How to find the right service provider

As managing the back office becomes more complex, chief financial and chief operating officers are under pressure to make sure their fund administration services are meeting all regulatory and investor demands. But how exactly then do GPs go about finding the right fund services provider? And from there on, how does one know when the relationship is working? In early February, PE Manager sat down with a mix of industry professionals to answer these questions: 
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MEET THE ROUNDTABLE

Jim Cass is a managing director at SEI, a fund services provider, where he focuses on SEI’s alternative investment manager clients. Cass has been with SEI since 1990 and has held various roles during that time, including serving as the managing director of operations and working in the product solutions team.

Anne Anquillare co-founded PEF Services, a fund administration provider for small and emerging fund managers, in 2002. She is the chief executive officer of the company. Anquillare has been active in the private equity industry since 1993 and was a general partner of Walden Capital Partners, an SBIC fund licensed in 1996.

Steven Schaefer is a partner and chief financial officer of Graycliff Partners, a New York-based midmarket and mezzanine firm. Schaefer is responsible for overseeing the firm’s operations and finance activities. He joined Graycliff’s predecessor firm HSBC Capital, the US private equity arm of HSBC Group, in 2004.

John Truehart joined Hudson Ventures as chief financial officer in 2006. Prior to joining the New York venture capital firm, Truehart was for eight years the controller for private equity firm Charterhouse Group, where he was responsible for all aspects of fund accounting. Between 1994 and 1998, Truehart was employed as a manager in the partnership accounting area of Alliance Capital Management Corporation.
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When deciding whether to partner with an outside fund administrator, private equity chief finance and operating officers have heard all the arguments both for and against. But often the party weighing in on the decision will come with their own prerogatives, making it difficult to objectively determine if outsourcing certain back office functions is the right move for the firm. 

Here’s what we mean: fund administration providers have a compelling case to make that their expertise and familiarity with capital call notices, distributions, investor reporting services and so on can provide significant value to private equity firms. This after all is the core focus of their business. But explaining that value to prospective clients can sometimes seem little more than a smooth sales pitch.

Chief financial or operating officers, on the other hand, are stewards of the back- and middle-office. And when it’s your name that’s responsible for any operational slip-ups, you tend to want as much control over the processes as possible. Relinquishing some of that oversight to a third party administrator can feel like a leap of faith. What’s more is that some finance and compliance professionals fear that outsourcing a portion of their work could even place their job in jeopardy. A three-person accounting team, for example, may worry about being kept on when a good deal of heavy lifting is done externally.

Then again, some private equity firms aren’t even fully aware of the various third party fund services now available. The technology and sophistication of outside administrators has matured rapidly as the industry institutionalized over the last decade. 

Nonetheless, if current trends are anything to go by, fund administrators have been overcoming these obstacles to become a lasting presence in the industry. Handling everything in-house is simply not practical for a large percentage of firms as LPs demand better, faster reporting and conduct more exhaustive operational due diligence on GPs. In similar vein, regulators are requiring GPs to put in place strict controls over accounting, valuation policies, cash monitoring and other back office functions. 

MATCHMAKING 

In early February, PE Manager gathered a mix of fund administrators and chief financial officers in mid-town Manhattan to talk about the ideal relationship the two parties should cultivate. Our conversation touched on many aspects of this dynamic, but one underlying theme present throughout the roundtable discussion was that a private equity firm can experience significant operational boosts if the right service provider for their needs is found. With the right partnership in place, concerns over control, quality (and for some, job security) suddenly become nonfactors. But how then does a GP considering outsourcing certain back-office functions find its service provider match?   

It starts with an honest look into the firm’s operations, and discovering where improvements can be made, says Jim Cass, a managing director at fund services provider SEI.  

“Are you looking for lift in your portfolio accounting turnaround time? Could your K-1s be sent out any quicker? Is the firm tax efficient?”

Cass advises firms to take a consistent approach in deciding which back-office functions have room for improvement, and then ultimately select an outside service provider based on those needs. During the evaluation, “the same people who made the decision to outsource should take the lead in finding the right service provider,” says Cass. “Often problems can arise if it was one person’s decision – who may have had their own way of thinking about the matter – and it then falls to a team of partners who select and enter into the third party agreement. You need consensus.”

Anne Anquillare, co-founder and chief executive officer of PEF Services, a fund administration provider, adds that the decision will also need to consider the firm’s available resources. “There are many different kinds of fund administration providers that specialize in different segments of the market,” says Anquillare, commenting that her firm caters to small and emerging private capital funds – a group that has relatively limited resources for fund administration but in greater need of an outside partner who can keep them up to speed with the latest best practices.   

Anquillare describes small and emerging fund managers as being more receptive to a fund administrator’s guidance and methodologies. SEI, which in comparison services GPs with larger operations, encounters more ingrained practices, says Cass. As such, it’s vital for both parties to clearly lay out their goals and expectations from the start, which if done sufficiently, can help a service provider introduce new ways of thinking or methodologies to a GP who has grown comfortable with their own internal practices over a number of years, he explains. 

“When their expectations for why they made the decision to pick you, and your expectations for why you think they picked you, start to deviate for different reasons, you can create unnecessary challenges in the relationship,” warns Cass. 

Another strategy for large and/or complex firms to consider when searching for an outside service provider is to hire a consultant. “Compared to firms that go out and search on their own, the consultants often ask more pointed and educated questions,” says Cass. “The downside is it can prolong the search process, but more times than not, you’ll end up with a better model in the end.”

