“Do you really want the senior accountant or controller – someone earning six figures – to be spending time on simple journal entries and bank reconciliations?”
Jay Maher asks the rhetorical question knowing full well what the chief financial officers (CFOs) seated around the table with him are thinking. From Form PF to the Foreign Account Tax Compliance Act (FATCA) to the Alternative Investment Fund Managers Directive (AIFMD), there have been so many new regulations demanding private fund CFOs’ attention that any time wasted on easily automated tasks is enough to make them step back and rethink the entire workflow process.
Alongside Maher, a country executive at Alter Domus, are two other representatives from the fund administration space: SEI managing director Jim Cass and Augentius managing director Brendan Tyne, both of whom acknowledge that fund service providers are benefiting from the tsunami of new reporting requirements crashing down on CFOs.
“There isn’t a secret sauce that works for all clients across the board,” says Cass, offering his take on the logic of outsourcing to ease CFOs’ workload. “We merge industry best practices with our experience and our clients’ individual nuances to create a customized solution based on established guidelines. But on a basic level, we scale the work, assign the right people for the right jobs, and build processes and controls to automate the work where possible.”
It’s no surprise a fund administrator sees the economic rationale of his own business model, but anecdotal evidence supports his position. In conversations with pfm, CFOs increasingly mention the need to outsource and invest in new technologies to optimally manage their limited resources. The hard data paints a grayer picture. Research conducted by parent publisher PEI and EY found that a notable fraction of private equity firms continue to resist outsourcing functions (see graph on p.24), but also discovered that investors are feeling much more comfortable about GPs outsourcing core finance functions like tax and accounting. Some LPs are even beginning to demand it.
It’s only a matter of time before fund managers follow investors’ leads, reckons Tyne, who believes the private equity asset class is following the same path to outsourcing taken by most hedge fund managers 10 years ago.
“Five years ago, private equity managers would receive due diligence questionnaires (DDQs) from pension funds that asked, ‘Do you use a third-party administrator?’ Now they all ask, ‘Who is your third-party administrator?’”
Still, a notable percentage of GPs have retained many finance and administrative functions in-house for a reason. Relinquishing control over internal processes can feel uncomfortable – a hesitant CFO may prefer direct oversight over his or her tax, accounting and reporting responsibilities. But the sheer amount of work – including state tax returns, K-1 deliveries and LP meetings – is making the status quo unsustainable: CFOs either need to convince senior management a bigger back office is needed, or to turn to outside specialists for help. Meanwhile, threats like cybersecurity and unclear marketing rules in Europe are shaping how GPs speak about the need to solicit (or decline) the help of third-party administrators.
It was against this backdrop that pfm assembled an equal mix of fund administrators and private fund CFOs in midtown Manhattan to discuss the evolving relationship between the two parties. After pleasantries were exchanged, it wasn’t long before the roundtable’s CFOs began airing their biggest outsourcing concerns and questions.
Tough questions (and answers)
Preferring to have direct supervision over staff is perhaps the most cited objection to outsourcing. When funds are administered in-house, the CFO can walk down the hall to check the progress of a capital call notice or satisfy an enquiry in mere minutes.
Using a third-party administrator means sometimes having to “wait a couple of hours” before getting a response back, says Rodd Macklin, chief financial and chief compliance officer at NGP Energy Technology Partners, a firm that outsources. “Not having the general ledger at my fingertips is really the only issue for me.”
Wanting a team wholly dedicated to one set of fund accounts is probably the second most-cited concern.
Peter Lyons, chief financial and chief compliance officer of Leeds Equity, wonders how an outside administrator – dividing its resources across any number of clients – could replace a team of in-house staff “working 60 to 70 hours a week that know our partnership agreement backward and forward.”
He asks the roundtable’s fund administrators how they treat LPA terms open to interpretation, those which may require the CFO’s best judgment.
Cass fields the question first. “It’s a valid point, and one of the reasons there are different service models in place, where one size doesn’t fit all. Depending on the firm’s size and complexity, an administrator could actually have that same dedicated team in place – it’s why we call ourselves an extension of your back office.”
Alternatively, Cass elaborates, the administrator can assign specialists to different portions of the work. One individual solely handles the settlement of securities transactions, another the bank reconciliations, and so on.
