Among their numerous (and growing) responsibilities at the firm, CFOs always have the management company’s budget in the back of their mind. Some CFOs confront the budget on an annual basis, but many tell pfm that they look it over more frequently, sitting down with partners and COOs quarterly or even monthly to ensure that the firm is staying on track.
At any rate, seasoned CFOs know that, while every detail may be perfectly mapped out on paper, unexpected budgeting challenges are bound to arise. When those hiccups happen, CFOs need to put out the fire and ensure that the firm can run smoothly in spite of any obstacle. But while CFOs can ring their peers to share best practices in areas like compliance and valuation, budgeting is an issue that varies too wildly from firm to firm, and is not always seen as an easy topic on which to compare and contrast.
Nonetheless, pfm carefully devised four budget-related challenges from which a wide range of firms should be able to glean insights. Four CFOs answered our call for guidance.
Budget challenge 1:
Your current fund is at the end of its investment period and fees are winding down, but your next fund has yet to launch. How do you estimate uncertainty in your cash flow projections, or any other difficulties related to budget forecasting – as well as your relationship/agreements with any third party banking providers – during that transition?
As CFO at HGGC Lance Taylor puts it, “That’s a situation you never want to be in.” However, especially for newer firms, a gap in between fundraises is a very real threat, and can pose serious budget complications. Our CFOs agree that the best way to handle this scenario is to maintain a higher capital balance for each of the partners who are running the business, so that it gives the firm more flexibility during leaner times.
At every private equity firm, the biggest cost is its employees. If there’s a delay in raising a new fund, CFOs may have to start thinking about reducing the headcount, or more likely, addressing the largest variable expense item: bonuses. While this scenario may mean bonuses are deferred or reduced, the partners bear the brunt of the fluctuations. “That’s how a true partnership works; when there are ups, they get the ups and when there are downs, they take the downs,” says Taylor.
Rockland Capital CFO and CCO Terry Everett agrees that a management line of credit can come in handy in this kind of scenario, but cautions that one is not always readily available. Younger firms especially may find it challenging to get banks to lend to them without a history of management fee revenue across multiple funds. “Depending on where you are in the life of your firm, trying to obtain such a credit facility can create its own set of challenges,” she warns.
INSIDE VIEW: KPS Capital Partners
“When funds are in that transition period where fees are ratcheting down for Fund X but a firm does not have Fund Y ready to go, you have to consider cutting expenses. And you can never be sure that the next fund is going to be the same size or bigger than the last one. We don’t use a line of credit so every once in a while, we take stock make sure we aren’t getting too fat, asking ‘Do we really need to spend this money? What if it were 10 years ago, would we make this expenditure?’ We separate out the wants from the needs, which prepares you for when you need to tighten the belts. We never want to just spend money just because we have it, because we want to apply the same level of discipline we expect our portfolio companies to apply as well.”
-Stephen Hoey, partner, administration and CFO, KPS Capital Partners
Budget challenge 2:
Your fund does a flurry of deals one quarter, but then nothing for the next 12 months. What’s the game plan?
For some private equity managers, this situation may not be the end of the world budget-wise. The way most limited partnership agreements (LPAs) are written, when you’re in your investment period, you’re able to collect management fees and have cash flow from that time period, irrespective of how many deals the team is getting done. A lengthy dry spell can be more problematic, CFOs warn, if it occurs when a firm is raising a new fund and trying to find seed investments.
Overall, this period might do more to affect a firm’s psyche than its budget. When real estate private equity firm True North Management Group closed its second fund in March 2010, the US real estate markets were just beginning to emerge from the doldrums of the great financial crisis. True North chose not to invest until December of 2010. Waiting for the right deals took a “real force of will,” says former CFO Desmond McGowan. “During the initial part of the investment period most fund managers face a lot of pressure from their investors to invest, who want to get their money working. Long delays also magnify the ‘J-Curve’ effect. All of that pales, however, in comparison to making a bad investment decision,” he adds.
INSIDE VIEW: Rockland Capital
“If your deal team has not consummated a deal for 12 months, 12 months of your investment period has just been used up. Which means you’re going to get to the flip period on the management fee structure without having a substantial portion of your capital invested. If there are no deals in the market that are compelling, it would be unwise for the deal team to pursue deals with the primary purpose of investing the capital. It requires a bit of restraint on the part of the deal professionals; they are feeling the pressure of having that huge dry spell and they’re likely fielding a lot of questions from LPs. This is a time when communication with LPs is essential, along with scheduling time to describe to them what’s happening in the market creating these situations where we aren’t doing deals. Hopefully, these dry spells are due to market conditions as opposed to going after deals and not winning the bid. That would be more of a challenge to explain to the LPs.
