A significant aspect of any private equity investment is trusting the manager to make the right decisions. It is, after all, why investors pay fees. But how far should that trust relationship be tested? And how much transparency should managers be expected to provide, in order to appease their investors?
This is a tricky question to answer but it is, perhaps, becoming more pertinent as investors look at the global economy slowing, and start to think about how they would manage liquidity in their private equity portfolios. If a recession were to hit tomorrow, how would they expect managers to respond?
In a 2020 LP survey Private Equity Wire produced with SS&C Intralinks, 182 global LPs were asked how satisfied they were with the level of transparency provided by alternative fund managers (not just PE). A score of 1 meant ‘Excellent’, whereas a score of 5 meant ‘Needs to significantly improve’. The average score was 4.3 – in other words, ‘could do better’.
In addition, one third of survey respondents cited portfolio and risk analytics as their biggest technology need, suggesting that investors are looking to do more work internally to manage their portfolios and keep on top of the details – not easy when GP transparency is apparently lacking.
“During the 2008 global financial crash when everything on the screen was flashing red, the biggest challenge for investors was determining what they owned, what was happening to what they owned, what the flash reports were on those investments, and getting quality communication from their GPs,” says Andrea Auerbach, Global Head of Private Investments, Cambridge Associates LLC.
Technology and analytical tools have improved significantly over the last decade. When investors were faced with liquidity decisions in 2008, and calling their GPs to find out how portfolio companies were performing, the problem was that either: a) managers themselves didn’t have good information; or, b) the companies were in free fall and they didn’t want to tell investors.
“One of the themes we have been communicating to our clients for a while now is ‘You need to be prepared’,” says Auerbach. “You need to understand which scenarios might play out in a downturn and to what extent you would need to make adjustments to the portfolio to have more cash on hand, and to start telling GPs you need operating metrics and ask, ‘Do you have the ability to tell me this information now?’”
In Auerbach’s view, the 4.3 score referenced above should serve as a red flag, not just to PE managers but to all alternative fund managers: “Step up your game, it’s 2019. If we have another bump in the road, I’m not going to expect any excuses from managers.”
As investors look at how their investments are performing in a late-stage cycle, they want as much granular information as possible. But this can only go so far.
“It’s important to show investors what’s going on in the portfolio, to a certain degree, but there is a limit to how much information we can share. If the investor is a co-investor in the asset, however, that is a completely different story.
“We report on how we are creating value in each asset in the portfolio. As long as we can display that, that is the most important thing,” says Andrew Harrison, Head of Investor Relations at Silverfleet Capital.
The quality of fund reporting is key to how much transparency an LP feels they are getting from their managers. In the SS&C Intralinks survey, when asked what is most important when selecting a manager at the pre-allocation stage, the quality of fund reporting was, on average ranked fourth out of five, with the caliber of the portfolio team by far the number one consideration.
This raises an interesting dilemma: if a manager is delivering exceptional performance, does it matter if their technology or reporting capabilities are in the ‘could do better’ category? Probably not.
However, when all the dials start spinning wildly again in the next economic recession, if GPs don’t have good IT infrastructure and good technology analytics on their underlying investments, the LP relationship(s) might start to fray.
“With respect to newer managers (who weren’t around during the last financial crash), when we are engaging with them and evaluating them, the question we ask is: ‘How much information are you gathering?’ New managers, by definition are next generation, and for some, having the capability to see portfolio information on their mobile devices and flash reports is important to them.
“So I think next generation managers will have greater, more immediate transparency for themselves, which should then translate into greater transparency for their investors,” suggests Auerbach.
At Silverfleet, Harrison is in no doubt that technology has helped the firm to improve its analytical capabilities to build insights on portfolio companies.
“We use systems that our portfolio companies report into, providing all their financials on a monthly and quarterly basis,” confirms Harrison. “All of that data is centralised and different KPIs are reported; financial KPIs, ESG-related KPIs, headcount KPIs. It means that if we have certain questions from LPs, we can access those data points from the database system.
“This helps us create bespoke reporting if need be, in addition to producing our quarterly reports.”
At Cambridge Associates, they have added portfolio and risk analytics software to their platform and in Auerbach’s view, this capability is fast becoming a necessity for LPs because they need to know what they own and what the portfolio is doing (in terms of performance).
“Now is a great time for LPs to be asking for information from their fund managers because when there’s more volatility in the market, I suspect it will be harder to come by,” opines Auerbach.
It helps that reporting best practices, such as those championed by the Institutional Limited Partners Association (ILPA), allow GPs to standardise reports in a way to address transparency concerns among investors. But not all firms are readily embracing it. Some 67 per cent of LPs in the SS&C Intralinks survey confirmed they had seen no increased use of ILPA reporting among GPs.
At Silverfleet, however, they have embraced ILPA reporting from day one.
“By default, I think managers should be reporting in the way that ILPA advises them to. We follow this as a bear minimum and in addition we do our own bespoke analysis and reporting – getting insights on certain markets we are working in,” says Harrison.
The reason for this is that LPs have become far more sophisticated. Many of Silverfleet’s investors have specific investment programmes with pre-defined parameters and guidelines. As a result, they need to understand what is going on in certain markets and sectors Silverfleet is operating in because it impacts on how they run these investment programmes.
“I think they are looking for a bit more than a standard report telling them what the portfolio is doing and what the fund’s assets are marked at. While it sets a good level of guidance, our investors expect something beyond an ILPA-type reporting mechanism,” concludes Harrison.