“At some firms, particularly the smaller ones with limited resources, it might be a situation where everyone has to be a jack of all trades – which could mean someone with a MBA devoting time to the general ledger, or an Excel spreadsheet, when what they really want to be doing, and indeed may be more qualified, is something more on the deal-side. With an administrator, we can have specialists along the chain, masters of certain functions. It allows us to ‘assembly line’ the work to a certain degree, allowing time to then work on exceptions or uncommon transactions,” Cass explains.
Maher offers a different kind of follow-up, noting that administrators who handle multiple partnership agreements end up accumulating ample experience interpreting various fund terms across a range of clients. “At any rate, it’s our job to walk the CFO through our interpretation of, say, the waterfall distribution. And once we all reach agreement on the fund terms, it’s a very smooth transition to outsource.”
It’s one of the roundtable’s CFOs, Macklin, who responds to Lyons’ question with a third point. He sets the scene by describing a tense call he received earlier in the year:
“It was a friend of mine, a CFO, who just lost his Number Two person right as busy season was heating up. He was completely panicked, and wanted to know more about my model – and whether outsourcing was something that could provide him some relief. ”
The underlying point, of course, is that well-staffed third-party administrators are better able to cope with the loss of talent, something especially valuable when the work inbox begins piling up. Moreover, administrators, in one respect, can act as a knowledge repository for back and mid-office staff. The sudden departure of a controller, or even the CFO, can be a significant loss of institutional memory for the firm.
But what about that first objection? The one about losing direct supervision over staff.
Without having immediate oversight of the fund administration process, or knowing what precise level of care is being devoted to the fund, CFOs end up wanting to double-check or “shadow” an outside service provider’s work.
Joshua Cherry-Seto, chief financial officer of Blue Wolf Capital Partners, cites carried interest as a prime example of where CFOs often feel nervous about loss of control.
“Everyone’s LPA is different, and so the waterfalls are complicated. For example, as partners move around and their carry allocation rights change, you may be juggling multiple high water marks for when people start getting into the money. It’s hard to let an administrator take that on without feeling the need to stand over their shoulder.”
Maher responds saying that administrators are regularly speaking with industry software providers that specialize in waterfall calculations to “allow the CFO to perform a top-level review of the waterfall cascade, see how it lays out economically, and feel comfortable that the numbers look good without having to perform a full shadow”
Cass elaborates on the point, mentioning that new technology is providing greater transparency into administrators’ processes through workflow tools that “allow the CFO to interact, discuss situations that are open to interpretation and have a vote where they want to be involved.” Progress bars that track the status of a capital call notice, for example, allow the CFO to “know where we are at in the process in real time,” says Cass. “Allowing client access makes it less about double-checking and oversight and more about enabling a partnership where manager and administrator act as one.”
Ultimately, administrators’ goal is to reach a point where the client doesn’t feel the need to shadow the work at all, adds Tyne.
“I’ll be surprised if in 10 years from now we still have this ‘shadow’ concept,” he continues. “Part of it is that, compared to other asset classes, private equity funds have been slow to adopt the outsourcing model, and so are still getting comfortable with the idea of relying on a third-party administrator to manage an entire suite of services.”
With thoughts of the future circling the air, Cass makes an equally bold prediction: “I don’t think you’ll even call it administration 10 to 15 years from now. The term denotes record-keeping and secretarial work; but the business model has evolved into a full offering that includes regulatory filings, custody arrangements, reconciliation and more mid-office services.”
There’s a deeper truth to his point. Fund administrators are increasingly becoming specialists to keep pace with client demands. As GPs blur their investment strategies, and utilize complex legal structures to accommodate LP demands, they’re eager for a smarter way to manage the accompanying paperwork and workload. Many wonder how exactly their third-party service providers can help.
Managing the complexity
Tax is a prime example of where CFOs are looking for relief. In recent years, GPs have become increasingly comfortable with the idea of investing in portfolio companies organized as flow-through entities (such as limited liability companies) for tax purposes. But the tax efficiencies achieved come at a cost: more work for the firm’s finance unit.
