Overall materiality, performance materiality and the clearly trivial threshold for a fund audit, and what a clean opinion can leave uncorrected in NAV, TVPI and carry.
Fund auditors set overall materiality as a percentage of net assets, then take a share of it as performance materiality and a small fraction as the "clearly trivial" threshold. On an illustrative fund with 800.0 of net assets and a 1 per cent benchmark, materiality is 8.0, performance materiality 6.0 and the trivial threshold 0.40. A clean opinion therefore says nothing about errors below those levels: 6.0 is a 6.7 per cent mis-mark of the fund's largest holding.
Worked in full in Operational Due Diligence in Private Equity by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Operational due diligence leans on the audit. A big-name auditor and an unqualified opinion are often the strongest evidence a manager can show that its NAV is right. But an audit opinion is a statement about material misstatement, and materiality is a number the auditor chooses. Knowing how that number is built tells the investor what the opinion covers, and what questions to ask about everything it does not.
| Input | Value |
|---|---|
| Net assets | 800.0 |
| Materiality benchmark, share of net assets | 1% |
| Performance materiality, share of overall materiality | 75% |
| Clearly trivial threshold, share of overall materiality | 5% |
| Paid-in capital to date | 640.0 |
| Distributions to date | 300.0 |
| Carried interest rate, fund in carry | 20% |
| Largest holding, at fair value | 90.0 |
| Number of holdings | 18 |
The percentages are illustrative. Each auditor sets its own, and they are judgments, not rules: the auditing standards define the concepts and leave the levels to the engagement team.
Step 1: overall materiality. The amount above which a misstatement, alone or in aggregate, would be expected to change the decisions of the people relying on the accounts.
Overall materiality = 800.0 × 1% = 8.0
Step 2: performance materiality. Set lower, so that errors the auditor fails to find plus errors it finds and leaves uncorrected are unlikely to add up to more than 8.0. It drives the size of the samples and which balances are tested in detail.
Performance materiality = 8.0 × 75% = 6.0
Step 3: the clearly trivial threshold. Differences below it are not accumulated as misstatements at all.
Clearly trivial = 8.0 × 5% = 0.40
Step 4: translate the thresholds into what an investor reads.
TVPI as reported = (300.0 + 800.0) ÷ 640.0 = 1.719x
A 6.0 overstatement moves it by 6.0 ÷ 640.0 = 0.0094x; 8.0 moves it by 0.0125x
Carry paid on a 6.0 overstatement at 20% = 1.20; on 8.0, 1.60
A 2.5% LP's share of a 6.0 error = 0.150
Measured against the fund, 6.0 is small: 0.75 per cent of net assets and under a hundredth of a turn of TVPI. Measured against a single position, it is not. It is 6.7 per cent of the 90.0 largest holding and 13.5 per cent of the 44.4 average one. For a Level 3 portfolio, where the auditor typically assesses whether the manager's mark sits within a reasonable range rather than at a point, a range of plus or minus 5 per cent on the largest holding is plus or minus 4.5, comfortably inside performance materiality. A clean opinion can sit on top of a valuation consistently placed at the top of every range.
The number that matters to an LP is not materiality but carry. If the fund is in carry, every unit of overstatement that feeds a carry payment, through a NAV-based distribution test or a distribution in kind, pays 20 per cent of itself to the GP, and recovering it relies on the clawback.
| Benchmark | Overall | Performance | Trivial | TVPI effect of overall | Carry on overall | Share of largest holding |
|---|---|---|---|---|---|---|
| 0.5% of net assets | 4.0 | 3.0 | 0.20 | 0.0063x | 0.80 | 4.4% |
| 1.0% of net assets | 8.0 | 6.0 | 0.40 | 0.0125x | 1.60 | 8.9% |
| 2.0% of net assets | 16.0 | 12.0 | 0.80 | 0.0250x | 3.20 | 17.8% |
Doubling the benchmark doubles everything the opinion can absorb. At 2 per cent, a 17.8 per cent error on the largest holding would sit below overall materiality. The benchmark is disclosed in some audit reports and can always be asked for; an ODD questionnaire that records the auditor's name but not its materiality has recorded the less useful half.
Suppose the audit finds four differences the manager declines to book: 2.1, 1.6, 1.4 and 0.35. Each is below performance materiality and together they total 5.45, 0.68 per cent of net assets, leaving 2.55 of headroom under 8.0. The opinion is unaffected. The fourth difference is below the 0.40 trivial threshold and may not even be listed. The other three appear in the auditor's summary of unadjusted differences, which goes to the manager and its board or advisory committee, not to the investors, unless someone asks.
Reading an unqualified opinion as "the NAV is right". It means that, within the limits of its sampling, the auditor found no uncorrected misstatement, alone or in aggregate, above 8.0. The diligence questions follow directly: what benchmark and percentage were used; what were the uncorrected differences and in which direction; were they concentrated in valuation; and does the manager book every proposed adjustment or argue them down. A manager whose uncorrected differences all point the same way, every year, is telling you something the opinion will never say.
The book treats custody, audit and the finance function as core ODD domains; the free workbook for this case shows how a rating model can bury a fatal flaw in an average. Testing the NAV itself for bias is worked in how to test if a GP's unaudited NAV is biased.
For investment funds the usual base is net assets, because that is what investors rely on. The percentage is the auditor's judgment and is illustrative here: at 1 per cent of 800.0 of net assets, overall materiality is 8.0; at 0.5 per cent it would be 4.0 and at 2 per cent 16.0. Ask the auditor or the GP which figure was used.
A lower threshold, set below overall materiality, used to plan testing so that undetected and uncorrected errors together stay under materiality. At an illustrative 75 per cent of 8.0, performance materiality is 6.0. On a fund whose largest holding is 90.0, that is a 6.7 per cent mis-mark of that one position.
Yes, by amounts below materiality. In the illustrative case four uncorrected differences totalling 5.45, 0.68 per cent of net assets, sit under the 8.0 threshold and do not affect the opinion. An investor learns of them only by asking for the summary of unadjusted differences.
This article is one calculation from Operational Due Diligence in Private Equity. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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