The transparency myth

If there were a ?buzzword of the year? award in private equity, there would not be much of a contest in 2001: ?transparency? would win it with ease. While the global private equity industry has spent the year wrestling with a whole raft of problems, no other stick has been used more mercilessly to beat it with than the fact that it remains by far the most opaque and secretive community in international financial services.

It is of course the bear market more than anything that has focused the mind of pundits and investors on the issue. When times were good, it didn't seem to matter how the industry went about its business. But now that distributions have all but dried up, investors are demanding a great deal more visibility.

Many general partners profess to having seen the writing on the wall

?There's huge pressure on private equity to open up, and it's coming from different directions?, says Mario Giannini, president of Hamilton Lane, the Philadelphia-based fund of funds manager. ?I'm not sure that general partners fully understand what's coming down.?

The debate is far from new. But assets under management in private equity have grown exponentially since the last market downturn, and many investing institutions have upped their level of exposure to the asset class so significantly that the current drag in performance is indeed extremely painful. That is why the tone of the debate has become fiercer, and why the agenda is controlled not by the private equity managers but their investors. Indeed, there now seems to be something inevitable about the idea that private equity will have to shape up or else, and many general partners profess to having seen the writing on the wall.

But exactly what such shaping up should mean is far from a foregone conclusion. Private Equity is populated by mostly fixed-life, non-reinvesting fund structures investing in notoriously illiquid assets that ultimately cannot be valued objectively. This, many believe, constrains the possibility of transparency in private equity relative to other asset classes.

Furthermore, it is generally agreed that to subject private equity funds to excessive public scrutiny and to disregard the long-term nature of their business can lead to misinterpretation of their performance. Most private equity investments take between three to seven years to bear fruit, and most funds have a total life cycle of more than a decade. A prematurely published assessment of the quality of an investment portfolio can lead to profound misjudgements, which will do unnecessary ? and unjustifiable – damage to a general partner's franchise.

The pain begins with the simple things
The real charge levied against private equity is that it has been using these constraints and idiosyncrasies as an excuse for rejecting altogether calls for greater transparency and better communication. The result is that, despite the boom of the late 1990s, private equity as an asset class has still won relatively few followers, and 99 per cent of the world's capital is put to work elsewhere. Now that the market is facing tough times, many of those with exposure to private equity are questioning the wisdom of having gone there in the first place.

Many industry practitioners believe that given its secretive nature, investors are right to treat private equity with caution. ?Investors can't be expected to invest in private equity on the assumption that they have to do all the digging for information to find out what returns are available. It's just very infantile,? says John McCrory, chief executive of UK fund of fund manager Westport Private Equity.

The point is echoed by Edmund Truell, the incumbent chairman of the BVCA and chief executive of Duke Street Capital in London. ?If you expect to be treated seriously as an asset class, you have to behave like one?, he says.

At present, many investors feel that they don't even have to go so far as asking the really serious questions about investment returns and fund performance in order to get frustrated at the lack of clarity on what goes on inside private equity partnerships. Says one: ?It actually starts with very simple things. When looking at funds I'm invested in, it is still incredibly difficult for me to find out how much I have committed, how much has been drawn down, and how much has been distributed.?

If reporting on basic events in a fund is one source of frustration, reporting on general partner compensation is another. ?It really should not be difficult to report exact numbers on how much general partners are making, and yet this area is almost totally opaque?, says Jon Moulton of Alchemy Partners. ?We have a budget approved by our investors each year as to how we run the place, but that's virtually unique in the industry.?

Controlling the agenda
It is in areas such as these that the industry's relative lack of maturity becomes most apparent, and it is here that some important improvements could be made at relatively modest cost. In terms of implementing change, many of the more transparency-minded GPs agree that it will be key for private equity to be seen as actively setting the agenda. ?We have to make some crucial changes, and it will be much better it they come about in ways that we as general partners can actually control, rather than the limited partners, or even the legislators, forcing change upon us?, says Truell.

A voluntary exercise in self-improvement will be particularly helpful when it comes to reporting on individual fund performance from general to limited partners. What makes this such a problematic area is not so much that the information in question may not be available at fund level. It typically is. The real problem lies in understanding how a given set of fund performance data has been calculated, what it is that the data is saying, and whether it can indeed be used to answer the questions investors are asking. ?To simply throw an IRR at investors without telling them how it has been worked out is completely meaningless. There are too many different ways of calculating it?, says Ivan Vercoutère, managing partner of Swiss fund of funds manager LTG Capital Partners.

