Although March ushers in a change of seasons from Winter to Spring, it also brings about another type of season… audit season, for investment managers and their funds. And while managers and a fund’s auditor are currently in the throes of preparation of audited financial statements over the coming weeks, this time of year is also a good reminder as to what an institutional allocator should analyze once they receive the audited financials from funds, with some particular focus on the nuance of crypto fund audits.
Timing & Delays
Generally, if you are allocated to any type of hedge fund, you should expect an audit will be received sometime from late April to mid-May. Assuming a fiscal year-end of December 31, by this point into the new year, a fund should have produced their final December 2025 NAV, which may take longer to produce (versus NAVs of other months) as the December NAV is often the period for which fund managers crystalize their incentive fees. However, there can be some examples of investors receiving fund audits from May through June, which for certain crypto strategies can be due to the complexity of instruments traded or sheer volume of daily transactions.
In the instance a manager anticipates an audit will be delayed, a fund investor should immediately inquire as to why there is a delay, as it may be an indication of trouble with the audits completion. To add, if a manager is also registered with the U.S. SEC, under “the Custody Rule” or Rule 206(4)-2), and they do not file for an extension of audit finalization, the manager may be in violation of the rule and subject to penalties.
From Crypto Insights Group’s FirmIQ™ data, which collects and scores nearly 100 operational-related questions of investment managers, 13% of fund managers have responded that their funds have experienced a delayed audit. Such a percentage of delayed audits suggests allocators should ensure they ask the right due diligence questions before committing capital to an existing fund, and commit to ensuring ongoing due diligence and transparency is maintained so as to anticipate any future delays in receiving a fund’s audit.
Opinions, Financials & Notes
Once and audit is delivered and received, the best approach to reviewing the document should be to focus on particular sections of an audited financial statement, which are:
- The Auditor’s Opinion: An opinion will cover a few important details about how the work was conducted, such as the method and standards of the audit, and the period (dates) the audit has covered. Most importantly, though, a reader should look for language which indicates there may have been an exception to how the audit process was performed, which may include phrasing such as “Emphasis of Matter,” or “Qualified Opinion.” These terms are often an auditor’s way of communicating potential issues.
Utilizing data from CIG’s FirmIQ™, we see over 8% of managers have responded that their funds have received a qualified opinion or emphasis of matter within their audits. For crypto strategies, this number may appear high relative to the percentage of non-crypto fund audits with such opinions, but when assessed to the fact that common audit standards have still not concretely defined how all digital assets should be audited, the 8% likely indicates many auditors are hedging their opinions based on not having accepted rules for crypto audit standards.
- Fund Financial Statements: Of the three financial statements provided, including the fund’s balance sheet (assets and liabilities), statement of operations and statement of cash flows, operational risks may be found within a fund's redemption flows, the concentration of assets (i.e., for U.S. GAAP standards, assets over 5% must be specifically identified), the percentage of gross liabilities - which can reveal excessive amounts of leverage, and operating expenses. In short, these numbers can reveal how well a manager is operating a fund.
- Notes To Financial Statements: The notes tell the story of what went into the numbers you see in the financials, which means they are another good source of information and means to identify potential risks. Examples include:
- Related-Party transactions, which may identify if a manager is transacting between clients, such as funds or separately managed accounts. A manager may have a valid reason for selling assets from one account and having another buy them, but as an investor you want to ensure such transactions are done via “arms-length” valuations, and in the instance of a fund, have been approved by a board of directors. For crypto funds, the transacting of assets do not occur from one account’s wallet to another, but can appear as a purchase of assets through a fund’s structured special purpose vehicles (SPVs) or side pockets.
- Fair values of fund holdings (assets or liabilities) will identify the accounting valuation standard as either Level 1, Level 2 or Level 3. In short, Level 1 are easily priced holdings, such as holdings with daily market quotes. Level 2 holdings require further input for valuing, such as “observable” inputs, often a “broker quote.” Where Level 3 holdings rely on unobservable inputs, such as an investment manager utilizing an internal valuation model. For many crypto strategies, a vast majority of digital assets fall under Level 1 and occasionally Level 2. However, there have been past examples of Level 3 crypto holdings, which often come in flavors such as SAFEs, SAFTs, locked tokens, and some DeFi assets which are reliant upon a multitude of smart contracts for pricing data, and can be cumbersome for an auditor to properly reconcile months after the fund acquired the asset.
- Per share operating performance, is the auditor’s recalculation of the income or loss per share over the period of the audit, which should match the performance calculated by the fund manager, and fund administrator, reported in an investors monthly statement. Often if there is a discrepancy between the auditor’s performance calculations and that of the manager (or administrator), it may lead to the recalculation of a past NAV and month’s performance, which is problematic for investors who bought shares in such a particular month or redeemed.
- Lastly, subsequent events will detail fund capital flows (subscriptions and redemptions) post the fiscal year-end, which can be used by an investor as a means to understand the current financial standing of a fund.
Other Analysis
The above provides some of the common ways to properly scrutinize a fund’s audited financial statements. However, there are other matters an investor should consider in either evaluating a fund during a due diligence process or monitor on an ongoing basis. Examples include an investment manager often changing the fund auditor, as an indication of a good relationship between a manager and an auditor would be using the same auditor for a period of three to five years; a fund which has not produced an audit for every year it has operated; an auditor terminating an engagement with a fund; and an auditor with citations or violations as reported by a regulator or the Public Company Accounting Oversight Board (PCAOB).
The team at Crypto Insights Group has combined decades of experience operating and evaluating both traditional and crypto funds, as former fund managers who worked with teams auditing our funds, or conducting due diligence on hundreds of third-party managers.
Through reviewing audited financials statements, and maintaining relationships with auditors through our due diligence services, CIG is able to benchmark the standards and methods of digital asset fund audits, providing guidance to fund managers searching for auditors with experience in their specific strategies, and supporting allocators in understanding the operational risks identified through audits.
To learn more about how Crypto Insights Group supports operational due diligence for digital asset funds, book a Crypto Insights Group Demo.
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