Consider the demanding lot of a private fund controller. His mornings are devoted to answering information requests sent by impatient LPs the night before. To gather all the right information, he must trawl different systems and databases scattered across the firm’s IT infrastructure. Annoyingly, some of the information needed may be stored offline, or still sitting with a deal team based in a sister office. By noon, his boss, the chief financial officer, is asking why his other responsibilities like financial reporting and cash management aren’t receiving the requisite attention.
It’s a common scene at many private investment firms, says Ray Haarstick, the founder of Relevant Equity Systems, a provider of software tools for GP finance teams and fund administrators. “Take into account the complexity of today’s deal structures and limited partnership agreements, and you can really see how much of a problem it can be to retrieve meaningful information from your data systems. You need the right technology and processes in place.”
Nodding in agreement is Jim Cass, a managing director at fund administration service provider SEI, who specializes in alternative investments.
Cass says fund managers basically have two options when it comes to data management: “They can buy individual systems out there for each and every function, or one that is more of a ‘one-stop-shop’, providing bundled functionalities.”
Given the difficulties faced by our hypothetical controller, this raises the question: why doesn’t every GP put in place the second type of system, which fully integrates all back-, middle- and front-office functions?
But our third roundtable participant, Jason Donner, chief financial officer of New York-based private equity firm Veritas Capital, believes that oversimplifies the issue. Happily, his technology and administration challenges are well understood by Haarstick and Cass, who as industry service providers, are able to share some compelling strategies for GPs to clear those hurdles.
Sewing systems together
Donner says that a common challenge facing private fund CFOs is how to integrate their systems better. “Our challenge is, like for so many other GPs, to make the different systems we have acquired over time work together.”
Most firms still use manual processes for certain functions, while other processes are being automated, perhaps with a commercial off-the-shelf system, custom in-house technology or even a legacy system. Other processes may be outsourced to a third party administrator, who stores the data off-site, possibly away from immediate view. Often these systems and technology are purchased or modified on an ad hoc basis in response to external factors like LP demands or new regulations – which “makes data integration even more difficult”, says Cass.
To quantify the extent of the problem: according to EY research conducted in collaboration with PEI, 53 percent of private equity CFOs believe their firm’s biggest technology problem is having systems that are incapable of talking to each other.
However, even if you leave the cost implications aside – and many CFOs have to make do with a small IT budget – purchasing a brand new holistic system isn’t necessarily the most attractive option.
For one thing, different service providers have developed market niches and expertise in certain areas. “GPs often want the ‘best-of-breed’ cash management or fund accounting system,” says Cass.
Then there’s the issue that more and more fund advisors are pursuing multiple investment strategies (including private debt, real estate and even co-investments). That adds another layer of complexity if GPs want a fully integrated system that can handle things like reporting, transfers, distributions and other requirements across all their investment channels, says Haarstick.
Instead, many firms are doing whatever they can to “electronically sew their systems and technology together”, he continues.
“What I hear a lot is: ‘Gosh, help us get away from all this duplication’. I know of a firm in Europe that has their data scattered all over the place. So the IR team in New York might be looking at performance information that is two months older then what the finance team in London is using. There’s a tremendous challenge for private fund professionals to put their data in once and have it immediately available everywhere.”
A system limited to one particular office, or even worse one individual, can also be a red flag to LPs, adds Cass. “You’re looking at a key-man risk if it’s only the CFO who knows how to send out the capital call notice, or who understands the tables and hidden cells used in a spreadsheet for the waterfall calculation.”
Firms “stuck in spreadsheet city”, as Cass puts it, are vulnerable in other ways. Reporting becomes more of a challenge when data can’t be easily aggregated or shared across systems, according to Donner. “LP information requests are regularly coming in – and you don’t want to spend significant time manually slicing and dicing the data to find your answer.”
Haarstick adds that reporting has become such a burden that both investment firms and third party administrators are adding staff dedicated solely to that task. “To me that’s just crazy, because in a system you should be able to easily create your own reports and save time.”
For instance, systems should allow users to drag and drop portfolio company information at will, says Haarstick. “Say I want certain portfolio companies’ primary contacts, cost basis, the date when they were last valued, which deal partners are responsible for monitoring, and so on – you should be able to create, save and run that report in seconds.”
One benefit of this, Haarstick says, is that GPs can easily track how much money individual partners are putting to work and what their success rate has been. “And savvy firms are not just measuring individual partner performance; they’re using the data to collaborate. The software can be used to kick off discussions at executive retreats about what deal structures worked best for each of the GP’s investment teams.”
Historical data only preserved on Excel spreadsheets can also limit the firm’s ability to provide LPs with interactive performance information, says Cass.
He describes a scenario in which a fund advisor has just finished implementing sophisticated reporting software. Deal team members and other partners begin feeding portfolio information and other data into the new system from the firm’s recently closed flagship fund IV. “Investors may have committed capital across all four funds, but if the reporting system only contains data on fund IV, then investors can’t quickly aggregate the GP’s entire performance history on an interactive dashboard provided by the new system. Instead, they must pick up the phone and request historical records, or comb through their own internal systems for the data.”
