Private equity outsourcing can lead to meaningful partnerships
For any private equity fund manager, choosing to outsource the accounting and administration role is a significant decision. But there are benefits to doing so and it can lead to achieving operational best practices, as was discussed in a webinar session on 13 March 2018, hosted by Private Equity Wire in conjunction with Gemini.
The webinar, entitled “Achieving Operational Alpha in PE Fund Administration,” featured: Dominique Severino, Partner, Orthogon Partners, a New York-based alternative asset manager specialising in esoteric assets; Dennis Schall, Partner, Alternative Investment Group, Marcum LLP, a full service accounting firm, and David Young, President of Gemini Alternative Funds, LLC (‘Gemini Alt’), a US fund administrator and part of NorthStar Financial Services Group LLC.
The panel was moderated by James Williams (pictured), Managing Editor of Private Equity Wire.
Setting the scene
If one looks back at the last 12 months with respect to PE, there is reason for optimism. Total AuM is now USD2.83 trillion, and follows a 12-month period of fund raising environment during which USD453 billion in aggregate AuM was raised by more than 900 funds, surpassing the USD414 billion raised in 2007.
Private equity now has nearly USD1 trillion in dry powder – that’s a lot of money to put to work. And whilst there is undoubtedly strong investor demand, investors are likely to become even more discerning in whom they allocate to. They want to be confident that GPs can put all that dry powder to work in a high valuation marketplace.
“Can GPs apply their investment expertise without getting distracted by non-core investment activities?” asked Williams.
Leave it to the experts
Part of the ODD process today is to look for evidence that managers are indeed focused on the task at hand. This has led to an increased adoption in outsourcing. Whilst it has been underway for a number of years in Europe, with PwC estimating that 70 per cent of European PE firms now outsource, the figure is still only 30 to 40 per cent in the US.
“When you partner with the right third party firm, you get a level of operational expertise at an efficient price, and that allows asset managers time and resources to focus on their core strength – the assets,” said Severino. “As an emerging manager, we are limited in the number of hires we can make. By outsourcing the fund’s administration functions, we get access to a whole team of experts that live and breathe this subject matter 24/7. Not only do they have the latest industry knowledge and the most innovative technology, they also have lots of practice applying it across their many clients. That is very beneficial to us.”
Time to focus on deal making
The more help a PE manager gets from trusted partners the more effective the front-office can be in terms of sourcing deals and generating the best possible performance in the fund for investors. Managers get help with investor relations dealing with capital call letters, capital contributions, cash flows coming in and out of the fund: multiple operations that help emerging managers in particular, who may not have a full compliment of staff to do those things.
“Another aspect is giving comfort to investors,” commented Schall. “They know the fund manager is focusing on the business and that the cash is going to the proper investments they are making because they have a third party monitoring cash flows. Moreover, it gives comfort to the auditor. I look at not only if a PE manager has an administrator but at the quality of administrator and my pricing is adjusted accordingly. I can’t afford to have an audited financial statement with my name on it that’s wrong.
“If I have to spend more time fixing what the administrator didn’t do correctly it’s going to cost the manager more on the audit and tax side.”
Young summed it up succinctly when he said that over the past five years, PE managers have developed more controls and incorporated operational best practices in order to preserve and expand their allocations from institutional investors. “They are compelled to continue to evolve their operating models to keep pace with the wider asset management industry,” he said.
The webinar audience was asked to vote on this and the results were emphatic:
Q1: DO YOU THINK IT IS ADVANTAGEOUS TO OUTSOURCE THE ADMIN FUNCTION OR TO KEEP IT IN-HOUSE?
YES – 96%
NO – 4%
This would seem to suggest the outsourcing trend is now becoming a more established pattern of activity. Crucially, it is not something that institutional investors are tending to frown upon, as they understand perfectly well the economic and independent oversight advantages on offer.
“The PE manager should be focused on sourcing investment opportunities, evaluating potential transactions, valuation monitoring and management of the current portfolio and establishing clear and consistent lines of communication with LPs.
Then the service partners bring their areas of expertise to the table: the attorneys, auditors, administrators and so on. We have specific focus areas and expertise that we apply to the operations of a fund to make a better overall offering to the limited partners,” said Young.
Partners not providers
The point about being partners rather than providers is crucial in terms of understanding how managers can achieve operational best practices. Not only does it require trust, it requires working in clear channels of communication with all service partners, so that everyone knows what is being done.
“They shouldn’t be afraid to speak to each other to ultimately benefit the fund manager and their end investors,” argued Schall.
This mindset of making the administrator an extension of the manager’s operations team has helped Orthogon Partners reassure its investors. It is able to demonstrate how the fund’s data is being secured, that there are proper controls in place, and that a second pair of eyes is monitoring cash in the fund at all times.