A little known secret during this matchmaking process is that “while GPs are completing their due diligence on us, we’re performing due diligence on them,” says Anquillare. “Will the GP be proactive in their communication with its fund administrator? Where does the back-office stand today in its level of organization and discipline? And how can we take it to a place where it needs to go?”

Indeed, while GPs may believe that any third-party service provider would jump at the chance for their business, the reality is far more complicated. Some fund administrators prefer working with clients who have a point person at the firm who can help them implement change, and ultimately improvements to internal systems. For them, having  a chief operating or financial officer intimately familiar with the firm’s reporting, accounting, tax and valuation systems helps foster a “team dynamic” in administration, says Anquillare.

TALK TO PEERS 

Diving into more detail, Graycliff Partners chief financial officer Steven Schaefer says firms can make use of a number of channels to find the right administrator. “Talk to members of the Private Equity Chief Financial Officer Association about if they outsource and who they’ve selected. There’s a lot of information sharing that takes place in that network about industry experiences, where any dirty laundry on an administrator is going to be aired out.”

Schaefer went on to say that many chief financial officers will also seek their auditor’s opinion during the selection process. “They’ll ask: Who have you seen in this space? Many administrators just want to focus on the larger players, those that will bring in up to several hundred thousand dollars of fees per year. It means you need to find a service provider that fits your fund size – and sometimes that can be done by simply picking up the phone and calling funds of similar size for their insights.” 

PEF Services’ Anquillare went on to add that client referrals make up a big portion of her firm’s business. “And referrals doesn’t just mean from one chief financial officer to another, but from fund formation lawyers as well.” 

As with most matters in the private equity sector, what LPs want is a final piece of the puzzle, adds Hudson Ventures chief financial officer John Truehart. “Smaller LPs generally place less demands on the firm’s systems, but more institutional investors can be harder to impress.”

With the conversations turning towards LPs, it wasn’t long before costs became the next focus point of discussion. GPs must walk a fine line when deciding which fund administration expenses fall to the fund, and which are borne by the firm itself. Even if an upgrade to reporting technology for example was made to satisfy investors’ wishes, a GP may be reluctant to charge the fund for the service as a way of damaging investor relations. At the same time, shrinking management fees makes the decision a difficult one either way. 

That’s why allowing the Limited Partnership Agreement (LPA) to provide GPs’ flexibility in deciding where expenses are allocated is a growing trend in the industry, says Schaefer. “And when that right is negotiated upfront, it can win you a lot of favor with investors when taking on the expense as your own anyways.”

Some expenses are generally accepted by LPs, adds Anquillare. “Anything in support of the audit or financial statements is considered a cost to the fund, but other expenses like bookkeeping are less cut and dry.” 

GETTING COMFORTABLE

As mentioned, issues over quality and control must be addressed when selecting a fund services provider. According to the roundtables’ two chief financial officers, Schaefer and Truehart, there is a level of comfort in knowing that the individual overseeing fund accounting for instance is only a short walk down the hall to answer questions or provide progress updates. 

“With an in-house team, it’s easier to look over their shoulder and see what they’re doing,” says Schaefer. “When a function is outsourced, deliverables need to be scheduled in advance, or you might experience a time lag.” 

Anquillare jokes that she could install nanny-cams to give chief financial officers that level of oversight, but the real goal is to have “trust, communication and coordination between the client and their team at the fund administrator”. Communication between the two parties often happens in real-time, especially when working on a deadline, she adds. 

Using the example of a capital call notice that needs to be created and delivered to LPs in a short two hour time-window, Anquillare describes a situation in which “emails are flying back and forth, phone calls are being made, and information is shared at a steady pace. It’s a very interactive process.” When a fund administrator is responsive to client needs and consistently provides a quality service, that loss of on-site control isn’t a concern, she argues. 

Cass agrees: “We’re really just an extension of the back office.” He adds that a high-level of “virtual comfort” can be provided to GPs by allowing them to track completion of the workflow with online portals and daily summary reports. The goal is to “get to a point where you’re telling firms what they need to do next, as opposed to them telling you what needs to happen.”

And when it comes to ensuring quality service, Schaefer advises GPs take a look at a service provider’s turnover rate for insights into their reliability and capabilities. “When the job market is good in New York City, it’s much harder to retain talent.” But then again, that same risk is present with respect to preserving in-house talent, he adds. 

Anquillare agrees with the point but adds a few nuances. Namely that many fund administrators find it easier to hire and retain back-office professionals, who “are not viewed as overhead, but a vital part of the engine.” For a fund administrator, “they are our front-office professionals.” 

Addressing concerns over quality and control, Anquillare and Cass also make the point that a third party administrator is, in a way, a knowledge repository for back- and mid-office staff. “With the departure of a chief financial officer, the firm can experience a significant loss in institutional memory. We’re here to educate the next chief financial officer coming in the door to ensure a cleaner transition,” says Anquillare.

With the roundtable drawing to a close, the participants circled back to the need for private equity firms to consider how and when partnering with an outside service provider could improve a firm’s internal mechanics. Summarizing the mood of the room neatly was a sports analogy Anquillare made during the two-hour conversation: “Investment professionals may be the team’s offense, able to win you the game, but finance and operational professionals are your team’s defense. They prevent you from losing.” And as the game becomes tougher, many firms are finding that their defense is enhanced best by outside experts.