While it’s interesting to note that private equity managers outsource their administration and back-office work at a much lower rate than managers of other asset classes, such as traditional long-only investors and hedge funds, a closer look reveals that there are also big differences between American and European private equity managers.
In fact, one might say that there is a continental divide when it comes to outsourcing, with European managers far more disposed to externalising their back-office functions than their US peers. “In the US, only a minority of private equity managers will outsource administration, whereas in Europe it is almost the rule,” says a major European institutional investor. For the rest of the world, according to Preqin, it is estimated about 30 percent of administration at private equity globally is outsourced. In addition, analysis by PwC suggests non-US managers are more likely to outsource than US firms.
The reason for this divergence is fairly straightforward. The US regulatory regime is less exhaustive and dogmatic than that of the European Union, while the EU’s institutional investor community is more sensitive and uncompromising when it comes to managers who self-administer their portfolios, citing that the practice can lead to conflicts of interest.
There are also differences between US and EU accounting processes for private equity, and although this seems to be changing, it is still an open question as to whether the US and European ways of doing business are converging.
Despite the core challenges of Brexit and the instability of Italy’s debt-laden banking system, European-focused private equity strategies are growing, with managers anticipating strong future returns from the region. Bain & Company found that private equity funds focused on European buyouts recorded a 16 percent increase in fundraising in 2016, bringing flows to $53 billion, whereas funds favouring North American buyouts grew only 3 percent to $106 billion.
US private equity funds may be further motivated to seek out EU mandates and investors because of local market issues. Domestic managers must consider US political risk while realising that the risk can be mitigated through a diversified client base.
“EU investors have different expectations than those in the US, especially when it comes to their awareness of and support for the use of independent third-party providers”
European institutions have a long track record of supporting private equity, and US managers are redoubling their fundraising efforts in the region, resulting in a robust European private equity fundraising environment. Invest Europe, an industry association, reported that fundraising in Europe hit €74 billion in 2016, a 37 percent increase over 2015 and the highest level recorded for the region since 2008.
As Europe looks more attractive from an investment and investor perspective, US managers may have to adapt their operational processes.
EU investors have different expectations than those in the US, especially when it comes to their awareness of and support for the use of independent third-party providers. US allocators are generally comfortable with managers performing valuation and net asset value calculations internally, but this can be a deal-blocker for EU institutional clients.
Outsourcing tasks related to regulatory and operational requirements lets fund managers focus on the corporate transactions and potential investment opportunities that feed the bottom line. Furthermore, by delegating these tasks to independent, third-party providers, managers can offer end clients extra assurance that best practices and standards are being followed.
Of course, managers remain liable for what goes on in their operational processes, so while outsourcing may relieve them of most compliance work, they must still provide proper oversight to their service providers.
Another major distinction between US and EU private equity involves accounting practices, especially as they affect the waterfall distribution structure. Put simply, a waterfall is the method by which distributions are calculated and shared between general partners and limited partners. So how does it differ east and west of the Atlantic?
In the US, the carry is paid on a deal-by-deal basis. Some argue that this method encourages short-termism, as it does not account for future transactions and their profitability. Clients assume more risk, although clawbacks can be initiated if subsequent deals go badly wrong.
In Europe, the carry is paid at the end of the fund’s lifecycle instead of on a per-deal basis. This makes distributions more equitable overall, with managers taking on a greater share of the risk.
Recently, more US funds have begun embracing the European approach, spurred by limited partner demand.
Historically, US managers reluctant to incur the costs of doing business in Europe have focused primarily on the domestic market. But Europe is currently showing signs of promise, and some US managers are reimagining their business strategies to take advantage of this.
As US managers increasingly explore investment and fundraising opportunities in Europe, they will need to make some meaningful operational changes to their businesses, including appointing independent service providers and revising their accounting practices. While this will bring costs, it will also create opportunities, and it is certainly something US private equity funds should consider before pursuing more European capital. Undertaking such measures will contribute to the growing convergence between European and US private equity operating models.
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