?When I think about our back office I think of a swan,? says one of the general partners at a large UK private equity firm that is currently managing a number of funds. ?Above the water we're gliding along looking pretty cool and unflustered. Look beneath the water though and we're swimming like crazy. Down in the engine room, everything's having to work pretty hard.? Welcome to the unglamorous but vital world of private equity fund reporting and administration.
As private equity has grown into a global asset class, ranging from multi-billion Euro funds to niche players with €100m funds, so various parts of the industry have evolved at differing rates. At its most basic, whilst front office components such as deal origination have grown into sophisticated business groups where often former investment bankers execute complex sales or acquisitions, the back office components such as portfolio tracking and limited partner administration (including that most important element, the capital call) have developed in a far more piecemeal and, most would argue, haphazard way. This is the case even with the large, well-established firms according to those who have spent time working with the back office teams at these firms. And when it comes to the newer, smaller funds you may well find as you walk in the door that the receptionist busy at her keyboard is preparing the capital call notices.
?I remember being introduced to a seventy something year old guy at this big buyout firm? recollects Steven Millner, a managing partner at DML, a New York-based firm that is helping bring some order to private equity firms' back office. ?He was their back office: most of the work was done manually and the information was largely in his head. He wasn't doing a bad job but you did get the sense that if something happened to him there would be a real problem.?
You don't have to be seventy years old though to have felt increasingly stretched if you have been involved in administering a private equity firms' funds. In the recent past, one critical factor was the increase in the number of investments each fund was making and the pace at which they were exited. In the late 1990s, and especially in relation to Internet companies, private equity firms were buying into businesses and immediately readying them for an IPO that delivered an exit sometimes within 12 months. As one then associate at a US private equity firm active in the dot com space recounts: ?We were buzzing: it seemed as if there was always at least one of our investee companies listing and stock distributions were a permanent process. Trying to keep track of what was going to whom when was a nightmare.?
Although deal flow may have declined from 2000, another part of private equity fund administration has been making life for back office personnel more complicated. When the music stopped and the dot com boom turned to bust, many more limited partners started to demand more information more often from their general partners. As Millner comments: ?GPs weren't the only ones wanting to know what exposure a fund had to a particular sector or company. The LPs were now much more interested too, and this had the phones ringing on GPs desks far more often. In the past this meant that the GP's secretary would field the call whilst the GP called down to get the LP's file bought up.?
It is much more likely too that the number of funds a private equity firm is managing and the number of LPs in each will have jumped in number. To illustrate: buyout specialists Cinven are approaching the close of their circa. €4bn Fund III with some 80 LPs booked in. And whilst Dutch private equity firm Gilde had just 4 LPs in its first buyout fund, this number had jumped to 28 when it closed its second €535m fund in August last year. As the swan-citing GP quoted earlier says: ?There are palpably more people you have to communicate with in today's private equity community and this has significantly increased the burden on private equity firm's back office systems and personnel. And there's also the opportunity cost of having your deal-making people getting caught up in this process too.?
Enter the software houses
This is where the software specialists see the opportunity to sell an end-to-end solution to private equity firms. Estimates suggest that there are over 4500 private equity firms worldwide and that this number is increasing (still) by a net 150 firms per annum, so the scale of the opportunity seems compelling. By delivering an integrated set of applications that can be web-based or run on intranets, these suppliers are quick to point out to stressed GPs that their existing systems can't cope. Vipul Minocha, vice president of engineering for the EquityEnterprise software system offered by US-based Relevant Equity Systems, says that there are typically three degrees of operational systems to be found in private equity firms. ?There are those who are trying to make an off-the-shelf accounting package work; then there are those who have gone down the Excel route and have often a collection of different XLS spreadsheets spread around the firm; and then there are those who have had a developer build them a one-off system that almost invariably has provided only a partial solution.?
?There are palpably more people you have to communicate with in today's private equity community?
The software providers are enthusiastic because they find plenty of processes inside private equity firms that can be centralised and automated. Few aspects of the front or back office at a firm can be counted outside the remit of a centralised database system. All of the systems available therefore encourage the client to automate front office tasks including fundraising, deal management, investor relations and contact management. The same is offered for back office tasks such as fund administration, portfolio management and the generation of quarterly reports. Next into the mix comes the various fund structures many firms are now operating: beyond the standard limited partnerships and corporate structures set up there are often parallel vehicles, feeder funds and co-investments to manage also. And then you have the added dimension of non-domestic investments and investors to deal with: here a system that is set up to deal with multi-currency tracking becomes a significant value-add.
Talk to any developer of these systems and it's clear that the logic of increased efficiency, closer operational integration and enhanced transparency seems irresistible. As Don Winger, founder and CEO at Analytx, a New York-headquartered software company delivering administration solutions to private equity firms, reveals when describing how the Analytx systems can handle fund accounting, these are sophisticated products: ?A user has the ability to create an unlimited number of sharing ratio schemes, per fund, that automatically calculates based upon committed capital, paid-in capital, or the current capital balance. You can also create tiered allocations such as a split of the gain from stock distribution using separate ratios. And the system will automatically pull and allocate valuations from the investments module with all the supporting detail.? Systems such as Analytx also let users set up their own levels of security (partitioning information to enable different levels of access), and they typically work with all the mainstream operating systems (Windows NT being the most obvious).
