The significance of these matters has never been more in focus for private equity managers as they report to their investors, and now, frequently, regulatory bodies.. Also the Limited Partners who require more information in order to manage their portfolios, drive decision making and in many cases deal with their own reporting and regulatory matters.
Although the exact future of private equity investing and the relationship between managers and investors has yet to be written, the evolution of a long journey ahead is most certainly underway.
DRIVERS FOR INCREASED REPORTING AND DISCLOSURE
Prior to the financial crisis, private equity investors necessarily accepted some level of opacity from their managers. This was due in large part to the high rates of return that the best managers were able to generate for investors. Furthermore, given the demand for access to the elite managers, LPs typically did not “rock the boat” by being overly demanding of managers or making onerous requests for information.
But the events of 2008 changed this considerably. As capital markets dried up, private equity investments were impacted on multiple levels. The dearth of transactions led initially to fewer distributions, greater uncertainly regarding future cash flows and, eventually, reduced returns for LPs. Continuing capital calls for expenses, new and add-on investments exacerbated the liquidity crisis that investors were feeling across their entire portfolios. For recent entrants to private equity investing, the lack of clarity around cash flows was even more challenging. Investors attempting to gauge their exposures to markets or various economic factors found it difficult to assess risk at the portfolio level if they could not understand the credit, counterparty, sector, and market risk of their private equity investments.
The increasing sophistication of investors and fallout from the financial crisis has led investors to scrutinise private equity performance metrics more critically. Increased disclosure is no longer a “nice to have” option that fund managers may or may not provide to their investors, but rather basic requirements to get past the due diligence of most investors. Further more, a willingness to disclose information and data can be a factor that GPs use to differentiate themselves from competitors.Ultimately, the investor is looking for industry standardisation in order to be able to maximize their ability to analyse performance, risk and other metrics across their entire portfolio.
TRENDS EVOLVING
In addition to macro market factors driving change in the reporting relationship between managers and investors, specific industry trends are also impacting, if not being driven by, the need for closer alignment and more granular reporting.
Increasingly, sophisticated investors are seeking products that provide more liquidity, shorter duration, and more control in various bespoke solutions. Separately managed accounts and direct co-investment vehicles are increasing in frequency, for the benefit of investors who do not wish to be commingled with other investors who may have different objectives, or who want to have an enhanced degree of control over how capital is allocated, as well as increased visibility into those investments.
Alternative investment asset managers themselves are creating additional complexity in reporting and transparency with the increasingly blurred lines between private equity structures and investments and more actively traded instruments.
Family offices (FOs) who manage the affairs of very wealthy families have long had interest in private equity investing. Many FOs made their fortunes through entrepreneurial activities, often as the founders of privately-held companies. They are long-term in nature, and understand the value of patient investing. Given the talent available as Wall Street firms grapple with profitability pressures and the terms of the pending Volcker Rule, many FOs have built teams to manage private equity internally.
Importantly, diverging approaches to improving transparency differ not only across vehicle and client type, but also across investor segments. “Old school” private equity investors have a long-term, historical view of the asset class, and may not as quickly question the need for deep transparency in this asset class. Where newer investors in the asset class may have more experience with listed equities and more traditional markets and have been immediately horrified by the lack of transparency. Attempts at standardisation will prove more challenging in an industry that doesn’t necessarily speak with one consistent voice.
INVESTORS AS AGENTS OF CHANGE
The Institutional Limited Partners Association (ILPA) is playing an increasing role around improving transparency for private equity investors. With over 250 members who collectively manage over $1 trillion in private assets globally, ILPA has established operating guidelines to drive consistency in the manner in which GPs are reporting certain information to their investors.
Its Private Equity Principles centre around an alignment of interests, improved governance, and increased transparency.
These principles include the suggestions that fee and carried interest calculations be transparent and subject to LP and independent auditor review and certification; detailed valuation and financial information related to portfolio companies should be made available as requested on a quarterly basis; and GPs should reinforce their duty of care beyond the minimum standard for indemnification. In October 2011, ILPA took a step further by issuing quarterly reporting standards and capital call and distribution notice templates. While the templates are highly instructive, they are not meant to be definitive. ILPA itself recognises that “a single set of terms cannot provide for the broad flexibility of market circumstance.”
ILPA is a trade group, not a regulator, and therefore its recommendations are non-binding. Sceptics have wondered the extent to which managers would voluntarily embrace such standards, given their pedigree and their ability to attract new investors who might not insist on implementing ILPA’s guidelines. Large managers seem to be leading the way in terms of responsiveness. Although these managers have strong reputations, some are trying to use their willingness to improve their disclosure as a source of differentiation, or perhaps already responding to the voice of the investor: CalPERS, for example, has formally announced that starting March 1, 2012, GPs will have to comply with its new ILPA-style terms on capital calls and distributions. 2 It may also be the case that the largest managers have the resources (people and technology) available to change their communications—not just the actual reporting, but the approach to collecting data and ensuring its quality.
While there are clear signs of evolution in the GP/LP dialogue, the clear and consistent agreement is that one solution will not fit all of the needs of the industry’s constituents.
The Evolution has only just begun. All evidence indicates that alignment among the GPs and LPs is moving in the right direction. Managers are building processes and capabilities commensurate with the increasing needs of their investors. It remains to be seen whether the increasing impact of a regulatory overhang stunts, or perhaps fuels, that progression.
CFOs and COOs are on the front line of this information revolution, required to set up the back office, processes and infrastructure to meet the increasing reporting and information needs of investors, and weaving this into an organisational structure of risk management, compliance and oversight to address the new and evolving regulatory environment throughout the globe, in a manner that also aligns with their investors’ compliance requirements.
There are many players who will have a role in this evolution, beyond the GPs and LPs themselves. Technology must play an increasing role in capturing, managing and reporting the hoards of data captured for both internal and external reporting purposes. Firms continue to invest heavily in technology to meet these increasing needs and those technology providers, both historical industry brands and new firms sprouting to meet the new and increasing demands, are also increasing their presence in this space. In order to improve risk management and control, the historical focus on core accounting and reporting has necessarily expanded to include portfolio transparency, benchmarking, enhanced investor reporting tools, data feeds, and aggregation of portfolio information with other asset classes.
Other industry constituents will also play increasingly important roles in areas such as assisting with regulatory compliance in the new landscape, advising and consulting on operating platforms and procedures, and creating a more consistent outsourcing model for the administration of funds in accordance with evolving industry standards.
There is ample evidence to suggest that investors remain committed to the asset class. Moreover, given low expected returns for most of the developed world for some time, investors are unlikely to add to their traditional investments at the expense of their private equity allocations. Despite the pressures from investors and regulators alike, the future of private equity has yet to be fully written.
While there are demands for a certain level of standardisation, there is not a “one-size-fits-all” solution: some investors will rely on the regulators to set these standards, others will negotiate directly with fund managers, and others still will rely on new investment structures to meet their goals. Although the precise vision of the future remains cloudy, this much is clear: there is no going back.
Joe Patellaro is the global head of Citi’s private equity services business unit; and Massimo Zannella is a director of private equity services.
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