Regulation will spur outsourcing

Firms looking for outsourced service providers should asses their abilities to address upcoming regulations.

Although private equity firms in the US have generally not outsourced fund operations as much as their European counterparts, they may find themselves under increasing pressure to do so both to reduce costs and to appease LPs demanding greater transparency. Add to this a need to more efficiently deal with new regulations coming down the pipe. 

Until recently, private equity funds have only grown larger and more complex. Now, just as firms are looking to cut overhead, the market finds itself at the cusp of the introduction of more expensive firm-management functions than ever, in part due to unprecedented government initiatives.

Because of this, the CFO of a firm with $5 billion in capital said he expects more firms of all sizes to be more geared towards outsourcing in the future. In agreement, the head of accounting for a financial advisory firm added that outsourcing may be especially ideal for smaller firms or those just starting out in the market, especially at times like this when deal flow is challenging.

“You might not have a lot of investment opportunities, and you may have built a team internally and have five or six team members without much to do in the current environment,” he said. “If you have an outsourced relationship, from a cost perspective you should be able to sit down with your service provider and have a conversation about the activity and having a flexible model from a resourcing and pricing standpoint.”

Not surprisingly the reliance on outsourced service providers is more advanced among hedge funds, many of which are relatively small. Beyond the back office, a growing number of hedge fund managers have been giving unprecedented powers to third-party administrators over investments, according to the Hedge Fund Law Report. In order to demonstrate their commitment to compliance and best practices to investors, some firms have given their administrators authority to block trades outside a fund’s mandate and liquidate the fund if it is down more than 10 percent a year.
 
Likewise, some predict that private equity firms will begin giving outsourced firms influence over a lengthening list of functions in the front, mid and back offices.

Spanning all three areas is technology. One of the biggest operational considerations is the type of technology a provider uses, rather than using Excel or Word to handle their business which is fraught with error, said William Rouse of financial outsourcing firm Geller & Co.

A number of established private equity software and systems providers are “very strong systems and are tested in the market,” he said. “The key is selecting technology that has a lot of functionality and can do administration like capital calls and distribution and sending out correspondence. The more functionality you can build into the technology, as well as reporting capabilities in case a GP or LP wants a specific report for accounting purposes, that’s the outsource provider you want to select.”

Phillip Ratner, also with Geller, says that speed in responding to a query from a client or GP is also essential, and even if there is no answer yet some sort of response should be sent within an hour. The financial advisory accounting head agreed, adding, “I need to feel like it is not going to take hours to get back to me, that’s where outsourcing can really break down. You want to be a priority even after the honeymoon phase when the contracts have been signed.”

Crucially for our times, in evaluating the quality of staff, firms should bear in mind the proposals coming out of Washington. An administrator should be able to handle upcoming regulatory issues, examine the challenges involved with the new instruments that the private equity market is investing in and be up to date on issues like SAS 70 auditing compliance.

“What you’ll want in any administrator is the ability to follow the reams of impending legislation and be able to make sense out of it, provide the client with what they need to do and be able to look at what’s coming down the pipe and give some guidance, because many private equity firms don’t have that expertise in-house,” said Deb Yamin, senior vice president of alternative investments strategy and product management at financial services provider State Street. “Institutions investing increasingly in the private equity segment are asking for that type of expertise from their funds and the administrators that their funds employ.”

However, firms shouldn’t go into it thinking that outsourcing is a catch-all answer. Rather, they should understand that each function that gets moved outside requires different considerations. “The first thing a private equity firm needs to do is be thoughtful on a function-by-function basis and understand what the trade-offs and potential benefits are,” said Boston Consulting Group senior partner John Rose. “That leads you to creating relationships for each function with a small set hopefully of providers because one of the critical issues is knowing who you are working with and to outsource under the right conditions.”