With limited partners already paying a hefty management fee to support operational costs of management firms, the extent to which GPs then either impose additional running costs on the fund, or else look to share the costs, can sometimes become a bone of contention.
Part of the issue is a growing trend towards outsourcing. As complex regulation has proliferated and as increasingly sophisticated LPs have demanded a more streamlined approach, more and more management firms are focusing their in-house attention on fundraising and investment alone.
Blue Wolf Capital CFO and CCO Joshua Cherry-Seto adds that tight labor markets make in-house hiring difficult and as service providers become more sophisticated, they are providing greater value and scalability. The impact of covid-19 will only accelerate the demand for outsourcing. The outbreak of the coronavirus and subsequent international lockdown shone a spotlight on individual firms’ business continuity pans and automation capabilities.
Indeed, as an initial reluctance to cede control of operational functions wanes, a desire to get back to core business blossoms. But as everything from fund administration and investor reporting to data management and even compensation consultants and mock auditors is farmed out to third parties, the question of who should be paying for these services intensifies.
“Being able to clearly outline why you are outsourcing; how fees are being used to pay for it and how those costs are being recovered is extremely important for LPs,” says Neal Prunier, director of standards and best practices at ILPA. “The benefits have to be weighed against the costs to the fund and ultimately to the investor.”
Anne Anquillare, CEO of PEF Services, adds: “We have absolutely seen outsourcing gain momentum, at the bequest of LPs and unofficially by regulators.”
The hired help
The latest Private Funds CFO Fees & Expenses Survey showed that over 90 percent of firms are outsourcing the majority of their legal work, while over half are outsourcing the majority of their fund admin. Over a third turn to some form of outside expertise for help around valuations, while 44 percent hire in data management support.
One area where there has been a shift toward bringing the service back in house is that of valuations. Troutman Pepper partner Julia Corelli believes this is reflected in findings that suggest the Limited Partner Advisory Committee is increasingly being relied upon to approve changes to valuation methodologies in the wake of SEC scrutiny.
The extent to which the fund or manager picks up the bill, meanwhile, depends on what service is involved. The areas of data access, management and security are among those most likely to be fully borne by the management firm, while fund administration is most likely to be fully absorbed by the fund. The costs involved with employing ESG consultants, meanwhile, are primarily borne by the management firm, with 67 percent picking up the full cost. However, if the consultant is the requirement of a specific LP, 22 percent would require that LP to bear the cost themselves.
“The trend is certainly to try and charge as much to the fund as possible if you are using outsiders,” says Corelli. “That is where the tension arises because LPs are already paying a management fee. Where managers have hired outside expertise in areas such as fund administration, as private equity has become operationally more complex, those costs are generally viewed as a fund expense. Other services such as data analytics or industry consultants now tend to be paid for by the management company, however, following tremendous push back from investors.”
Keeping it in-house
Not all firms believe outsourcing is the way forward. “Private equity managers and administrators will cite efficiencies and enhanced ability to focus on their core investment strategies as reasons for outsourcing their accounting function, for example,” says Lou Sciarretta, chief operating officer at Kline Hill. “In addition, administrators will have controls, processes and technologies that newer firms, in particular, may find too costly or time-consuming to implement in-house.
“However, other firms with complex carry waterfalls, multiple fund strategies, varying fee schedules or a mix of separate accounts, advisory and commingled funds may find that an in-house function provides greater consistency around accounting talent, staff turnover and high-quality service to LPs than a fund administor may be able to provide,” Sciarretta adds.
Where services are kept in-house, meanwhile, the majority of firms do pay for their provision through the management fee, the survey finds. However, 11 percent charge the fund, even when no third-party provider has been brought in.
Furthermore, of those that expect the fund to stump up for additional costs, 27 percent do not disclose the nature of services provided, and 39 percent provide no details about their allocation methodologies.
“If a firm effectively outsources its back office to itself, it is obliged to prove it is offering market rate or better, and that it is providing the same or a better service than could be found elsewhere,” says Anquillare. “That’s hard to do, because it is not their core business.”
“It’s definitely a controversial practice,” adds Prunier at ILPA. “LPs get frustrated because it becomes yet another way to bring money in, where there isn’t necessarily the skill set there to support it. That is certainly problematic.”