Converting existing in-house processes and historical data into a new system can be done in just one calendar quarter, says Cass. “And this historical conversion is worthwhile even just to cleanse your reporting procedures so that everything is consistent across funds – like for instance the calculation of IRR.”
Equally, it’s now easy enough for GPs to instantly access and play with data that’s stored offsite at a third party administration firm. Cass says gaining a live look at data may have been a problem in the past for some GPs that outsourced reporting. But today’s administrators have developed technology and interfaces “that allow managers to look into what we’re doing 24/7 so that we’re truly an extension of their back office”, he insists.
Haarstick agrees, saying there’s now “a fluidity of data” between GPs and their service firms. “Fund administrators who use Relevant EquityWorks can provide their clients with on-demand access to their live data – so a GP can instantaneously check their fund performance, portfolio companies and waterfall distributions without having to ring anyone up. GPs can also enter quarter-end valuations right into the fund administrator’s system, saving time and money.”
The mention of distribution waterfalls steers the conversation to the role technology can play in helping to simplify how investment returns should be shared between GP and LPs – a topic of growing interest amongst private fund CFOs looking for ways to automate the laborious and time-consuming waterfall calculation.
In simpler times, CFOs would just work out how much cash investors received first, check whether any LPs were due rebates on management fee or carry, and then start distributing money to GPs and LPs on the standard 20/80 split – not an entirely simple process, but something that could be completed on a spreadsheet with relative ease. But today, when complications like feeder funds, clawback provisions and multi-layered tiers of carried interest rights are factored in, the waterfall calculation is enough to test any CFO’s patience.
Doing this all on a spreadsheet can be a daunting task,” says Donner. “If a system doesn’t support layers of funds, it can get difficult.” Nonetheless Donner says he prefers running the calculation himself for verification purposes. “Getting the waterfall wrong would be a big problem.”
Cass adds that a trusted service provider familiar with the waterfall process can provide relief. “You build a track record of trust with clients over time. Nonetheless, I could tell someone until I’m blue in the face how many times it’s been calculated, and calculated correctly, but often times they still feel more comfortable doing it themselves. So if they insist on double-checking, we’ll work to find some ways to automate the process together.”
To do so, Cass says an outside administrator should be brought into the limited partnership negotiation process as soon as possible. “If we see those early drafts, we can provide feedback on ways to make the waterfall and other areas more operationally efficient without changing any of the material terms. By tweaking this or that language, you could for instance accomplish the same fee schedule, but make the accounting work behind it much easier to complete.”
Finding areas to automate ultimately means reduced administration costs, adds Haarstick. “Some administrators are charging $100,000-plus to model a waterfall. Well, why? It’s because there’s so much [manual] calculation going on and [so many] spreadsheets.”
Here, too, technology can be a savior, he continues. “Instead of having the finance team and lawyer burn wasted hours on the waterfall, we’ll create a spreadsheet model, with their input, that maps out how the allocations work. Then once the GP, his attorney and auditor sign off on the layers of calculations, we’ll configure that waterfall.”
Some CFOs considering different software packages able to automate the waterfall distribution have been put off after realizing that (for instance) any change in their LP base, or any new allocation of carry amongst the partners, would mean the software was no longer tailored perfectly to their needs.
“Our latest ‘Waterfall Obligations’ add-in handles transfers of interest, mid-stream changes to waterfall layers, discounted management fees and carry, and opt-outs,” says Haarstick in response to this concern. “When we do need to model an odd new term we haven’t seen before, it is a matter of a couple of weeks – probably only three to five days of billable time – to implement a specific layer of a waterfall that may not already exist.”
Of course, all the help on waterfall calculations in the world won’t mean much if the software system or outside administrator isn’t told about a partner leaving or some other change that impacts the distribution model – making communication a key component of a firm’s use of technology.
Cass stresses that a good fund administrator is fundamentally connected to the firm’s organization. “We strive for open communication both ways, so that everyone is on the same page about what needs to get done and under what timeframe.” That means the right infrastructure and relationships has to be in place. “There needs to be a key point person in both firms who knows the funds inside out. To be efficient, you want your third-party administrator dialing that specific person, likely the CFO – not a reception number for hours on end hoping to get to somebody.”
But what it shouldn’t mean, adds Cass, is the administrator becomes a burden by communicating needlessly. “You’re paying us a fee and trusting us to take these things off your workload.”
Haarstick believes the day of “real-time answers” is already here. “Folks want to enter their data once, and then leverage it throughout their organization – even if that organization extends to their fund administrator.
In other words, he says, everyone needs to “eliminate the duplication of data which forces firms to constantly reconcile multiple versions of ‘the truth’”. It’s a problem that today’s technology and systems are becoming much better equipped to handle