There are typically two reasons as to why deals aren’t getting done: it’s either economic in nature, or just poor execution, and you don’t want to be the latter. If this were to occur, in the best case that 12-month dry spell occurs during a time when your fund is still in the investment period, but in event that it crosses over to your flip period, you do have to be mindful of the impact on the budget. A prudent firm would look at alternatives such as at not taking as much out of the company for management team bonus compensation, and pulling back on nice-to-haves versus the must-haves (i.e. things such as conferences, where the costs will be borne by the management company and where travel can often become expensive).”
-Terry Everett, CFO and CCO, Rockland Capital
Budget challenge 3:
How do you determine how much to budget for line items like computer equipment and technology that can change rapidly from year to year?
Judging by responses from CFOs, policies on the technology budget vary from firm to firm, and the rules are, for the most part, made to be broken. All the firms we spoke to have two- to three-year replacement policies for laptops, and around five-year replacement policies for servers, while other upgrades like updating software or moving to the cloud are less predictable.
Hoey notes that while KPS does not have a hard and fast technology budget, the team is always looking to improve based on recommendations from IT consultants or feedback from team members who have heard of useful hardware or software tools being used elsewhere. “We could go a number of months or even a year not updating anything and then all the sudden we upgrade this, that and the other thing,” he adds. “We want our professionals to have the best tools available to allow them to be more efficient. It fits with our firm’s goal of continuous improvement.”
As a best practice, Taylor suggests sitting down with your IT director to map out a detailed five-year plan, budgeting for server upgrades, software upgrades and other improvements the firm may want to put in place down the road to make its technology more efficient. However, since IT budgets can represent a smaller fraction of a firm’s overall budget, some variation is acceptable and expected, particularly when it comes to new devices or resources for the deal team. “It’s small dollars in the grand scheme of things. Anything to make the deal teams’ lives easier and get the next deal done is usually money well spent,” he says.
Everett adds it can be tough to “quash the excitement” of a new device. “It’s the new shiny objects that come along as technology advances that light a fire and get employees excited about wanting to have the latest and greatest technology,” she says. “But if an employee wants the device and can make a good argument about why it’s needed, we’ll probably get it, particularly if it makes an employee more productive.”
INSIDE VIEW: True North Management Group
“All budgeting exercises should look at both operating costs and investment, and the best example of that is technology. During my time at True North, my budget practice for personal computers was, irrespective of how old the machine was, it was replaced after 3 years. Machines get newer, they get faster, but more importantly they break far more often in years four and five than they do in years two and three. With servers, we were on more of a five-year schedule. But then you also have the subtle things, like what am I going to add in terms of new technology and new software? And you have to couple those questions with an assessment from an HR point of view as to how receptive your group is, or what the payoff will be for implementing, say, a new client relationship management system, or a mid-office function like an enhanced investor reporting system or a portal.”
-Desmond McGowan, former CFO, True North Management Group
Budget challenge 4:
How do you coordinate conversations between lawyers, auditors, tax advisers and others when you’re working on a budget before the LPA has been finalized?
Issues like the way the LPA treats transaction and monitoring fees and other offsets, and how services like legal and tax advice are charged back to the fund, have become particular focuses of the US Securities and Exchange Commission (SEC) during exams of late. Most recently and publicly, The Blackstone Group faced fines for receiving a better deal on legal feels than its funds received for the same firm. Terms like this, that can greatly impact the budget at the management company level, need to be dictated in the LPA, something firms need to consider if they have not come out with a new fund since the SEC scrutiny became heightened post Dodd-Frank.
Once you’re at the drafting stage with your LPA, you’ve probably had a good six months or more of forewarning that you’re heading towards the fundraising trail, notes Everett. “At that point you’re talking to your fund formation lawyers, asking them what they’re seeing in market terms and whether there have been any shifts in trends,” she says. “Have those discussions early on, because it would be ill-advised and risky to go out with an LPA that’s off-market.”
At Rockland, another consideration when it comes to audit and tax fees is the annual fund budget Everett and her team must present to the LP advisory committee every year. There, she has experienced a push and pull with her LPs around pricing, where some LPs only want to use Big Four firms, for example, that come with a higher price tag, even though the firm may prefer a smaller regional firm to save on fund expenses. In those situations, it is important to have candid, ongoing conversations with LPs, who may become more flexible, she notes.
INSIDE VIEW: HGGC
“I think of this question in two parts: One, how much do you budget into your fundraise as an organizational cost cap so that you cover your costs without crippling your future management fee stream? This drives the cost discussions with your service providers who are assisting you in your fundraising activities. And two, what types of fees are you going to enumerate in your LPA and PPM; are they market level fees and what level of disclosure is needed to be transparent on those fees? Because of the scrutiny from the SEC, there’s a lot of attention going into drafting the fee and expense sections of the LPA to make sure they’re clear, and that they accurately represent how we do things within the firm.”
-Lance Taylor, CFO, HGGC
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