Fri, 19/02/2016 - 13:41
Private equity managers are finding that increased demands for transparency from their LPs are requiring them to change their mindset, especially when it comes to sharing information on how assets are valued.
LPs are doing more due diligence, asking PE managers to explain why they value a target company at, say, 8X EBITDA, and a comparable non-target company at 10X EBITDA. In effect, LPs want to get more involved in the valuation process. This is the new normal that all alternative fund managers are waking up to, and in part, it is being driven by the onset of regulation.
As PE managers become more open with LPs, this is helping them to get more comfortable with the prospect of structuring regulated fund structures under AIFMD, where the valuation policy has to be closely adhered to and clearly communicated to investors. In that respect, the fund administrator has a vital role to play, particularly as they will often also provide depositary lite services, where maintaining a clear oversight of the fund’s activities is paramount.
“We separate out the two sides of the business: administration services and depositary services. However, they certainly keep a very open line of communication between each other,” says Jim Cass (pictured), SVP and Managing Director, SEI Investment Manager Services. “With AIFMD, the requirements continue to get more stringent relative to how assets are classified either as financial instruments or other assets. The valuation policy sits underneath.
“At SEI, rather than opining over a specific valuation, we prefer to be objective in the valuation process, and actively ensure that the procedures are not deviated from and the inputs that the manager uses to calculate the asset’s valuation are closely followed and adhered to.”
The SEC is paying closer attention to how PE managers calculate valuations and expenses in their funds. Last March, the US regulator filed charges against Patriarch Partners for not adhering to the valuation methodology outlined in the PPM. Transparency and evidence of robust, consistent valuation policies and procedures, especially if a PE manager is running on onshore variant of an offshore structure, has become very much the order of the day.
“Regardless of whether you’ve got a managed account, an offshore fund, or an onshore fund: the valuation policy has to be consistent,” says Ross Ellis, Vice President and Managing Director of the Knowledge Partnership in the Investment Manager Services division at SEI.
“Regardless of the kind of fund structure created or strategies managed, whether it’s a PE fund or a hedge fund, the SEC is going to be interested about what valuation policy is being applied to come up with the fund’s NAV, and where conflicts of interest may arise, particularly those that have the ability to negatively affect investors,” adds Cass, who confirms that SEI is seeing more clients asking them to produce what is known as an NAV confirmation letter. This provides a breakdown of where each of the assets in a fund lie within the FASB 157 guidelines (Level 1, Level 2 and Level 3). All Level 3 assets are priced based on ‘fair value’ given their illiquidity and with respect to Level 3 pricing, LPs want to know how much has been independently verified by an administrator; a trend that is set to continue.
“With respect to private equity and real estate, there are two core items our clients and prospects have increasingly been focused on: the firm’s overall valuation policy, and what the right level of expenses is that should be borne by the fund versus the management company (‘GP’). We’ve seen that PE firms are increasingly interested in outsourcing some of their accounting and back office processes. Additionally, fund administrators such as SEI are being asked to help determine with managers (and their legal team) what kind of expenses can be run through the fund versus the management company. They know that the regulators are keenly focused on this and they want to get ahead of it and ensure there’s a well-thought out process that can be supported,” confirms Cass.
Regulators increasingly want to see that PE managers are sticking to their valuation policies. Should a manager deviate, for whatever reason, they need to ensure they have answers as to why they made certain choices when valuing assets. Some fair value assets are highly subjective. A manager might have information about an asset that gives him good reason to discount it, or price it at a premium. Either way, documenting those reasons and making sure that there is a clear rationale is becoming increasingly important.
This is not, however, just PE managers responding to growing regulation. Many are choosing to outsource valuation processes to gain a competitive advantage over their peers and show to investors that an independent set of eyes is involved.
“It should be noted that the disclosures and transparency managers should provide in order to stay competitive in the marketplace aren’t just driven by what a regulator wants; they are also driven by sophisticated institutional investors who want to understand exactly how the manager values the assets before making an allocation. They are seeking as much data as possible so that they can make more insightful decisions, not just regarding the specific PE or hedge fund, but how that investment fits into and correlates with other investments in the overall portfolio.
“As part of our job as a fund administrator, we need to make sure that our clients are following valuation policies in a correct and consistent manner. Our clients find these checks and balances useful and an important part of the process,” says Cass, who continues: “As an administrator, we always want to review the offering document to ensure that it is applied consistently for each of the fund’s LPs.”
As Ellis points out, everything has to be defendable.
Most well run private equity groups don’t manage their portfolios to accommodate the regulators; they do it to accommodate what is best for their investors and provide them with the right level of transparency. “LPs are asking for the same things the regulators are asking for, so a lot of the operational policies are being put in place to do the right thing, to attract and retain investors while complying with all applicable regulations,” says Ellis.
