Private funds professionals have dealt with a string of challenges over the past two years, with the covid-19 pandemic and increasing regulator scrutiny having had a lasting impact on the way private funds operate.
As inflation rises across key markets and the Russia-Ukraine war continues in Europe, managers will seek to hedge their businesses against the worst of the impact. Here, we set out three key trends that are likely to dominate market discussions over the coming months.
1Paying the price
The latest major change to hit the market has come in the form of rising inflation, according to several market experts.
“Inflation introduces additional risk into forecasting the future, which is fundamental to valuations,” says Andrew Robinson, a corporate finance partner who leads Deloitte’s specialist valuation group. “That will lead to lower valuations for some companies. However, certain businesses will be better off, and potentially valued higher than before, in an inflationary environment. That’s because they will be able to make higher revenues, either through contractual or regulatory mechanisms, or consumer demand, but their costs may not inflate as much.”
Lingering uncertainty over how long such an inflationary environment will last is one of the key questions that private funds are currently grappling with.
Attul Karir, a financial services partner at PwC, says: “Part of the challenge is that it feels like short-term inflation expectations are more elevated than long-term ones. It seems to me that this could be more of a near-term phenomenon, and clearly it is uncertain how long it will persist. This is highly dynamic and therefore investors and valuers will need to monitor this closely going forward, with a particular focus on announcements from the leading central banks.”
As for what comes next, David Fowler, global head of private equity at Sanne Group, says: “We will now see private equity managers taking much more interest in businesses where they can add growth and operational efficiency through technology rather than labor.”
2ESG gets taxing
While environmental, social and corporate governance issues have been rising up LPs’ agendas in recent years, only a few LPs have so far identified tax fairness as an ESG priority. However, that sentiment may be starting to change.
“Tax transgressions – (however these are defined) – can have real reputational consequences,” says Lucy Urwin, tax associate at law firm Macfarlanes. “The rise of ESG as a mainstream topic has been a catalyst here, with the ‘G’ attracting an enhanced focus on businesses’ decision-making, risk management and systems and delivery – including on tax.”
Uncertainty over what exactly is expected from GPs on tax fairness issues can cause headaches for some private funds. As Urwin points out: “Tax fairness is likely to mean different things to different stakeholders” in the absence of “definitive or pragmatic guidance.”
The UN’s Principles for Responsible Investment has taken some steps to address this lack of clarity, having published a discussion paper on tax fairness in 2021, while the Global Reporting Initiative produced a standard for tax disclosure in 2019. However, as tax is not covered by other ESG reporting standards that are currently dominating conversations within private equity, there is still more to be done to increase the market’s awareness of the importance of tax.
As dynamic changes in the market add to the workload of fund managers and administrators in the short term, it is likely that oversight into fund operations will need to sharpen to combat new tax and accounting requirements.
Sanne’s Fowler says that, from an accountancy perspective, there will now be more focus from auditors on the detail of valuations as a result of inflation, particularly regarding how inventory and deferred tax liabilities are reported at the portfolio company level and the liquidity of highly leveraged businesses.
Meanwhile, increasing scrutiny into fund practices is also impacting the fund domicile landscape, according to market experts who say that GPs are becoming more likely to choose a domicile their LPs will trust when selecting a location to raise a fund. While taxation remains a key consideration when it comes to fund domiciles, regulation and legal structures, changing investment trends and client expectations have become increasingly important for fund managers in an age where data is dominating decision-making processes.
Though jurisdictions such Ireland, Jersey and Singapore are increasing in popularity as fund domiciles among managers, the go-to destinations of the Cayman Islands, Luxembourg and Delaware are still by far the most popular jurisdictions, according to a 2021 survey of fund managers carried out by affiliate title PERE and RBC Investor and Treasury Services.
“There’s no doubt that having lawyers, accountants, transfer agents, custody banks, depositories and a big financial industry already set up makes a massive difference,” says David Collington, wealth and asset management sector lead at KPMG’s Financial Services Regulatory Insight Centre.
However, some argue that competition between fund domiciles is a good thing. “To give the investors the best funds, it’s important for fund managers and asset managers to be able to access expertise from around the globe,” says Julie Patterson, a regulatory consultant and Collington’s predecessor at KPMG’s regulatory unit.
Patterson continues: “We need the right mechanisms in place to ensure there’s sufficient management control in a domicile to have governance over a fund. This is the nitty-gritty debate about how you actually define substance, and I think that will go on for some time.”