Just how important it is for all parties to be clear on the methodologies underlying net asset value and IRR calculations was demonstrated earlier this year when CalPERS, the Californian public sector pension fund, took the unprecedented step of publishing individual fund performance data on its website. Following pressure from general partners, CalPERS eventually withdrew the data, allowing that the numbers had encouraged some potentially misleading face value comparisons between partnerships whose underlying characteristics differed fundamentally.

The much-publicised incident did much to push the question of transparency to the very top of the industry's agenda, but it also came as a reminder of how little is likely to be achieved until the industry adopts a common valuation and reporting standard. Unless investors can make sense of a set of fund performance figures without having to go through the small print of each one to understand what they represent, there is little point in calling for a greater degree of public disclosure.

US GPs are left to their own devices
In this respect private equity has a long way to go. In the US, still by far the largest private equity and venture capital market in the world, no guidelines exist as to how private equity funds should go about marking up or down the value of their underlying investments over time and subsequently report relevant changes to their NAV back to investors.

Without a formal framework governing this process in place, the flow of information from GP to LP depends almost entirely on the broader relationship that exists between the two. Leading institutions such as CalPERS that are looking to actively manage their exposure to the asset class tend to demand greater insight into the partnerships that they are invested in. As a result, they typically succeed in securing better access to relevant information close to the internal dynamics of a portfolio. As for GPs, it is the long-established private equity firms, funds owned by large financial institutions as well as newcomers looking to compensate for their lack of performance track record, that voluntarily report back to their advisory boards and investors on a quarterly, sometimes monthly basis. ?The larger private equity firms are beginning to develop a common methodology, with the captive players often leading the way?, says Giannini of Hamilton Lane.

The real problem lies in understanding what the performance data is actually saying

The voluntary reporting tends to be unaudited, but independent auditors are called in once a year to verify a manager's annual results. However, even then the GP's initial estimation of a portfolio's NAV, based on his valuation of the underlying investments, is the key determinant on the numbers that will eventually get published. ?In our experience, in the US, the independent auditors will not review the valuations of specific investments unless they are asked to do so, and they may question a major discrepancy in the overall valuation by the fund,? says Soody Nelson, managing director and head of Standard & Poor's Market Value Group which is responsible for rating private equity securitisations.

This means for the limited partners that there is a good deal of trust involved in the GP's commitment to valuing his investments in a reasonable manner, in other words one that reflects actual market conditions. According to Nelson, GPs have little incentive to excessively mark up their positions, because in the final analysis it is the market that at the point of exit will deliver an unambiguous message on valuation. Nevertheless it is a key issue whether ?an investment's value is marked up or down appropriately, and in a timely fashion?, she says.

Exactly what the terms ?appropriate? and ?timely? should denote in this context goes of course to the heart of the debate. ?Many GPs believe that the asset class is designed precisely not to mark to market, and that to force it upon private equity would mean to eliminate much of what it is meant to do for investors?, Giannini observes. The argument is that because of the long-term nature of private equity's approach to generating value, quarterly or even monthly reporting is not only meaningless, it constitutes a significant distraction from what GPs really ought to be doing, which is making and nurturing investments. The accounting anomaly of not marking to market should therefore be legitimate.

But not all general partners subscribe to this view. Says Truell: ?It's a lovely argument, but it's not what our customers want. Large institutions want to manage their investments from the top down, allocating 20 per cent here, five per cent there. They invest 99 per cent of their money in other asset classes, and they're not going to change their investment decision-making process for the sake of private equity.?

Truell's point touches on the difficulties many limited partners experienced after public equity markets tumbled and private equity managers were slow to write down the valuations of their holdings accordingly. As a result, many institutions ended up with the proportion of assets tied up in alternative investments exceeding the limits set by their allocation models.

To be sure, limited partners don't always consider the industry's slow reaction to changing conditions a problem. ?The issue of marking to market is a double-edged sword?, says Giannini. ?Many LPs actually like private equity precisely because GPs do not write down immediately when public markets fall. This can have an important diversifying effect on a portfolio.?

Diverging investor preferences aside, as long as GPs are left to their own devices when it comes to pricing and reporting, investors will find it extremely difficult to make meaningful comparisons between individual private equity managers and their performance. More importantly still, they will also have a hard time working out exactly what the asset class is doing for them relative to the other investment products that they're buying.

Removing the fear factor
In terms of developing a common framework within which such questions can be dealt with, Europe is a good deal further ahead than the US. Valuation and disclosure guidelines were first published by the BVCA in 1991 and, according to Truell, ?have become a widely accepted starting point that has been consistently applied for the last seven or eight years.? The European Venture Capital Association (EVCA) recently produced its own document. The two associations are currently co-operating on a review of their respective guidelines with a view to publishing a joint framework in 2002. Also on the agenda is the formulation of joint guidelines on reporting as well as a framework for calculating IRR.