Given the long-term nature of PE funds, it is no surprise that LPs want to understand valuations and expenses before they allocate capital. Most Level 3 valuation policies are based on what is the deemed exit price but Cass says that for a lot of illiquid assets it is very difficult to come up with a valuation six months into a deal “that might take a lot longer to liquidate. It puts managers in a bit of a conundrum sometimes coming up with what they feel is a fair value when the time horizon for the investment is so long. PE firms are increasingly using valuation specialist agencies to assist them in making their valuation policy more robust.”
To underscore just how important reporting has become to LPs, a new survey by Ernst & Young (Disruption: A seismic shift in the private equity industry) found that when investors were asked what they were most concerned with, beyond track record, 45 per cent said reporting; that compares with just 11 per cent a year earlier. Some 77 per cent of investors said that transparency would improve the reporting they receive, whilst 60 per cent referenced timeliness.
From the GP’s perspective, regulation is clearly having an impact. Asked whether they had been subject to a regulatory audit or examination in the past two years, the percentage of those who responded ‘Yes’ rose from 28 per cent in 2013 to 47 per cent in 2015.
These findings all point towards a change in the operational set-up that PE managers are having to adopt. Previously, they were left to focus on managing their portfolios and delivering returns. Although still highly favoured among investors, PE fund managers must now go a step further and combine strong performance with greater insight into how they manage those portfolios. This is largely down to improved technology and a desire today, across all industries, for people to consume data.
Not that PE managers are responding to this transparency challenge by fully outsourcing their valuation processes to external parties. Many of them have extremely strong operations teams in-house. What is now happening is that fund administrators are being utilised to ease the burden and bring operational scale to bear:
“At SEI, we have a lot more insight and inputs because we work with many managers that may invest in a similar fashion to one another. But we realise that there is a nuance to everybody’s portfolio management style and the positions they take on various matters and you have to respect that. They might come up with very logical reasons for why a valuation for a similar asset should be different to one held by another manager. That is perfectly acceptable as long as it can be well-documented and supported.
“It’s around making sure they can justify individually how they come up with those valuations; whether or not they used the correct inputs is something an administrator can assist with,” states Cass.
One of the consequences of using external valuation specialists, whilst maintaining a firm’s internal valuation methodology, is that it creates the potential for disagreements over Level 3 asset prices. What is important in any such arrangement is that the PE manager and the third party price the asset(s) in full accordance with the valuation policy that the fund has been approved to use. This creates a unified approach and ensures that the manager is sticking to the valuation guidelines set out in the PPM.
In some ways this is helping PE managers adopt best practices. The vast majority would never think of misleading their LPs, but by having an independent set of eyes overseeing the valuation process, it at least demonstrates that the manager has the LPs’ best interests in mind. Moreover, it helps those PE managers who are thinking of expanding their business model into the regulated fund space to get used to the idea of working with an administrator and depositary.
“Although there are regulations in place to protect investors, we have a duty to ensure that if we are calculating valuations that want to be used for end investor reporting purposes, we do so diligently and accurately; we take that role seriously,” says Cass. When asked whether he thought more PE managers might establish regulated funds as they get comfortable outsourcing valuation processes, Cass responds:
“I definitely think there is a lot more market acceptance to the stringent requirements in Europe; it’s the new normal. Managers are getting more familiar with AIFMD and the role of the depositary. Our clients are having more conversations over introducing a regulated fund as a distribution trigger to gather fund assets from European investors. The one thing we’ve seen consistently among our clients is that they do not like the ‘if you build it, they will come’ philosophy. They all realize the inherent difficulties in raising assets, especially in countries away from their home base, so they focus first on the wants and demands of their desired investor base, then determine the most relevant and potentially successful distribution strategy before they decide on the vehicle that makes sense for that region.
“The cost of business is going up but all that means is that managers have a clearer understanding of the hurdle rate they need to overcome to make the right level of profit margin.”
SEC enforcement cases, such as that against Patriach Partners, are likely to increase going forward. It is therefore incumbent upon PE managers, and indeed all alternative investment managers, to think about how to strengthen their operational processes and improve the level of transparency with their investors. It could, in the end, become a key point of differentiation.
In conclusion, Cass thinks that when examples are made of managers cutting corners or not doing things the right way, it encourages the rest to up their game.
“You certainly don’t want to be made an example of and found out as the firm not following the proper guidelines, whether it is in the press or by the regulators directly. When these stories break it is sometimes good for the industry as it offers up the opportunity to recalibrate one’s valuation policy. The SEC has the obligation to enforce the rules and penalise those not doing so. One of the administrator’s responsibilities is to ensure that the manager follows the rules so that it never gets in the regulator’s crosshairs,” concludes Cass.
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