What Hedge Funds Should Know About the 5% Look-Through Rule

If you’re involved in fund of fund financial statement preparation, odds are that you’ve stumbled over the 5% look-through rule – probably while muttering something unprintable at your Excel file. According to GAAP guidance for investment companies in ASC 946-210-50, the rule requires investment funds to disclose the proportionately owned underlying holdings of any investee fund that represents more than 5% of their own net assets.

Why the 5% Look-Through Rule Exists

The look-through requirement is intended to promote transparency in reporting significant indirect investments, particularly when an investment fund invests in other funds. Under ASC 946-210-50-6, if a reporting fund invests in another fund whose underlying investments exceed 5% of the reporting fund’s proportionate net assets, those underlying holdings must be disclosed separately. The disclosure includes the name of issuer, number of shares or principal amount, and fair value of each holding. Long and short positions in the same issuer are reported separately.

For example, assume Fund X invests in two funds – Fund A and Fund B – each with exposure to Bitcoin. If Fund A holds a 2% proportionate interest, which is below the 5% look-through threshold and does not require separate disclosure on its own, and Fund B holds a 4% proportionate interest, their combined exposure of 6% exceeds the 5% threshold and therefore requires separate disclosure. The aggregation applies only to long positions, with short positions aggregated separately

Similarly, if Fund A holds Apple debt representing 3% of Fund X’s net assets and Fund B holds Apple equity representing 4%, both must be disclosed separately because they are issued by the same company, even though neither investment individually exceeds the 5% threshold.

The underlying principle is straightforward: when a fund allocates a meaningful portion of its capital through another investment vehicle, investors should have visibility into the exposures that allocation creates. The rule helps prevent concentration risk from being masked by indirect holdings.

Practical Challenges

Applying the 5% look-through rule can be operationally difficult. Obtaining the underlying holdings from third-party funds, particularly those that prefer to limit transparency, can prove challenging. The audited financial statements of the underlying fund would typically include a condensed schedule of investments, which doesn’t provide detail for positions under 5% of net assets.  When information is unavailable, disclosure of that fact may suffice under ASC 946-210-50-3.

For fund-of-fund structures, compliance requires consistent monitoring of NAV percentages, communication with underlying fund managers, and regular updates to disclosures as values change. While the process can be time-consuming, it remains a key component of sound financial reporting and investor transparency.

What about Investments Owned by Registered Investment Advisors and Registered Funds?

It is important to note that the 5% look-through rule applies to investment companies – not to the Registered Investment Advisors (RIAs) who provide advice to them. RIAs typically do not apply ASC 946 to their own corporate financial statements because they are not classified as investment companies under GAAP’s definition. Instead, they present themselves as operating companies, which do not include a Schedule of Investments or require a look-through disclosure for significant indirect fund investments.

Similarly, Regulated Investment Companies (RICs) are not subject to this particular disclosure requirement, even though they follow other ASC guidelines and SEC reporting rules. Just imagine if every RIA and RIC had to disclose the underlying investments of their investment fund holdings to the entire world, it might very well lead to some significant backlash.

Why It Matters

In an environment of heightened regulatory scrutiny, investor demands for transparency, and increasing complexity in fund structures, the 5% look-through rule remains a fundamental safeguard. For investment funds and fund-of-funds, it ensures that material indirect exposures are identified and disclosed, providing investors with a clearer picture of underlying risks.

Key Takeaways

Preparers and reviewers of fund financial statements should:

• Monitor indirect holdings regularly to identify exposures that may exceed the 5% threshold.
• Obtain look-through data when possible and document efforts when it is not available.
• Ensure that disclosures reflect both long and short positions accurately.
• Confirm GAAP interpretations and presentation with your professional service providers early in the reporting process.

By maintaining compliance with the 5% look-through rule, funds strengthen transparency, improve investor confidence, and reduce the risk of regulatory findings during audit review.