Because putting a price on an unquoted investment is part art, part science, any guidelines that want to be pragmatic will inevitably give a broad range of reporting discretion. But application across the industry of a common valuation and reporting standard is easily the single most important condition for private equity to be able to move towards full disclosure of information, which is where the whole of the financial services industry is headed.

Full disclosure, which among other things would make possible the publication of meaningful performance league tables, is still of course a stomach-turning notion for many private equity practitioners, although the number of opponents to the concept appears to be shrinking. Insiders say that the members of the BVCA are currently split right down the middle on the issue.

?There is nothing to hide, the performance is there?

The current stalemate notwithstanding, Westport's McCrory for one has no doubt that the debate among GPs is moving in a certain direction and that a consensus is slowly taking shape. He says the industry will soon agree to move to full disclosure, if only because otherwise investors will continue to approach the asset class with the perception that fund managers are deliberately hiding bad performance. ?There is nothing to hide, the performance is there. If things are dealt with openly and results can be verified, the fear factor that people are fudging will be removed.?

Edmund Truell says that in the UK, more general partners are beginning to realise that their ?behaving in an institutionally acceptable way is giving them a competitive advantage over US funds in particular and to a lesser extent over European-based managers too.? If greater discipline in their dealings with investors will indeed give some GPs an edge when fundraising, it would seem a case of when rather than if their less processminded peers will follow suit.

Secondaries and securitisers drive change
But self-interest is not the only factor pushing private equity firms towards a greater degree of openness. The secondary market is gearing up for an unprecedented level of activity, as more and more limited partners are looking to sell on their interests. The intense due diligence at portfolio level that secondary buyers carry out when looking to purchase limited partner interests means that general partners will have to get used to actively co-operating with these buyers.

Another increasingly important channel for over-allocated pension funds and banks looking to take whole portfolios off their balance sheets is securitisation. Rating agencies and providers of capital insurance participating in the securitisation process will insist on very detailed, general partner-specific data during the due diligence process.

Urs Wietlisbach of Partners Group, the Swiss fund of funds firm which is a keen developer of private equity based structured products, says that in order to securitise private equity assets, a level of analysis is required that goes far beyond working through the aggregated performance data that is provided by commercial research organisations such as VentureEconomics or indeed the industry associations.

?The ratings agencies and reinsurers are comfortable with the aggregate data from sources such as VentureEconomics, as long as they are satisfied that people like us understand its validity?, says Wietlisbach. ?To run our modelling, we go to each individual investment in each partnership.?

What Partners Group takes away from this in-depth treatment is some very substantial knowledge about what a general partnership and its portfolio look like on the inside. ?We know much more about GP portfolios than other fund of funds managers, just because we are required to,? Wietlisbach notes.

Far from perceiving this kind of scrutiny as a nuisance, GPs are beginning to see the benefits that this can generate for them. Wietlisbach says that Partners can add value to partnerships by pointing them to other funds that have similar assets in their portfolios, which can lead to co-operation between them that otherwise might not have occurred.

The ultimate trade-off
So where is the private equity industry headed? Looking at the various proponents – some of which are in direct opposition to the old ways of doing things, other merely impatient to remove obstacles to new ways of unlocking value – it is hard not to feel that here is an industry about to be stripped of its longheld privacy.

The issue of transparency in private equity is in the process of being dealt with, even though there has not been much of a concerted effort made by investors pressing for change. It's a buyer's market, so if investors were to close ranks and jointly articulate their demands, GPs would be forced to react and much progress could be made very quickly. But concerted LP efforts do not have much of a track record in private equity.

One force that could make a major difference in this context is the Institutional Limited Partners Association (ILPA), the US-based international investor network whose more than 300 members manage over one trillion dollars worth of assets. Its chairman is Richard Hayes of CalPERS, who is well known to hold strong views as to what a more accessible private equity industry should look like. So far the ILPA has not flexed its muscles much, but many believe that it will, and general partner groups will be duly impressed once it does.

Sceptics say that investors are likely to let the current opportunity slip past them. Their argument is that once the market comes back and distributions begin to flow again, GPs will regain the upper hand by letting the chequebook do the talking. By that time, transparency will have been relegated to the second division of issues that need resolving.

Another possibly decisive question investors may have to answer before they deliver the kiss of death to private equity's opacity is how far they really want to push it. If the lack of visibility is one of the defining risk factors of the asset class, will removing it not make it harder to justify the higher returns that people are seeking from it? Investors may currently be in the driver's seat, but the ultimate trade-off they could well be facing is greater transparency, but lower returns. If in the final analysis this proves too bad a deal, transparency in private equity may remain an illusion, but this time by consent.