- Financial statements prepared in conformity with GAAP
- Portfolio valuations, including methodologies and supporting documentation
- Capital account calculations, including allocations of income, expenses, gains, and losses
- Economic terms of the limited partnership agreement, including management fees, carried interest, and waterfall provisions
- An opinion on the fair presentation of the financial statements in accordance with GAAP
The auditor reviews whether the fund's financial statements fairly represent the fund's financial position and results of operations. This includes testing whether fees are calculated correctly, whether valuations are reasonable, and whether the LPA's economic terms are being followed.
Consequences of Non-Compliance
Custody rule violations are among the most common deficiency findings in SEC examinations. The SEC takes this rule seriously because it directly protects investor assets. Non-compliance can result in enforcement action, corrective measures imposed by the SEC, and significant reputational damage with current and prospective LPs.
The 120-day deadline for distributing audited financial statements is a hard deadline. Missing it means you have failed to satisfy the audit exception, which means you are out of compliance with the custody rule for the entire year. There is no grace period and no cure provision. If you miss the deadline, you must either complete a surprise examination or disclose the failure.
Practical Notes
Engage your auditor early. For calendar-year funds, the 120-day deadline falls on April 30. Audit season for private funds is compressed, with most PCAOB-registered firms handling dozens or hundreds of fund audits in the same window. Firms that engage their auditor late in the process risk missing the deadline simply because the auditor cannot complete the work in time.
Coordination between your fund administrator and auditor is essential. The administrator prepares the financial statements, capital account schedules, fee calculations, and supporting documentation that the auditor relies on. Clean, well-organized records from the administrator reduce audit time and cost. Disorganized records create delays, additional audit fees, and risk to the 120-day deadline.
If you manage multiple funds, each fund requires its own audit. The custody rule applies at the fund level, not the adviser level. A single missed audit on one fund creates a custody rule violation for that fund, even if all your other funds are in compliance.
This article is for informational purposes only and does not constitute legal advice. Consult qualified professionals for guidance specific to your situation.