Efficiency and transparency?
But how far can they go? News in December last year that one of these firms, San Francisco-based Round1, had collapsed after having received $22m of private equity investment, suggested that life was not proving that easy for these firms. As Winger at Analytx comments: ?It has been a difficult year for the private equity industry and for us too. Operations at 110 Wall Street, blocks away from the World Trade Centre, were suspended for weeks after 911. And there have been development and market issues that we've had to deal with ? but we're on our feet and growing? (the firm now has offices in London and Hong Kong as well as across the US). A number of factors can be discerned as having made life more difficult for the software houses. Competition is one: there are still at least half a dozen firms pushing their own specialised software solution to the private equity community. Another factor is market conditions: now is not a great time to be encouraging a GP to invest tens of thousands of dollars in user licences when his portfolio is looking distinctly under par. Also relevant is a more fundamental philosophical aspect: maximising transparency via enhanced systems and technology is where operational methodologies and strategic objectives at most private equity firms can collide. Winger at Analytx calls it ?managed transparency.? He is referring to what, as well as how, private equity funds are reporting to their limited partners.
Transparency in private equity continues to be a hotly debated topic. As the heady days of 1999 and 2000 turned into a restive 2001 when funds had to reveal at times spectacular write-offs, so the need to deliver coherent information about your investors' positions became far more urgent. How transparent the GPs were able to make their funds has been at the centre of this debate. Some detect what they regard as reluctance on the part of the GPs to deliver timely information ? more than one LP has found out about an investment made by ?their? fund from the media before hearing anything from the fund itself. Others point out that timeliness is never easy ? the GPs will often not advise their LPs until an investment offer has been formally acknowledged and the media will often pick up on a rumour far sooner. And when it comes to reporting portfolio performance many will point out that such information is inevitably flawed on account of the difficulty of valuing the private companies that make up a fund's portfolio.
That said, there is a groundswell of opinion amongst the LP community that is asking for more reliable and more manageable information from private equity firms. As this month's America Monitor reveals elsewhere in this issue, the Institutional Limited Partners Association (ILPA) is beginning to flex its muscles and one thing it is clearly keen to push for is a set of standards when it comes to the quarterly reports LPs receive from their GPs. A telling illustration of why this groundswell is occurring involves state pension giant and extensive private equity investor CalPERS which receives approximately 200 reports every quarter in as many different formats from the private equity firms it has invested in. Besides making it much more difficult to analyse the information, there is the more practical burden of having to capture and re-input the information and data from the different firms. An easy to use and manipulable report that follows some standard guidelines regarding what is reported (besides how its reported) appeals hugely both to LPs and to the software suppliers.
One issue that has been resoundingly dealt with has been the means to deliver this information. The software firms have developed sophisticated reporting packages expressly for private equity firms to use when releasing information to their LPs. Analytx, for example, has developed its Venture Complete system to let all parts of a private equity firm feed a master database with information which in turn can deliver a host of special reports and tools for both in-house and external users. The firm's Venture Web LP product has been developed expressly to let a private equity firm publish information quickly and effectively for its LPs. Yet as Winger, the firm's CEO, points out, ?our clients (the GPs) still want to make sure that they manage the information flow (to LPs). Total transparency is not on the agenda, for the moment.?
Al Foreman, Director of Business Development for Equitrak, another private equity information management system developed by New York-based Vitech Systems Group, Inc., confirms that providing a technically powerful system is only part of the answer. ?We have gone for an open architecture for our system because, although there was commonality for a majority of the functions required across the industry, the two key areas of reporting and calculations had to be customised from firm to firm.? In other words, when it comes to producing reports for internal or external consumption, and when the metrics determining IRR or hurdles or waterfall payments have to be integrated into the system, no two private equity firms are the same. And it is this absence of standardisation that makes life much more complicated for the system providers and also encourages some to suspect that private equity still lacks the orthodox rules and methodologies that are the hallmarks of a mature asset class.
Many are quick to point out though that private equity is not a mature asset class. It was, until the 1990s, and to use Harvard's Professor Josh Lerner's phrase, a ?cottage industry.? And just as Lerner has argued that IRR is no longer an adequate measure to use when calculating fund performance (see last month's PEI), so people like Bowman and Winger argue that the back office systems used by most private equity firms are outmoded. The question remaining is to what degree private equity firms consider the automating of their work processes to also be the means to standardise the format and content of information flowing from the firm to its investors.
Post script: now turn to this issue's Asset Class column (page 11) to read how a group of LPs and GPs are teaming up with a software house in an effort to create a set of reporting standards for the private equity industry. The first steps towards delivering transparency via technology look like they have been made. PEI will track and report on their, as well as others', progress throughout.