The private equity market has grown at an unprecedented rate in recent years. It is also evolving quickly, perhaps more so than any other sector of the asset management industry. This has put pressure on operational requirements that historically have been much simpler for private equity firms than for most other types of investment organisations. This is no longer the case. To take a closer look at this increasingly challenging operating environment, SEI recently surveyed more than 200 professionals at private equity firms, institutional investors and consultants.
The regulatory environment is one area that almost everyone agrees is becoming more complex. The implications are profound enough that 30 percent of the GPs in our survey said compliance comprised their single biggest operational challenge. Regulatory compliance is also becoming a more expensive proposition. More than four out of five GPs (83 percent) say compliance costs are rising faster than other operating expenses. Almost half (47 percent) said they were rising much faster.
An increasingly complex web of regulations challenges many private equity firms. This is particularly true for firms operating globally. The Alternative Investment Fund Managers Directive (AIFMD) has exhaustive reporting requirements for private equity firms in Europe. Form PF is now required by the Securities and Exchange Commission (SEC) of firms in the US. The Foreign Account Tax Compliance Act (FATCA) obliges firms to provide accountholder information to the Internal Revenue Service, and other organisations are also looking for similar types of data.
As daunting as these changes are, however, further challenges lay ahead. There is the potential for tax reform, including the treatment of carried interest. The rules for marketing and solicitation continue to evolve. And the definition of accredited investor is up for debate. Most firms recognise that compliance will continue to become more complex. The smart ones will prepare for even more audits, exams and enforcement going forward.
Further challenges stem from increasingly influential investors. Large institutional investors in particular are wielding more clout, clamouring for greater transparency, negotiating lower fees and arranging for customised investment products. Their demands have taken on greater urgency over the past year, with the SEC warning about inappropriate expenses and CalPERS revealing that it could not adequately track fees paid to private equity managers.
Meanwhile, deeper and stricter due diligence is becoming the norm. Almost two out of three LPs (63 percent) in the survey say they are intensifying their operational due diligence efforts. Many are bolstering their internal capabilities, while others are reporting that they have engaged independent consultants to carry out due diligence.
Investor demands are also reshaping data and reporting standards and pressuring the bottom line. Almost one in five PE firms (19 percent) in the survey say data management has become their single biggest concern. A similar number say investor reporting is their single biggest operational headache. Data exists, but in many cases does so in silos, and PE managers are often found lagging their hedge fund counterparts in integrating and utilising data from various systems. There is potential for it all to be brought together to generate meaningful insights, but this proactive approach has to date proven to be beyond the capabilities of most firms.
BLURRING OF LINES
Another source of growing complexity is the increasingly diverse investment landscape. Traditional approaches including co-investment, direct investment and separate accounts continue to dominate, but they are increasingly joined by more liquid options. The secondaries market continues to grow, as taboos fade and trading is facilitated by the proliferation of intermediaries and exchanges.
There is also a blurring of the lines with other asset classes. Venture capital, for example, has long been viewed as a distinct asset class managed by specialists. That distinction is fading as VC firms invest in more mature entities while more private equity firms are getting involved with early stage companies.
Meanwhile, hedge funds are launching products with committed capital and are therefore administered like PE funds. It is debatable whether there will even be a meaningful distinction between hedge and private equity funds as separate asset classes 10 years from now. The more important differentiators may be fee structure and commitments.
Perhaps more fundamentally, the term private equity itself is becoming a misnomer. As direct lending vehicles continue to take market share from banks, private debt is increasingly being heralded as a cornerstone of many private “equity” firms’ growth strategies.
Even as all of these transformative trends force private equity firms to re-examine their operational capabilities, heightened competition is driving them to differentiate themselves from the pack. Some are placing greater emphasis on tracking, analysing and disseminating operational metrics in an attempt to optimise the value of their portfolio companies. Others are working to produce customised reporting that better meets the needs of their limited partners.
These types of initiatives mean that data management is viewed more and more as a potential source of value. Combined with the challenges outlined above, they also mean more complex business models. In the past, private equity back- and middle-office functions were often handled by a skeleton staff using spreadsheets. In today’s world, these functions are seen as a critical part of the process that can make or break investor due diligence, client satisfaction, regulatory compliance and competitive returns.
This shift has private equity firms looking to bolster their staff with operational specialists, acquire more sophisticated technologies and increasingly partner with external firms that offer access to best-in-class operating infrastructures.
THE OUTSOURCING OPTION
Traditional processes – which are often performed manually – are stressed by growing complexity. Some firms find that their existing staff do not possess the requisite expertise, but they also face a growing talent shortage when they try to locate and hire the necessary personnel. Working with an outsourcing firm can not only provide the required experienced staffing leading to a reduction in errors, but it can also save time and potentially money. What can be a laborious and distracting chore for private equity firms can be done accurately, efficiently and cost effectively by experts who are tasked and equipped to do that very thing on a daily basis.
Scalability is another benefit. There is demonstrable appetite for funds managed by smaller or emerging firms, but while they may have the desirable investment track records, they are less likely to have a robust operational infrastructure in place. An external partner with a good industry-wide reputation not only allows the investment professionals running the firm to focus on their portfolio management jobs, but also provides a level of comfort to existing and potential investors.
Large managers, on the other hand, may already possess operational expertise and infrastructure, but there are many excellent reasons for even these firms to work with an outsourcing firm. These include the ability to monitor complex investment strategies, handle customised portfolios and accommodate the increased blurring of asset classes and investment vehicles.
NAVIGATING NEW FRONTIERS
The industry is likely to sport a growing number of diversified, multi-strategy managers. The embodiment of the convergence we’ve seen across the investment landscape over the past decade, these complex organisations require an array of systems, platforms and processes to handle their various strategies, vehicles, securities and investors.
However, unless they can solve the riddle of that additional complexity, large diversified firms may struggle to compete successfully against more specialised outfits. Most survey respondents took this view, with the majority of GPs, LPs, and consultants united in predicting that specialist firms were more likely to be competitive than diversified firms going forward. That being said, even firms maintaining relatively simple business models are unlikely to escape the additional complexity resulting from more competition, demanding investors and assertive regulators.
Being successful in this environment means effectively navigating the new operational frontier. Expertise, resilience, scalability and flexibility all need to be embedded in people, processes, systems, and security. For many private equity firms, this will mean leveraging the expertise of specialised partners and plugging into state-of-the-art platforms.
Giles Travers is a director within SEI’s Investment Manager Services division based in London, with a focus on European private equity and alternative investment funds. He can be reached at firstname.lastname@example.org
This article is sponsored by SEI and first appeared in PEI's Fund Administration supplement, published in June 2016.