“We work with the administrator to customize schedules and reporting to meet our investors’ needs.
“Investor standards are high in this market, and we want to give them what they want. Investors want to see an appropriate level of expertise, and they like to see that we are being cost efficient. However, they also want to be sure we are not sending their information to outside sources that we have no oversight on.
“At the end of the day they want to see evidence of interactive involvement between our team and our appointed service partners,” explained Severino.
Transparency of process
The word that gets used most frequently in the outsourcing discussion is transparency. This can be a bit of a double-edged sword because at times it goes undefined.
Young said that in his opinion, what investors strive most for is the depth and clarity of process: whether that is the process that a PE manager goes through in building the portfolio, monitoring the portfolio, or the process that gets outsourced to the administrator.
“Whatever the process might be, investors want to understand it and what it is every one of the individuals involved with the fund is doing,” he said.
This can prove hugely beneficial when GPs are looking to improve the lines of communication with their investors, such as the style and frequency of fund reporting. It’s important for any service partner to have a level of adaptability in order to adjust to the exact needs of a fund.
Asked whether outsourcing had helped Orthogon improve the level of communication with its LPs, Severino responded:
“Outsourced partners do help as they can provide a level of standardization to reporting. Administrators have hundreds, if not thousands of clients, and have a level of consistency to the details used in fund reporting based on experience. In that sense, having a third party involved definitely helps us to improve our level of communication and transparency.
“Ultimately, you have to get information to investors in the format they want. We are very transparent and dynamic with our reporting. We edit our standard reports based on questions and feedback from our investors, rather than completing different templates specific to each investor, so we are innovative and efficient in that regard.”
Young agreed that ILPA has done a great job of filling a gap and identifying key information in a standard template that GPs can avail of. “Standardisation is becoming more prevalent,” he said.
Regardless of whether the GP is receiving standard reports or particular customized reports, it is ultimately their responsibility what gets communicated to the end investors.
“Our clients see the information. They have a pulse on everything that is going on,” added Young.
As Schall was keen to stress, no manager can outsource their fiduciary responsibility to investors:
“Service partners are there to assist you in the reporting process but the fund manager is ultimately responsible for the financial statements and any other communications with investors. Outsourcing simply helps managers achieve this in a more efficient, cost-effective way.”
The audience was then asked a second question, and the results were as follows:
Q2: WHAT DO YOU THINK IS THE KEY ADVANTAGE TO OUTSOURCING?
COST EFFICIENCY – 48%
EXPERTISE – 90%
SECURITY OF INFORMATION – 33%
The audience was allowed to pick more than one options, hence why the numbers added up to more than 100 per cent.
Severino agreed with the audience that expertise is a key advantage. She caveated this point by saying it was dependent on what stage one’s firm is at.
“Any firm looking to outsource is doing so to gain expertise and for somebody to help them do something they can’t do themselves,” she said. This is a more particular concern for smaller and emerging managers than the very largest blue-chip names.
Young added that technology prowess was also an advantage to partnering with the right administrator. He said that at Gemini the focus is always on its clients’ specific needs and not providing a generic product offering but rather a tailored product offering.
“There are many nuances in PE funds: unique calculations for waterfalls, distributions, tracking committed capital. All of those elements differ across the PE funds landscape. We’ve ensured that our product offering is specific to each client,” said Young.
This reaffirms the partnership point and something that any PE manager looking to outsource for the first time should consider; having confidence in someone’s technology and security capabilities will go a long way to assuaging fears over a loss of control when internal functions move to an external party.
The final question in the webinar was as follows:
Q3: WHAT DO YOU THINK WILL BE THE KEY DRIVER FOR CONTINUED OUTSOURCING IN THE PE SPACE OVER THE NEXT FIVE YEARS?
REGULATORY COMPLIANCE DEMANDS – 67%
LP PRESSURE – 78%
PRODUCT COMPLEXITY – 39%
NONE OF THE ABOVE – 6%
Asked to conclude with their own views on how they see the outsourcing trend continuing to evolve, the panel responded as follows:
Dominique: “I definitely see the trend continuing among PE funds as they look to leverage additional expertise. I feel I couldn’t market to investors without saying I had an administrator. They want that second pair of eyes.”
David: “LP demand and desire for consistency of information will continue to drive funds to service partners. It creates better efficiency in the fund by allowing the fund manager to focus on what they do best, which is finding alpha-generating opportunities and delivering a superior product to their investors.”
Dennis: “I think over the next three to five years the outsourcing percentage figures in the US will get close to what they are currently in Europe. The cost of an audit is 35 per cent more if you don’t have an administrator. It’s not a luxury anymore, it’s a necessity and investors are demanding it.”