Fund Administration Special
As LPs continue to diversify their alternative portfolios and fund structures flourish and transform, what are investors looking for in their GPs? Investment expertise and all of its components are, of course, critical and core to a manager’s competitiveness. But a survey of alternatives investors by SEI suggests that operational expertise is not only needed to deliver investment results but also to deliver an improved and personalised client experience, which is of vital importance and adds to a GP’s competitive advantage.
Transparency, for example, continues to be a critically important consideration when investors evaluate funds and managers. More than half of all investors in the survey say it’s an extremely important factor, with the remaining 46 percent agreeing that it’s important. The trend towards greater transparency is well established, but expectations continue to outpace reality. Only 19 percent of investors have seen significant changes to transparency over the preceding three years. And while portfolio manager access is viewed by virtually all investors as an important aspect of transparency, there were very few who say they have seen significant changes in their level of access.
The truth is that many investors remain dissatisfied with the level of transparency available to them. Their frustration extends across a number of areas, but is particularly acute when it comes to operating expenses, which three out of four investors say are not transparent enough. Only 25 percent of investors are pleased with existing levels of transparency surrounding operating expenses, compared to 67 percent of GPs in our earlier survey who say they are sufficient.
This disconnect is especially noteworthy when it comes to fee amounts and structure as well as performance attribution. Portfolio transparency raises the fewest red flags, but even here 29 percent of investors say it’s insufficient. There are distinct regional differences: Asian investors are less likely to express dissatisfaction overall, while European and North American investors seem most intently focused on wanting more clarity about operating expenses (85 percent and 76 percent respectively) compared to Asian investors who are relatively optimistic, with a relatively low rate of dissatisfaction (29 percent).
Ultimately, GPs thought that transparency was sufficient to a degree greater than LPs did in every category covered by our surveys, revealing a gap could be at least partially bridgeable by the provision of more standardised, comparable reporting. While this survey did not address potential ways to resolve this disparity, it’s reasonable to think that LPs who receive clear and comparable reports from their managers are more likely to trust their managers and feel that nothing is being concealed.
Reporting frequency is key
Transparency is closely linked to reporting, so we asked LPs about the frequency and types of reports available. At this juncture, quarterly reporting remains the standard for private equity and most other types of alternative investments. Hedge funds comprise the main exception and generally report on a monthly basis. It should be noted that hedge funds have the widest variety of reporting periods, ranging from a few that report on an annual basis to a sizeable minority that generate weekly reports. While not common, customised reporting is most likely to be found for infrastructure funds.
Customised reports are more often provided to large investors, although it’s not clear whether this is because of the size of their investments or they are simply more demanding. Our GP survey revealed that 65 percent of managers already offer customisation. Large diversified managers with multiple asset classes were more likely to offer customised reports, but even 52 percent of the smallest GPs surveyed said they made customised reports available to at least some of their investors.
Four out of five LPs have online access to their accounts, but it does not always extend to all of their investments. Large North American institutions are the most likely to currently enjoy online access for all of their alternative investments. Of those who don’t currently have online access, most express a desire for it.
Expect more fee negotiations
Almost nine out of 10 investors say it’s important (or extremely important) that they are given the opportunity to negotiate fees. The expectation of fee negotiability rises in tandem with investor size, and not surprisingly, larger LPs have proven to be more successful in negotiating better terms for themselves. More than half of all LPs report at least some changes, but this varies from 73 percent of LPs with more than $25 billion of assets to only 29 percent of investors with less than $1 billion of assets.
Fee negotiations come in many flavours, and one survey participant pointed out the current strong fundraising climate meant many managers are not prepared to negotiate major items like management fees and carry, which remain close to 2 percent and 20 percent. They may, however, be willing to modify peripheral items. The investor went on to say that “managers have to some extent given in to pressure on fees, and market standards have moved slightly in favour of LPs. For instance, GPs are now generally offsetting 100 percent of transaction fees against management fees.”
Another investor concurred and indicated that fee negotiations are more tactical than widespread, saying that “fees have varied from none at all to drastically modified. Some managers will get very creative in order to receive our first investment. We have seen differed transaction fees, and discounts on the promote, but the asset management fee seems to be non-negotiable and it helps to keep the lights on.”
