PEF services on the evolution of operational due diligence

Anne Anquillare, CFA, president and CEO of PEF Services, on what the modern investor wants to see from its managers going forward.

This article is sponsored by PEF Services.

Q Do you get called on to speak with investors during due diligence processes on your GP clients’ funds, or does the DD not go that deep?

Yes, it definitely goes that deep. For a while now certainly, maybe not the investor, but the consultant has definitely reached out. Like everything else in private equity, what used to be two pages is now 12 – their checklists are getting longer and longer, which is fine – I actually think it is good for our industry.

In the past they might have just focused on the services we provided in order to ensure there was an independent party involved in the processes and financial transactions. But today they go very deep into things like our service level agreement. So it’s not just that we’re processing the capital call; it’s how we’re processing the capital call.

Anne Anquillare

They also take deep dives into secure communications. A lot of that has to do with the phishing attacks that have targeted our industry and have become very sophisticated. They really want to make sure that there is no sensitive data being transmitted via email.

Q What do they want to know?

They look at the engagement letters, they ask questions like, ‘What does this service cover?’ They definitely take their time to see how responsibilities are divided between us and the client.

Q We hear again and again how LPs are looking for more granular data on funds in which they invest; what are they looking for?

I think part of this is stemming from the LPs not just doing their due diligence process, but also ongoing monitoring. They’ve really beefed up their resources and processes in ongoing monitoring, so they’re doing a lot more recalculation. Not just the big guys, but smaller institutional investors as well. Just so they really understand what is in the partner capital account. For capital calls and distributions, they’ll double check it against their pro rata share, which is complicated in private equity because most things aren’t done pro rata. They will recalculate management fees, recalculate the allocation of carry, to ensure they really understand their partner capital account.

Q Do you have a sense of whether your clients [or their LPs] are accessing data on the go via phones and tablets or via laptops?

We monitor usage and whether they’re looking at a document or whether they’re looking at a dashboard, most of them are still going through laptops or tablets, but we are monitoring the use of mobile because viewing capital calls on your phone is a little tricky.

Q Are you seeing an increase in LPs requesting, and GPs providing, returns data that discounts use of a credit facility?

ILPA has done a lot of great work, as has the CFA Institute with GIPS. We have really worked hard with both of those organizations. It’s imperative that investors understand how a subscription line of credit impacts the risk and return of that underlying fund, because fundraising happens much sooner than it did in the past.

So GPs are fundraising off IRR, and they don’t necessarily have the other crucial performance metrics – DVPI, TVPI – they’re not fully-baked, they’re still very much in process. But they have an IRR, and it looks stellar, and the use of sub line of credit can have a huge impact on that. If a prospective investor isn’t able to carve that out, they may be making an investment decision based solely on a financing mechanism.

Q What progress is being made on that front?

We are moving towards a standard way of calculating IRR without leverage, and I shouldn’t say leverage, because there are other types of leverage; we are talking about a financing mechanism for the capital call. So, GIPS and ILPA are providing guidance on how you calculate the IRR, and the other multiples, removing the impact of the financing mechanism for the capital call, otherwise known as subscription line of credit.

Q Doesn’t the ‘unlevered’ number move into the realm of the hypothetical?

Not as long as you keep the cashflows intact; you’re just substituting the investors in place of the bank’s cashflows. As long as you’re not creating or destroying cashflows, you’re just really substituting parties into those cashflows. It is the cleanest way to remove the impact of the subscription line and also easiest way with existing systems.

Q But isn’t there still variation in the way IRR is calculated anyway?

Not so much. It is part of the same standardization. There used to be some creative yet improper ways that people treated recallable distributions in order to inflate certain metrics, but again GIPS addressed that ages ago. Awareness at the investor level has improved the best practice. If you are caught playing around with your recallables now, it’s very hard to rebuild the trust with your investors.

Q The process of investors needing information and getting it; how much of that is automated these days, and where do humans come into that process?

All of the data side of the house should be automated. We have always taken the approach that data needs to be sourced directly from the books and records of the fund. If it’s just coming from an Excel sheet, that may or may not have an error or an adjustment; that’s so risky. Data has to come direct – no human intervention allowed.

But where the processes do involve the human touch – private equity is complicated – explaining the data, explaining the data to the auditors, to the investors, to the CFO, you’re always explaining the data. So access to data needs to be automated. The explanations behind how that data came to be and what is the allocation – the why – needs to be explained a lot in our industry. Explaining the why, building the trust, that’s always going to be the human touch part of our industry.

Q What does operational due diligence look like today?

It’s evolving – it’s not just when they’re looking to invest in the fund. We receive ongoing calls and some consultants or staff at a family office will call us once a year, checking in: everything going okay? Any chance you can get get this to us? And the answers are evolving too. What we couldn’t provide last year, we can provide now. What is happening today is based on collaboration between our clients, their investors and us. It is great for the industry.