No easy solution

Technological advances have traditionally been seen as positive – every innovation making life a bit easier. But for private equity managers, the advancement in technology solutions for fund administration has in some ways made their job harder. Many are asking themselves whether there really is a “perfect” solution for their fund and how much transparency they may be sacrificing in the future. Private Equity International set up a conversation with John Malfettone, chief operating officer and chief compliance officer for Oak Hill Capital, Tim Smith, chief financial officer for Conversus, and the senior finance leader (SFL) for a US middle-market fund (who asked to speak off the record) to get their perspectives on how they are dealing with the rise of technology in fund administration.

PEI: Have you upgraded your technology solutions recently in response to any administration needs that have come up?

JM: As I think about upgrading our technology, I’ve been going to conferences and talking to other CFOs and COOs to inform myself about what is new in the market. My sense is that there really is no panacea, no perfect system out there. The technology for our industry has developed into a situation where there are a number of different players with different options, and whatever you select requires significant customisation to get it to work. With many of these out-of-the-box accounting or operating systems, there is still a lot of work that you have to do. And then the trap you fall into is that once you start customizing the technology, the next time there is a new release it becomes highly possible that your product won’t work anymore with that new release. So I think the lesson is to be wary of out-of-the-box solutions because it’s an oxymoron, they don’t exist.
SFL: We’ve had an Excel-based solution for traditional private equity. About five years ago we started to invest an approximately $2 billion fund and that was the pivotal point of thinking about whether we wanted to switch to a different system, and I think our main issue was that in 2005 there were not a lot of players out there, the landscape was much more limited. I think it was much more of a time commitment than we were focused on. We were a pretty small group at that point, and when you got to the level of customisation needed for a waterfall calculation, for example, we really found there was limited utility for a system.

JM: The two things that add the most complexity to our business are the number of LPs, meaning the number of unique names and addresses and contacts that you have to maintain and send information to, and the number of legal entities.  About a year ago I actually did a survey on this and when you look at the cost of accounting and finance it is highly correlated with those two factors. Firms with a large number of LPs and legal entities generally require technology solutions to make their processes faster and more reliable.

TS: I will echo what John said in that the problem here is customisation. Our investors are clamouring for more and more information as expected, so it is important to have a system that can track everything that goes on in our portfolio. We spend a lot of time customising reports so we can get the information in a certain way … but, the outputs are only as good as the inputs. As we all know in this industry there is little standardisation – one GP may report something one way and another may report the same event in a different way. So, we spend a lot of time customising, and when you spend that amount of time you are kind of stuck with what you have and it is hard to go back and unwind everything to change systems on a routine basis.

PEI: For those of you who are registered, are there products you are looking at that would make an SEC examination, for example, go more smoothly in the future?

JM: I would start by assessing your e-mail archiving system. It is important to have the ability to perform efficient key word searches, and to segregate and log privileged communications. There is software in the market that provides that capability, and although these products are somewhat nascent, this type of software is becoming more commonplace.

SFL: Part of our business is registered, and we have found that the e-mail vendors are extremely difficult to deal with. We are on our third vendor in only a year’s time, and getting history in there and other things seems a very difficult thing to do, just time-consuming and pricey.

The problem with the first vendor was we could not get any history at all, there were too many e-mails. We only had to do it from registration onward, which was back in 2008, so you wouldn’t think it would be that much for a pretty small firm, but it was too much for them to handle. For the second vendor the issue was if I typed the words “insider trading” in an e-mail, and it got replied to eight times, each of those e-mails would get flagged. You would go in and have thousands of e-mails flagged, and only 150 to 200 of them might be original e-mails, and it was incredibly cumbersome. So we shopped around and did a lot more research on the next system, and found one that deals with that, but it also still has issues with getting all the history in there. So there doesn’t seem to be a perfect solution.

PEI: What should firms that will be registering in the future be doing now?

SFL: An e-mail system is required, when the SEC wants a certain word looked up. What we have tried to do is create a better way to tag our research and keep track of our research, so we have put in this system known as Tamale which helps codify our research. All the research can be pulled together in a much easier fashion and put in a supporting deck and archived. So now we have our rationale for, if you get accused of insider trading, you can refute it by showing there were no communications with the person you are alleging, and here is a 100-page deck that outlines our investment rationale.

JM: If you are registered, people who have access to confidential, non-public information must pre-clear every time that person, their spouse or anyone living in their home wants to execute a trade. The volume of that activity and the auditing required to check compliance is pretty significant. We put in a security trading system to automate that process and the back end controls that go along with it.

PEI: From your perspective is there a point where it is not cost beneficial for middle-market firms to be implementing more expensive technology solutions?

JM: It depends on how complex you are—there is a point where complexity can overwhelm your Excel solutions. I think a lot of it is driven by the information requirements of your LPs: what information they want and how quickly they want it. I find that the part of TheNextRound that we liked, and I know InvesTran has the same thing, is an extranet. It is an information delivery mechanism preferred by most of our LPs. In addition, it is process and cost efficient since we were able to eliminate copying, collating and sending out thousands of pages of information every quarter.

SFL: We use IntraLinks. We had a fund with approximately 100 LPs and a bookkeeper that was literally sitting and PDF-ing each one and posting it to IntraLinks, which is hugely inefficient. With the way IntraLinks has upgraded its technology, it takes five to six minutes to post all the capital statements for a much larger fund, so the process has gotten 150 times better.

PEI: Is there a trade-off between transparency and efficiency as these solutions become more complex?

TS: There is a significant trade-off between transparency and efficiency, and we are all in an environment where time is extremely valuable.  We need efficiency to save costs and provide meaningful data, which is why these systems have necessarily become more cumbersome.

SFL: In Excel you have a bit more of a transparent solution, which may be a bit more cumbersome and not as efficient. You can see your Excel spreadsheet from column A to column M, down to row 400, and if you have the proper levels of review you should be able to catch things in there. The less transparent you get – because things are built into a system where you kind of have to trust the data a little bit – the more tendency people have to become reliant on the system. It is a dangerous place to go.

PEI: What is your position on keeping things in-house vs. outsourcing and have you changed your budgetary mix recently?

JM: Last year we looked at every area, including accounting, HR and IT. We found that outsourcing services to one of the large accounting companies would not prove beneficial from a cost or service perspective. For example, with most service providers, you have to give them notice of capital calls a certain number of days in advance, but we have the in-house capability to turn around a capital call in a day. And with respect to HR and IT, like many PE firms, we strive to provide tailored services on an immediate basis as needs arise. We found that for this kind of “high touch” service, it costs you more to outsource HR and IT.

TS: We outsource our accounting and administration work and there is no doubt that it is more expensive for us to do that as opposed to try and bring it in-house. At some point we will get large enough that it will make sense for us to have our own internal team to manage the processes and to take over more control. It’s part of the natural evolution. The trade-off of outsourcing is in the cost, accountability and efficiency. However, whether you outsource or in-source, you still have the accountability. Overall, technology in all parts of our businesses is changing rapidly and you have to be thoughtful about any changes you make.

Malfettone is partner, chief operating officer and chief compliance officer for Oak Hill Capital Management, a middle-market private equity firm which last year raised $3.8 billion for its third fund.
 
Smith is chief financial officer for Euronext-listed fund of funds Conversus, which had $91 million of distributions in the first quarter of this year.