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The founding laws of the Securities and Exchange Commission all share the assumption that the best way to protect investors is to ensure transparency. Private fund managers were originally excluded from these disclosure requirements, but that changed with the global financial crisis. Under Dodd-Frank, enacted in 2010, private capital firms were forced to follow the provisions in the SEC’s founding charters and the issue of fees and expenses came firmly onto the regulator’s radar.
Now, the SEC is tightening its grip on fees and expenses once more, with an array of new proposals currently under review. At the same time, investors themselves continue to build negotiating power, under the auspices of the Institutional Limited Partners Association.
Conducted biennially since 2014, the Private Funds CFO Fees & Expenses Survey has captured the latest evolutions in the balancing act that is the GP/LP relationship. As the industry again finds itself at a turning point, here are the most important developments identified this year.
A bad report?
New proposals issued by the SEC could force an overhaul of private markets reporting requirements for fees and expenses. Among those causing concern is the need to disclose how fees, rebates and expenses are calculated, including cross references to the fund’s governing documents. Expedited reporting within 45 days of the end of the quarter would also put pressure on back-office functions and could drive an increase in outsourcing.
The SEC has also tabled proposals relating to the presentation of performance metrics. These include the requirement to calculate performance as if a fund called capital rather than using a fund finance facility. According to some CFOs, reporting unlevered returns is not the same as reporting a return that would be generated by a fund without leverage, given that, without a line of credit, firms would have to call capital in advance and return that capital if a deal failed to complete.
Crossing the starting line
The point at which the management fee should kick in has long been a subject of debate. And yet in 2022, 47 percent of respondents still begin charging management fees at first close, regardless of when they start investing. Investors would prefer not to pay up until capital is called, of course. The issue is likely to become more pertinent as fundraising timelines extend in a downturn.
The issue of how broken-deal expenses are shared between the fund and potential co-investors is a hot topic in the industry, right now, not least because the SEC is threatening to get involved. A third of investors still deem that the fund should always pick up the cost, even if additional capital was slated from third parties, while only 14 percent routinely expect co-investors to pick up part of the bill, as part of their indication of co-investment interest.
The issue of who pays for what when it comes to marketing costs has always been controversial, but LPs are increasingly resistant to picking up the tab for travel expenses, in particular. The spiralling cost of flights and growing environmental awareness, has combined with a realisation – demonstrated through the pandemic – that much of the business of private equity can be conducted remotely. As one expert says, LPs are questioning what is really necessary and what is just a matter of convenience.
The ILPA effect
Only 17 percent of survey respondents use ILPA’s template for the reporting of fees and expenses. However, this is an increase on just 9 percent in 2020. According to one expert, the ILPA template represents a road map, which firms are adopting at a sustainable pace. From slow beginnings, therefore, this year’s findings represent a positive direction of travel. And as the SEC closes in on inconsistencies in fees and expenses reporting, uniformity of disclosure can only be a good thing.
There has been a marked uptick in the proportion of managers now exclusively outsourcing their fund administration. In 2020, just 29 percent of respondents relied entirely on third parties. In 2022, that figure has leapt to 51 percent. This shift has been driven, in part, by tight labor markets, as well as regulation. Should the SEC’s latest proposals come into force, the outsourcing of fund administration is likely to become more prevalent.