By Simon Beedle, Director, Private Equity Services
Private equity fund administration outsourcing is a trend that shows no sign of abating, as managers continue to face mounting regulatory obligations and growing transparency demands from their institutional investors.
Currently, approximately 20-30% of private equity and real estate funds outsource their fund administration. Although this may seem like a small portion of the industry compared to the 90% of hedge funds outsourcing, this is a significant increase from previous years. The adoption of outsourcing as evidenced in eVestment’s Alternative Fund Administrator Survey 2015 found private equity and real estate Assets under Administration (AuA) grew by 23.7 per-cent over the course of 2014. While overall AuA is lower than that of hedge funds, private equity is rapidly turning to third party administration.
The reasons for the adoption of outsourcing are varied, but investor demand, regulation and complexity of the industry are three leading drivers.
Perhaps one of the most significant is investors are asking for separation of duties and built-in transparency to the accounting and reporting process. This helps to protect investors’ interests within the framework of the limited partnership agreement and allows private equity firms to focus on their core competencies – the effective management of investments and safeguarding of capital.
Institutional investors are reassured by the independence and quality of reports that a third party administrator provides, particularly in light of the number of financial scandals over the past decade, such as Bernard Madoff. Historically, private equity had a reputation for opacity but the clout of institutional investors means such attitudes are fading.
Transparency will continue to be a focus for general partners with recent headlines generating more public awareness and putting additional pressure on the industry. The SEC has been very active in recent months, following its May warning to the private equity industry about overcharging investors with inappropriate fees and expenses, including the misallocation of “broken deal” expenses.
On July 21, a coalition of State and City Treasurers and Comptrollers sent a letter to Securities and Exchange Commission Chairwoman Mary Jo White asking for new regulation requiring more transparency and greater frequency in disclosing fees and expenses to limited partners. The letter, sent by representatives from 12 states and the District of Columbia, came shortly after the California Public Employees’ Retirement System (CalPERS) revealed it cannot track what fees have been paid to its private equity managers.
Not lost on most is the timing of this letter and the uptick in activity from the SEC. July 21, of course, was the five-year anniversary of Dodd-Frank.
These headlines – CalPERS and the coalition letter – are just a handful of examples of the uptick in attention being given to transparency.
Whether or not the SEC responds with new fee reporting requirements, investors and general partners are sure to adopt new practices in response to the media attention. More detailed reporting on a quarterly basis is likely to become the industry norm, and we can expect to see investors continue to be vocal on the regulatory front.
Clearly it is not just investor demand driving the paradigm shift towards outsourced back office solutions. Regulation is having a monumental impact on private equity operations.
Recent headlines aside, the private equity industry has already been adapting to stricter regulatory guidelines that increase reporting responsibilities. The European Union’s (EU) Alternative Investment Fund Managers Directive (AIFMD) requires private equity firms to submit a highly detailed Annex IV regulatory report, which contains more than 300 data points covering nearly every aspect of the business. This is in addition to the Form PF, which must be supplied to the Securities and Exchange Commission (SEC) as mandated under Dodd-Frank. These reports are time-consuming for funds to compile in-house.
Managers must also report details of U.S. accountholders directly to the Internal Revenue Service (IRS) or indirectly via their own national authorities under the Foreign Account Tax Compliance Act (FATCA). There are a number of additional tax reporting obligations taking effect including the UK FATCA and the Organisation for Economic Cooperation and Development’s (OECD) Common Reporting Standard (CRS), which seeks to facilitate accountholder information sharing across a number of signatory states.
Outsourcing these reporting requirements to a third party administrator saves time and money for managers. It also diminishes the risk of operational errors. To date, many private equity firms have relied on manual approaches to data collection, often through Excel spreadsheets. Utilizing a service provider that is well-versed in these regulatory requirements and can offer a market-leading technological infrastructure, skilled personnel and expertise, reduces managers’ reliance on antiquated systems and minimizes the risk of mistakes creeping in.
Complexity & Asset Class Growth
Meeting growing investor and regulatory demands will be challenging for private equity houses if they elect to internalize this work. It will require significant investment in people and technology, and this could prove a distraction to running a profitable business, particularly as fee pressures are growing.
With an influx of capital across the asset class lifting the overall assets under management, firms will benefit from being able to focus on staffing for investment, deal flow and business development rather than back office.
For small managers, such an investment in human capital and technology can be a major impediment and a potential hindrance to further growth; whereas, outsourcing this work to an administrator can provide immediate scalability. Spinout funds from larger firms represent a significant percentage of the smaller managers turning to third party fund administrators. There is clearly investor interest in these smaller firms. Coller Capital recently surveyed 113 limited partners and found that more than half had invested in multiple first-time funds since 2010. With no historic returns for these firms to point to other than performance as part of a previous fund, being able to partner with a third party administrator can help spinouts gain a competitive advantage in the due diligence process.
Equally, larger managers are also recognizing the virtues of outsourcing to administrators as their organizations become increasingly complex and diverse with a number beginning to adopt hedge fund strategies – something that is leading to a blurred line between the asset classes. Recent fundraising data from Dow Jones shows that in the first half of 2015, four of the industry’s largest funds raised a collective $35 billion, while 23 funds raised $1 billion or more each. With that amount of capital being put to work, diversification, and complexity, of investment strategies is likely to grow. Firms will need the technology and expertise to support this level of complexity and customization. For many, third party administrators are the most efficient solution.
No Slowing Down
It is clear the private equity industry has seen a lot of growth in recent years and has become an increasingly competitive asset class. A record amount of capital is being deployed, and along with it investors are becoming more vocal and regulatory bodies are watching activity more closely. Firms of all sizes are adopting practices to become more transparent and efficient in their reporting to gain a competitive advantage.
With all of these factors at play, private equity fund administration outsourcing is not a temporary phenomenon but a trend that is likely to proliferate going forward.