The new reality

The environment in which fund managers must operate currently is about as challenging as any since the inception of the private equity industry. Perhaps it is a natural outcome of a maturing industry, or perhaps the over exuberant swing of the pendulum, but today’s combination of market values, competition for investment opportunities, external pressures from investors, internal pressures for talent and succession, regulation and regulators’ enforcement mentality are pretty unique.  There is no doubt now: operating in the private investment industry, whether it is PE, venture, hedge, real estate or other alternatives, requires careful planning, meticulous execution and a really good crystal ball.  It is not for the fainthearted.

One element of operations that has become very clear through the regulatory examination process is that fund managers need to have the ability to foresee all the needs of their management of the funds at the outset and to disclose those needs clearly in their private placement memoranda.  Investors are more and more focused on the cost of their investment and the way those costs can go up in unexpected ways.  Putting too heavy a cost burden on the fund, i.e. making too many expenses be borne by the fund, will make fundraising very difficult even for the most seasoned  manager.

Then again, not being aggressive enough in expense allocations can make the management firm unsustainable, particularly in the back half of the fund’s life when management fee revenue typically declines.  So fund managers inquire of their friends and advisers – what do you do about “X.” how would you treat “Y.” Overall, there is very little in the way of any formal guidance on what kinds of expenses should be fund expenses and which shouldn’t. There is only the “one-size-fits all” guidance. It is all high level. So PEF, Pepper and pfm conducted this survey to try to highlight nuances that every fund CFO and CCO must manage.

Working backwards from lessons learned from the examination and enforcement arena, it is clear that definitive disclosures and living by what you said you were going to do are the only certain way to make both regulators and investors happy. So careful planning for the expected and leaving room for fair, equitable land consistent treatment of the unexpected, along with clear documentation of the rationale for treatment of the gray zone, is the only way to go. But how is a fund manager to predict the changes in the deal world? Or changes in an investor’s need for liquidity and the pressures that brings on the manager?

Take the auction process for deals and how that has changed over the past decade, driven largely by the increased competition for good investments.  At the risk of overgeneralizing, more expenses are incurred earlier in the process than a decade ago, there are generally more participants, and they generally have to submit full mark ups of documents before they are a finalist. That, by definition, means more broken deal expenses for any fund that participates in auctions, unless the management company absorbs more of the costs. While investors may like management firms to do so, having that kind of variable expense in the budget is unmanageable for all by the largest firms.

The answer may be an expense cap for the fund, or a cap on broken deal expenses, but investors have not yet gone there in the market due, I expect, to the disincentive that may place on managers who get close to the cap.

Some firms manage some legal costs by bringing advisers in house and gaining control over the line item for legal fees on deals by having in house folks do initial deal work. But then they lose the benefits of expertise that outside counsel can bring, so they supplement with outside counsel and that seems to be the happy medium, but no guarantee that even the outside counsel expense is a fund expense unless it is clearly made so in the fund’s governing agreement. Despite valiant efforts to predict how each transaction in which the fund invests or proposes to invest over the life of the fund, and no matter how great the draftsmanship in addressing each such type of expense, Murphy’s Law is such that it will not work in every situation.

Take consultants, for example. A fund agreement may provide that the management company can retain consultants to assist in evaluating a deal and charge their fees to the funds. If the deal does not ultimately close, a significant group of surveyed managers said the management firm pays the consultant’s fees. 

There is some understandable irritation in this for investors as the larger the funds or the AUM, the less likely the management firm is to pick up the costs of the consultant in a deal that does not close, even though they, arguably, should have better infrastructure to withstand the cost. If there were comparative data available for 5 or 10 years ago, would the result have been the same? I would submit that it would have shown more being picked up by the funds. Two large reasons for change are investor pressure on costs and changes in the way deals are often done nowadays.

Another change looming large in the night terrors of fund managers is regulatory expenses. Not so much the costs of registering as an investment adviser, nor the costs associated with being examined, but the cost of arguing, respectfully, of course, with regulators that there was not a violation. Initially, fund managers and investors did not disagree that the costs of registration were a management company expense as well as the costs of any examination or deficiency correction. This has heightened the scrutiny on both expense provisions in fund agreements as well as indemnification provisions. If a firm receives a deficiency letter from a routine examination claiming that certain costs should not have been fund expenses because they were not adequately disclosed to the investors that they would be so treated, and the firm pushes back and prevails in its view that it has treated costs appropriately, should those costs be fund expenses under the fund agreement and if not, should they be indemnified under the indemnification provisions? We did not ask this specific question in the survey, but given the results (see November issue of pfm), what would your answer be?

On the one hand, it is logical that there the firm agrees to bear the only certain examination costs when the fund agreement refers to regulatory costs being management company expenses. On the other hand, the back door effect of indemnification is something to be cautious about for investors who would not expect the fund to pick up these expenses.

Overall, the need for crystal clear disclosures and fund agreements is more apparent than ever. That, and real-time documentation of decisions on how to treat expense items, and consistency in the application of the firm’s principles about expenses, are the only almost-sure-fire ways to avoid a misunderstanding between the firm and its investors or between the SEC and the firm.

Julia Corelli is a partner with Pepper Hamilton’s corporate and securities practice group and co-chairs its funds services group, a core constituent of Pepper’s Investment Funds Industry Group (IFIG).