This article is sponsored by PEF Services.
As the private funds industry matures, the complexities increase. That is reflected in the growing trend towards outsourcing specialized services. But can the greater use of third-party valuation and fund administration firms benefit both limited partners and general partners? The 2018 pfm Fees and Expenses Benchmarking Survey offers some telling insights. Here we consider how to achieve alignment among all interested parties.
The rapid development of the private funds industry over the last two decades has brought increased demands from regulators and investors. That has encouraged the growth of third-party valuation and fund administration services to support the back office.
This has picked up speed since the 2008 financial crisis. GPs have adjusted to the more mature landscape by improving the way they select external services to take advantage of the growing number of specialized services.
Investors are helping drive the change. Mindful of the long-term nature of their commitments, they are looking for GPs that are savvy in their approach to managing private funds. And that requires both sides to agree about who pays what for a variety of specialized services ranging from data management to legal counsel so that LPs can be sure they are getting the right support and value for these services, whether they are provided in-house or by a third party.
That’s something that comes through loud and clear in the pfm 2018 Fees and Expenses Benchmarking Survey. The use of external service providers appears to be a growing trend, with 59 percent of GPs outsourcing all or most of their fund administration work.
Debt funds led the way with 67 percent using third-party fund administrators. Size is a factor: small and mid-sized firms with less than $500 million in assets were the main users of fund administrators, with the largest firms – those with more than $5 billion in assets – the least likely to outsource.
This should benefit investors as smaller fund managers are the most at risk of not having enough resources to cope with the changing demands of the private fund industry. They lack the management fees to attract human capital in the current hot job market. Leveraging a third-party fund administrator allows them to stretch their resources to obtain the industry expertise and scale needed for the expanded role the back office now assumes – with an eye to an improved service level for investors.
Using a third party allows internal resources to focus on the higher level tasks that are better suited to in-house teams with knowledge of the deal team and investor requirements. These include data analysis to ensure investors and the deal team are kept fully informed, as well as the oversight of third-party valuation and technology providers. A fund administrator’s scale and industry expertise really comes into its own on the more standardized services such as accounting, record keeping and delivering reports and documents through a best in class portal.
Work still needed
Now for the unsettling news. There is still a lot of work to do to ensure that fund managers and investors are getting the support and value from specialized services. There also needs to be better disclosure on who picks up the tab for their services.
Choosing a fund administration firm or valuation consultant can be a challenging task, especially if you are doing it for the first time. Here are some tips to ensure that GPs and LPs are getting support and value.
Avoid selecting a service provider solely on price and assets under administration. The quality and capabilities depend primarily on a service firm’s ability to attract, develop and retain top talent. While price and asset levels may be the easiest comparison point, it is the experience and credentials of the staff that is most relevant to success.
If your first selection doesn’t work out, then consider switching. Investors are not just seeking great returns. They also want fund managers that can operate their funds efficiently – and that requires careful selection and management of service providers. Things to look for in a fund administrator include ensuring that they have expertise in your fund strategy and that they are able to offer a customized service specific to your needs. If they don’t offer this, be prepared to look elsewhere.
Expect most of the costs of outsourcing to be picked up by the fund. The 2018 pfm Fees and Expenses Benchmarking Survey shows that investor-facing services such as side letter costs, fund administration, portfolio valuations and legal fees are typically picked up by the fund. This can be regarded as an alignment of interest between GPs and LPs because the fund’s back office is primarily servicing the investors.
As seen in the above chart, the economics does, however, differ between fund types. For example, funds with buyout strategies are more likely to charge the fund for fund administration services than other types of strategy but less likely to expect the fund to pay portfolio valuations costs.
But the situation is changing. We anticipate that, as the private funds industry continues to mature, expense allocations and disclosures will change, reflecting the alignment of interests between GPs and LPs. Recently, disclosing the use of a fund administrator has become the norm. GPs now tend to highlight their use during fundraising, with fund administrators often asked to participate in due diligence calls.
Coincidently, as LPs see the benefit from the addition of fund administrators, fund administration and the associated investor portal technology are specifically identified as partnership expenses in the limited partnership agreement. The same trend is developing for portfolio valuations as investors push to ensure that third parties are involved in marking the investments to market.
What is emerging is a strategic use of specialized services that benefits both GPs and LPs and provides for alignments among all parties. While fund managers have an incentive to keep fund expenses low to maximize net IRR, it is clear that investors don’t want GPs to sacrifice client services.
If anything, they are demanding more from the funds in terms of disclosure. The fact is that the fund’s back office is also the investor’s back office, even if it is provided by external administrators. That’s why this ability to add value to both GPs and LPs is so crucial. Get the balance between the use of internal and external resources right and it can benefit the firm, the fund and its investors. That is true strategic alignment.