General partners are under mounting operational pressure. From greater regulatory scrutiny and increased demands from investors to a whole array of complex data management issues, the scale of the operational challenge has increased by leaps and bounds over the past few years.
That is one of the key conclusions from SEI’s latest survey of the private equity industry. SEI polled more than 200 industry participants including general partners, limited partners and consultants to try to gauge where the private equity industry is headed.
The results paint a picture of an evolving industry embracing new opportunities as assets expand at an unprecedented rate: an astonishing 133x rise in assets – from $30 billion in 1995 to $4 trillion 20 years later.
Growing pains are perhaps to be expected. But what also emerges are some very specific operational challenges as regulatory pressures build, with compliance regarded as the biggest issue (see chart).
More than eight out of 10 GPs say compliance costs are climbing faster than other operating expenses. Two out of three LPs say they are increasing operational due diligence when hiring a new manager.
And data management is proving to be a vexing challenge. One out of three LPs now expect GPs to provide for data mapping in their portfolio monitoring systems.
What is the scale of this operational challenge and is outsourcing one of the answers?
Private equity is subject to considerably more regulation than in the past, a development that has profound implications for the competitive landscape. In its 2016 private equity survey, EY found that 47 percent of private equity firms in 2015 were subjected to a regulatory audit or examination over the previous two years, compared to only 28 percent in 2013.
The growing compliance burden is directly reflected in higher costs, with fully half of the GPs SEI surveyed saying that compliance costs are climbing “much faster” than other operating expenses.
Not unexpectedly, GPs operating globally are more affected by the growing compliance burden, since complexity and cost can multiply exponentially when dealing with multiple jurisdictions.
The Alternative Investment Fund Managers Directive (AIFMD) has exhaustive reporting requirements for private equity firms in Europe. Form PF is now required by the SEC of certain firms in the US. The Foreign Account Tax Compliance Act (FATCA) obliges firms to provide account holder information to the IRS, while the UK equivalent regime, commonly known as UK CDOT, performs a similar function in the UK’s crown dependencies and overseas territories.
The rollout of the Organisation for Economic Co-operation and Development’s Common Reporting Standard (OECD CRS) is more than just an enhanced version of FATCA and firms cannot just simply upgrade their current systems to comply.
As daunting as these changes are, however, more lay ahead. There is the potential for tax reform. 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.
GPs are running into more scrutiny from LPs in addition to regulators. Two out of three LPs surveyed say they are increasing the level of operational due diligence they perform when hiring a new manager. Many of these are building out their internal capabilities, while others are engaging independent consultants to bolster their due diligence efforts. Investors are now much more likely to ask for information not covered by standard due diligence questionnaires, focusing considerable attention on areas like cybersecurity that might have been overlooked in the past.
Investors have varying expectations of their fund managers, depending on their size, experience and relationship. Virtually all LPs expect quarterly reporting and almost as many expect GPs to provide financial statements. Two thirds of LPs expect reporting to meet Institutional Limited Partners Association (ILPA) standards.
One out of three set the bar even higher by insisting that GPs provide for data mapping into their portfolio monitoring systems. Those interested in this level of integration may currently be in the minority, but it is likely that their ranks will grow, especially as systems providers increasingly position themselves as being able to accommodate these requests and investors take a more holistic view of their portfolios.
Data management has also proven to be a vexing challenge for many firms, particularly as they face growing pressure for customised reporting. Data in many cases resides in silos and private equity managers appear to be lagging their hedge fund counterparts in integrating and using data from various systems. Some hedge funds are, for example, looking beyond data management to think about the additional value that can be extracted from data. Predictive analytics are being called upon to turn data into actionable insights that will allow fund managers to improve risk management and performance attribution. This has the potential to boost operational efficiency and create a competitive edge.
Many operational challenges are exacerbated by recent structural changes in the market. Most participants agree that the most obvious change has been the rising level of transparency. There is more visibility into risk, operations, performance and valuation than ever before. All of this is happening against a backdrop of lower fees. Fee pressure and transparency demands from large institutional investors are changing how data and reporting are handled across the industry, pressuring the bottom line at many funds.
Institutional investors are not the only ones pressuring managers to change. The predicted influx of wealthy individual investors will also leave a mark on operating models. High-net-worth individuals increasingly expect all parts of their portfolios to be accessible by transparent, secure, online reporting. Effectively servicing these investors will necessitate the development of portals and automated reporting tools. And when private equity enters the individual retirement space, watch out, as investor protection will bring an added burden to GPs.
The growing number of strategies managed by some firms is further stressing their operating infrastructure; compliance is rated the single most challenging aspect of managing a more diverse set of strategies.
Scalability is also proving a challenge, a problem that more firms will need to address if the market grows as quickly as predicted. Interestingly, GPs are least concerned with the quality of outsourced services available to them or any potential challenges involved in administering loans. Responses to the SEI survey show IT budgets are clearly focused on addressing the operational challenges highlighted by survey participants. Data management and compliance are top priorities.
So is outsourcing the answer? GPs are finding their traditional (and often manual) processes under pressure from growing business complexity. This is a critical issue for GPs facing deeper due diligence with less leeway and begs the question of which functions should be performed externally. Compared to other asset managers, private equity firms continue to perform many more functions in-house. Outsourcing has made inroads, but is relatively rare outside of custody, tax and accounting.
Some firms find that their staff lack the requisite expertise, but they face a talent shortage even when they try to locate and hire the necessary personnel. Working with an outsourcing firm can provide not only the required experienced staffing likely to lead 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 equipped to do it on a daily basis.
Improved workflow and more scalable processes are also compelling reasons to partner with outside service providers. Even firms that already possess operational expertise and infrastructure benefit from the enhanced ability to manage data, monitor complex investment strategies, handle customised portfolios and improve investor reporting.
This is not a time for “business as usual”. Regulators and investors are expected to pressure fund managers to improve their systems and processes. As GPs face greater competition and heightened scrutiny, they run the risk of falling short of new standards for excellence. As the stakes grow, important choices need to be made over investment focus, data handling, outsourcing partnerships and myriad other factors that could mean the difference between success and failure.
This story is sponsored by SEI and appeared in the Fund Administration Special 2017 published in Private Equity International in June 2017.