This article is sponsored by Ocorian.
How would you describe the current level of administrative outsourcing in private equity?
Europe has historically had a high level of outsourcing compared to the US, largely due to the expertise required to manage the different rules in individual member states. However, on both sides of the Atlantic, we are now seeing a greater expectation that the fund manager focuses on its core areas of expertise rather than getting distracted by ancillary functions.
The fund manager needs to focus on its client relationships at one end and on maximising the value of its assets at the other. The challenge is that in between those two pillars, there is an awful lot of hard work that needs to be done.
The GP has to decide whether to take on that complexity itself, which can be costly and can be a headache, or to rely on third parties. We have certainly seen an increase in the desire to outsource over the past decade. Indeed, in a survey of alternative investment managers we recently completed, 72 percent of respondents acknowledged that outsourcing would play a more central role for the fund manager over the next three years.
What role has technology played in these outsourcing decisions?
There is great interest in deploying technology to make everybody’s lives easier, but if you want to deploy technology effectively, it is invariably expensive. For a fund administration platform, for example, you then have the ongoing expenditure to maintain the system, keep it up to date and train staff to use it. Increasingly managers are deciding to leave the running of operations to experts that can spread the cost of that technology over many clients.
An overwhelming 99 percent of respondents to your survey predict that further regulation is on the way. What do you think the nature of that regulation will be and how will it impact outsourcing trends?
First, there is the blanket regulation that affects us all – the Foreign Account Tax Compliance Act and the Common Reporting Standards, for example. We are still in the starting gates when it comes to those initiatives. Right now, they represent a data collection exercise for the jurisdictions concerned. The next stage will be for those countries to decide what they are going to do once that data is available to the authorities. I think there is a definite possibility of further regulation there.
Then, of course, there is the Alternative Investment Fund Managers Directive. The consultation for AIFMD II began in October last year, and we are now awaiting the outcome. I suspect we will not see a complete overhaul of that regulation. It will more likely involve bringing member states’ interpretations of the regulation closer together. I think there will be a focus on improving how passporting works, particularly as it pertains to pre-marketing and the different interpretations of reverse solicitation. Overall, I think the mood music suggests we will see a less stringent approach and it will be helpful if member states can align so that everyone can approach fundraising in the same way.
What do the changes we have seen around substance rules mean for administrative outsourcing?
The changes that have taken place with the Base Erosion and Profit Shifting standards and the substance rules that various jurisdictions have implemented have led to a significant change in the way funds operate, particularly with regards to directors on the boards of the GP. A typical structure might have a fund manager who acts as the advisor to the board of an independent GP with that board made up of directors unrelated to the advisor. We are increasingly seeing boards where the fund manager has no control or ownership of the GP, so it is truly independent. I’m a director on two pan-European fund boards where the shares in the GP are held by a charitable trust.
Overall, the trend towards outsourcing regulation and compliance is pronounced, which is why we have been investing in this area, with the recent acquisition of two specialists, Newgate Compliance in the UK and Platinum Compliance in Guernsey. That side of the business is growing on the back of enhanced regulation and the need to have strong compliance functions to ensure managers meet their ever-changing obligations.
Increasingly, those obligations also include sustainability or ESG factors. How do you see that evolving?
The momentum behind tackling climate change is clearly a hot topic and one that is being driven into the fund management world today. Obviously, we have the EU sustainable finance regulation coming in this year. That is predominantly aimed at funds with a sustainability agenda, with all other funds classified as neutral.
It will be interesting to see the extent to which that impacts capital flows into funds offering those environmental credentials and the extent to which we start to see other fund managers playing catch up and starting to monitor and report on their environmental credentials as well. The process of recording and demonstrating sustainability is going to take a lot of time and effort and so is another area where outsourcing is likely to increase.
The survey also points to the importance of efficiency for fund managers. How should an administrator respond to those demands?
The average size of funds raised is growing. That means more investments being undertaken and more investors making commitments. All that brings with it added complexity, requiring a sophisticated administrative response, including both human capital expertise and technology.
That is not necessarily going to be cheap. You need to consider your definition of efficiency. Anyone who has run a second close equalisation on Excel will know what a painful experience it can be, for example. We have an equalisation engine that, more or less, involves just pressing a button. That ensures investors’ interests are correctly recorded in the general ledger of the fund and that the mistakes we may have seen 10 years ago are not made today. For me, that equates to efficiency.
What else are managers looking for in an administrator?
The starting point has to be depth of understanding of the underlying asset. We employ a lot of accountants and lawyers that sit as directors on our clients’ boards, providing the substance, management and control that a jurisdiction may require. They also bring the ability to interpret the deals being presented to them for approval. According to our survey, 89 percent of respondents feel that having a fund administration partner that comes up with proactive ideas to help their business succeed is important. Therefore, having a pool of asset-specific professionals to draw upon is of massive benefit to managers.
In addition, you need experience in running a fund and understanding how fund operations works. Having a robust fund administration system is, of course, vital. Finally, there is the important compliance and regulation component that I have mentioned. Fund managers are extremely focused on ensuring things are done in the right way. For example, investors need to be onboarded efficiently, but also meet the regulatory hurdles that a given jurisdiction has around know-your-customer checks. Managing that process can be hard work and getting it wrong can have serious adverse consequences. It is critical to work with a fund administrator that has a strong compliance function.
Does the administrator become even more important for newer managers?
Yes, I think so. There is a clear trend towards investors committing capital to fund managers that have a strong track record. Those managers typically find it easier to raise their next fund. However, there are also new teams that may be spinning out of well-regarded houses that do not have that readily attributable track record or mature operating model. There are real advantages for those types of firms to partner with an administrator, so that they present potential investors with a robust operating model, rather than just relying on their own expertise.
How do you see administrative outsourcing evolving?
There is potential for more outsourcing to third parties across multiple functions, including compliance, fundraising, accounting and corporate governance. These services can be provided by a single administrator in their entirety, or they can be broken up into their composite parts.
I believe we will see an increase in a bespoke approach, where the administrator sits down with the client and works out exactly what is required of them, rather than providing a standard product offering. Fund managers themselves are increasingly developing bespoke operating models and administrators need to recognise that it is not a case of one size fits all.
What role are LPs playing in outsourcing decisions?
We are seeing more and more outsourcing of accounting work. In fact, our survey revealed that 76 percent of respondents expect to outsource accounting in the next three years. That is not being driven by compliance, but rather reflects the rapid increase in investors demanding more information, more quickly, and in ways that suit their purposes rather than generic reporting. It is an area we have been heavily focusing on over the past five years.
We have developed a model where we can do the number crunching and then provide clients with an electronic file that can be uploaded to their own system. They do not have to re-key, but still get the benefit of that granular data that they can cut and splice to aid decision-making. Those managers that can provide that level of information in an easy to digest format for LPs will find it aids their ability to fundraise.
Download Ocorian’s full funds research report ‘Navigating COVEXIT: Do fund managers need an operational diet?’ at www.ocorian.com/act-with-clarity