Picking up the tab

With funds keen to farm out non-core functions, the issue of whether the management company or the fund should be paying outsourcing costs is rising up the agenda

The trend toward outsourcing continues unabated as firms increasingly farm out non-core functions, so that they can focus on their field of expertise – investing and divesting.

The shift is most notable when it comes to fund administration. Just over half of respondents to the Private Funds CFO Fees & Expenses Survey 2022 outsource their fund administration entirely, compared with just 29 percent two years earlier. This has been driven, in part, by a proliferation of regulation over the past decade. The additional burden represented by the SEC’s latest proposals are only likely to exacerbate the situation.

“Outsourcing is being driven by the need to increase efficiency and reduce cost, as well as the need to stay abreast of, and keep pace with, evolving regulatory requirements,” says Stephanie Pindyck-Costantino, partner at law firm Troutman Pepper.

“This is particularly true for small and mid-market managers. Outsourcing provides those firms with a breadth of knowledge and depth of resource that is becoming necessary, in many cases where the firm’s team is already at capacity, to meet the growing regulatory requirements.”

Patrick Bianchi, a private investment funds associate at Troutman Pepper, agrees, adding: “The new SEC proposals would require faster reporting times and more disclosures to LPs, all of which would increase demand for outsourcing.”

A difficult environment for recruiting is also heightening demand for third-party service providers. “The tight labor market is definitely driving outsourcing,” says Anne Anquillare, head of US fund services for CSC.

“Fund accounting and investor reporting are back-office functions in a private equity firm and it can be difficult to get those teams properly resourced. But for a third-party service provider, they represent the front office.

“And, as front office revenue generators, we can be focused on training and career progression, making it far easier for us to attract, retain and develop talent in these roles.”

Joshua Cherry-Seto, CFO of venture capital firm StartUp Health and until recently of Blue Wolf Capital, agrees. “It is challenging to hire internally at the moment, which means we have increased our outsourcing,” he says, adding that having a team of people familiar with a firm’s operations is preferable to having that knowledge reside with a single individual.

However, Cherry-Seto adds that outsourcing has been stressed by short-staffing at vendors too.

Splitting the bill

The question then becomes who should be paying for these outsourced services – should it be the management company or should it be the fund? The answer varies depending on the firm, of course, as well as the situation.

“Many of the most contentious costs are those where it is harder to determine how much the management company benefits from the service and what benefit there is to the fund,” says Pindyck-Costantino. “With some expenses like insurance or certain security expenses, for example, LPs have pushed hard to understand the allocation mechanics.”

Tom Angell, financial services practice leader at Withum, suggests that the issue is partly determined by the AUM of the manager. “I am sure you would find that multi-billion-dollar funds have a different take on what they are willing to absorb when compared to a $250 million AUM firm, that would be less able to take on those expenses,” he says.

One area that always proves contentious, however, is travel expenses. This has only intensified as LPs have prioritized sustainability, and as covid revealed just how much business could, in fact, be carried out remotely. The latest fees and expenses survey shows that 51 percent of respondents expect the fund to pick up the travel expenses of inhouse marketing staff.

“There has been increased focus on the cost of doing business across the board,” says Anquillare.

“LPs are questioning what is really necessary and what is just a matter of convenience.

“Additional expenses creeping onto funds’ P&Ls is one reason for the SEC’s proposed rules for enhanced disclosure. Investors need to understand the benefit that using specialist service providers brings to a fund. We are starting to see that dialogue take place during the negotiation of partnership agreements and with the LPAC as part of the governance of existing funds. It is an important evolution.”

The ILPA effect

Meanwhile, the standardization of fees and expenses reporting continues to make slow progress. Over 40 percent of respondents still rely on financial statements, and 22 percent deal with fees and expenses disclosure requests from LPs on an ad hoc basis. Only 17 percent use the ILPA fee reporting template, while 15 percent use a modified version.

“The ILPA template has been a great starting point for conversation, and firms are moving increasingly in that direction,” says Anquillare. “They may adopt 50 percent of the template for one fund, for example, and then 60 or 70 percent for the next. In that sense, ILPA is providing a road map, and adoption is happening at a pace that is sustainable.”

And that direction of travel is likely to continue as managers and investors seek more efficient reporting solutions, and as regulators continue to exert pressure.

“At the end of the day, disclosure is always going to be the manager’s friend,” says Pindyck-Costantino. “Firms will gravitate towards any attempt to streamline disclosures and bring formulaic transparency.”