“CFOs are only just coming to realize the additional administrative workload these structures create as fund tax returns become dependent on K-1s generated by portfolio companies and the mountain of state tax return notices these flow-through investments are resulting in at the fund level,” says Cherry-Seto, who predicts the trend to only accelerate. “The workload can be both chunky, bunching up around tax reporting, as well as non-core state coordination, both creating an opportunity for value-added administrative support.”
“We just did our first investment in a pass-through and the economics behind it are really attractive,” adds Lyons. “We setup a parallel alternative investment vehicle (AIV) and let LPs invest either through a traditional blocker or invest directly through the LLC – it was certainly more complex but I know that our deal teams are looking for opportunities to do more.”
While most of the structuring and planning here falls on the firm’s legal counsel and auditors, fund administrators are also being utilized to “manage this type of cyclical work,” says Maher.
“It’s important to have your administrator involved early in the investment process because the exact tax and legal structure could dictate your reporting requirements,” Maher continues. “And depending on the country you’re domiciled in, we can be heavily involved in those regulatory responsibilities.”
The industry is also experiencing a convergence of the different alternative asset classes at the moment. An increasing number of firms are exploring credit strategies and other product lines to diversify risk and increase assets under management.
“There is a lot of complexity in the types of systems GPs are purchasing now – a private equity manager exploring infrastructure, for example, needs a much more robust portfolio accounting system; it’s an area where you can’t get by with an excel spreadsheet to handle your bank debt processing. Not only that, institutional investors wouldn’t accept it,” says Cass.
What’s more is that investors that cross several assets classes, including private equity and real estate funds, are used to a certain level of transparency and reporting, which is “leading some to demand independent fund administration across the entire portfolio,” adds Maher.
Nowadays, GPs are also establishing funds all around the globe, resulting in the need for local expertise. Tyne argues that administrators with a global presence can allow GPs hunting for capital and deal opportunities in new lands to hit the ground running.
“The idea that administrators are just bookkeepers is no longer the case. We’re tracking regulatory and legal developments to stay on top of fund reporting requirements. We’re constantly investing in new technology to automate and simplify the process for GPs – who may not be familiar with a foreign regime they’re entering for the first time.”
The common denominator in these trends is clear: fund administration, more so than ever, is complex business. And complexity usually means cost, leading to the question: who’s going to pay for all this?
Splitting the check
Fund managers have a delicate balance to preserve when it comes to allocating fund administration costs. But perhaps surprisingly, the roundtable’s CFOs all agree fund administration costs have not been a major focus area for investors during fundraising and LPA negotiations.
“We last raised a fund in 2013, and LPs were far more interested in the nuts and bolts of our operations rather than any specific part of our fund administration,” says Cherry-Seto.
However, the roundtable agrees fund administration costs have become part of the larger conversation on fees and expenses – which regulators have placed a burning spotlight on via speeches and during exams in the last two years.
The term “fund administration” alone implies that administration costs are borne by the fund, but GPs are rightfully treating back- and mid-office expenses on a case-by-case basis.
“Our LPA was negotiated before we registered with the SEC in 2012 – so the partnership agreement didn’t take into account some of these new compliance costs,” says Macklin, whose firm decided Form PF filings and certain other costs related to SEC registration would be picked up by the management company.
During these expense allocation exercises, something to be mindful of is the rising reporting and regulatory costs for all parties involved, adds Maher. “The world has changed. Whether it’s Europe, the US or somewhere else, the cost of doing business has gone up; and LPs appreciate that the management company is not off scot free when deciding a fair division of expenses.”
Happily, fund administrators can help guide the expense allocation procedure when necessary, says Cass. “CFOs are always wearing their fiduciary hat for investors, but we try to have a dialogue to say ‘Based on our experience over the years with other private equity and other alts managers, here’s where we think the fees are appropriate for the management company and/or fund’, and then they’ll talk to their audit and legal partners to reach a final decision.”
All told, as more private fund managers consider outsourcing (assuming they haven’t done it already), administrators are making a clear proposition: leave it to us to invest in all the right IT, which is becoming increasingly specialized and expensive to facilitate today’s complicated deal structuring. And should more banks shed their fund administration practices, expect a build-up of talent at the firms dedicated to the job. Heightened reporting requirements – from both LPs and regulators – are helping fund administrators make that case; but the private funds industry is slow to adopt new practices. In this instance, however, it will be interesting to watch if that pattern will break.
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