Not all LPs have the same experience, however, with a European investor saying he thought managers were “more willing to shave off management fees than carry. You can get a management fee break if you’re in the first close or if it’s a GP’s first fund, often for a year or until the final close. LPs that can make a $50 million plus commitment are in a better bargaining position.”
Smaller investors validate that sentiment, but they may have less leverage. One survey participant noted that “We’re not writing big enough cheques to negotiate, so the only things I’ve observed is that fees are maybe 25 basis points less than they were a few years ago. The promotes are the part that hasn’t gone down. We work with consultants, and a number of the managers will allow the aggregation of a consultant’s clients for a fee break. We allocate $35 million to $50 million per fund. $100 million-plus is where things begin to get negotiable.”
As expectations shift, standards rise. Manager evaluation still focuses on the investment team and its process, but operational considerations are becoming more prominent. One survey participant noted that their due diligence procedures “… covered elements of operational due diligence, such as workload, viability of the management company, disaster recovery, business continuity, decision-making, etc. Operational due diligence will become an area of increasing focus going forward.”
Another investor described a division of labour where their organisation devoted their time to performance attribution while their consultants spent more time analysing operational infrastructure. He goes on to point out that they have, in fact, declined to invest in managers “… without real controls and compliance since they seemed to lack institutional quality.”
HOW MANAGERS CAN SATISFY INVESTORS
There is an almost universal expectation that the institutional appetite for alternative investments will continue to grow over the next few years. Our discussions with LPs and GPs alike reveal that significant changes will almost certainly accompany this growth. Demand patterns are shifting as private debt and infrastructure join private equity in the mainstream and hedge funds increasingly face tough competition in raising new assets.
Some management firms are becoming larger and diversified, even as they strive to retain the expertise of specialists. Fund structures are proliferating and customised arrangements are becoming more common. Investors are more aggressive about negotiating investment terms, even as the fundraising environment surges from strength to strength. The industry is more global and complicated than ever before, presenting both investors and managers with an excess of challenges and opportunities.
How operational standards are ultimately met is often left up to the managers. As one LP said when interviewed on the topic, “I assume they can take care of the technical back office or hire it out at their expense.”
This should not be taken to mean that investors are not partial to certain approaches. Any given LP is likely to prefer certain functions be outsourced by their GPs, while preferring that others are done in-house.
Almost half of all investors, for example, prefer that pricing and valuation work be done by an external provider. This rises to 69 percent if those without any particular preference are excluded. As a group, LPs generally express a preference for outsourcing fund administration and accounting functions as well.
There are some interesting discrepancies between investor preferences and GP practices when it comes to outsourcing. Our previous survey of GPs found that 68 percent of them outsourced cybersecurity, for example, but LPs say they prefer that it be handled in-house. Regulatory and compliance functions fit a similar pattern.
Portfolio management is predictably the function that investors would almost universally prefer to see done in-house, but there is little consensus when it comes to most other functions. In general, European LPs are the keenest advocates for outsourcing, while Asian investors are the most likely to prefer in-house solutions. Investment companies and family offices are more likely to prefer outsourcing than other types of investors. Pension plans are more likely to advocate for doing more things in house.
Many investors pointed out that outsourcing decisions are best made on a case-by-case basis, depending on the resources available. Smaller managers may not be equipped to handle legal and compliance issues as well as a larger firm, making it more sensible for them to enlist the services of an external partner. Others may struggle as “the PE industry focuses increasingly on ESG matters, [making this] an area which may also benefit from the use of outside consultants where teams are too small to build their own expertise.”
Whether LPs consciously emphasise operations or not, their rising expectations and growing sophistication places additional strain on GPs already faced with competitive pressure.
Investment expertise remains a vital factor in a manager’s success, but adaptable and integrated operating platforms will form the cornerstone of many competitive firms going forward as the alternatives business continues to evolve and become more complex.
Jim Cass is senior vice-president and managing director, business development and client servicing of SEI’s US-based alternative investment manager clients.
Richard Harland is managing director and head of EMEA sales, business development and relationship management at SEI Investment Manager Services.
This article is sponsored by SEI.