When it comes to managing mounting workloads, private equity offices find they need outside help.
The demands on today’s back office bear little resemblance to those of the pre-crisis days. From the need to keep up with complex regulatory requirements to new structures, bespoke LP-GP agreements and investors asking for look-through transparency on fund portfolios, the complexity of running a private equity firm and its funds has increased exponentially. Where once spreadsheets might have sufficed, now data collection and reporting requires much more sophisticated systems and processes.
For some, mainly the larger global asset managers, the answer has been to build large accounting, reporting, compliance and legal counsel teams, coupled with significant IT outlays. Yet for many others, the financial and risk management cost of running a back office entirely in-house is becoming increasingly prohibitive.
In a 2016 SEI survey of GPs, 82 percent said compliance costs were rising faster than other operating expenses, including half who said they were rising much faster. The same survey asked LPs about their expectations and found that 66 percent now expect firms to report according to Institutional Limited Partners Association standards and just less than a third require data mapping into portfolio monitoring systems – a level of granularity that would have been unheard of just a decade ago.
“Investors are increasingly looking for transparency in private equity as though each LP had its own fund,” says Cesar Estrada, head of private equity fund services at State Street. “Providing detailed information on portfolio company and fund performance would be challenging enough if firms were managing just one type of closed-ended plain vanilla fund, but these days, private equity comes in all kinds of packaging, making reporting ever more complex.”
Despite these increasing demands, the industry has so far been slow to adopt outsourcing models in many areas. While custody and tax functions are now outsourced by over half of private equity firms, according to the SEI survey, many other areas are still done in-house. Yet this is changing.
“The [Alternative Investment Fund Managers Directive] and the [Foreign Account Tax Compliance Act] are having a big impact,” says Chris Merry, chief executive of Ipes, a fund administrator. “In the mid-market we’re seeing firms consider outsourcing to keep up with regulatory and tax developments. The fact, for example, that AIFMD requires authorised firms to have a third-party depositary means that some firms are having to talk to service providers like us for the first time. It’s a foot in the door.”
Daniel Essoo, senior director of fund administrator JTC, agrees. “AIFMD in particular is prompting many firms to review their operations and revisit how they manage back-office functions,” he says. “This is a huge driver for new business for fund administrators, in particular as the directive hasn’t been rolled out in a recognised way across Europe and so keeping up with different jurisdictional requirements is a challenge. Many firms are having to restructure how they operate.”
The other key driver for outsourcing certain functions is pressure on management fees. As the traditional two-and-20 model has increasingly become subject to negotiation by LPs, the ability of some firms to build expensive human resources and invest in in-house IT systems has reduced. By contrast, fees paid to third parties including fund administrators and other outsourcers are drawn from the fund rather than from the management fee in most instances.
All these trends appear to point towards the increased uptake of outsourced fund services over the long term – and not just among the mid-market and smaller players. “Larger firms tend to build out their own teams in today’s market,” says Paul Lawrence, global head of funds at Intertrust. “But as third-party fund administrators continue to become more professional and their capabilities increase, we’ll reach a point where even the larger firms outsource a significant part of their fund administration, including compliance and risk management, because these will not be viewed as areas that add value to the firm as a fund manager – they’ll start to critically evaluate the cost-effectiveness of doing all back-office functions in-house.”
Yet there is still some way to go before in-house becomes obsolete. By their own admission, fund administrators and other third-party services providers are unable to provide the complete package for private equity. Part of this has to do with the origins of many in the market.
“Different fund administrators come to the market from different angles,” says Giles Travers, director of alternative investment funds at SEI. “You’ve got the banks, who have historically provided custody services to hedge funds, but who have started to move into private equity; the smaller independent boutiques, which tend to have a professional services background; and then you’ve got players like us that are global outsourcers, but whose origins were in fintech provision.”
As a result, consolidation is a big trend in the fund administration business. Some of this is driven by private equity investment in the sector, as the fragmented nature of the business and strong cashflow characteristics make the industry an interesting buy and build play, while others have listed to raise capital for acquisitions. Earlier this year, JTC acquired New Amsterdam Cititrust and, in April, Estera completed its deal to acquire Morgan Sharpe Administration.
Consolidation is not the only story, however. The industry is also having to adapt by investing heavily in IT and different skillsets to provide the kinds of services private equity firms need now and in the future. The development of new technologies is disrupting many industries and fund administration is starting to see this, too.
“We’re in the early stages of this, but as an industry, players are required to invest in technology and search for ways of making better use of data to automate processes and deliver more cost-effective solutions to clients,” says Lawrence. “This is evolving, but we need to get to the point where firms are confident enough in the resilience of the data and systems that they don’t need to shadow the processes at their end.”
Part of the issue is that there is currently no single technology solution that meets the needs of the constituent parts of the private equity business, requiring administrators to stitch together different systems to create a platform that works across, for example, all the accounting needs of a firm.
The next stage, says Travers, is integrating operational systems in a way that provides future flexibility. “We are developing a platform that can be agnostic to the type of product or vehicle structure that private equity firms offer,” he says. “Yet we also need to continue to solve today’s issues of how to provide transparency on workflow, such as compliance with FATCA and CRS, automate more processes and enable GPs to provide a better experience for their investors.”
This clearly requires a shift in the type of staff required by fund administrators. Many, for example, are bringing in experts to do the heavy lifting around IT systems. “As an industry, we are hiring more technology people,” says Essoo. “Yet unlike hedge funds, we’ll always need a high degree of human interaction in private equity because of the bespoke nature of the investments – they are all different. Even if automation increases, we’ll still need people; it’s just a question of what they do. I think technological developments will increase the value that fund administrators can offer at a human level.”
So, while fund administrators aren’t yet claiming to be all things to all firms, there is clearly a lot to play for in private equity. Total assets under administration grew in 2016 to $2.16 trillion, a 44 percent increase from 2015, according to eVestment figures, with growth in private equity business among administrators expected to be by far the highest of all alternative fund types.
Fund administration is changing – and it’s changing quickly. “Our industry is having to adapt to meet and preempt the changing needs of our private equity client base,” says Merry. “There is a lot of growth potential, but we do have to ensure we are ahead of the curve to benefit from that – competitive pressure is a lot higher now than it used to be.”