Expert commentary: Gen II on the tipping points

The private equity industry certainly hasn’t stood still in the last few years. Regulatory and compliance issues have LPs demanding greater detail in reporting along with heightened demands for transparency in operational processes and procedures. What that means is fund operations have become more complex, more labor intensive and more important than ever before.

Like any other business, private equity firms can develop a certain operational inertia where there’s a bias to maintain processes because “that’s how it’s always been done.” So what are some factors that argue for a firm to begin reviewing its current operational environment?

It’s rarely about the size of assets under management or when a GP moves into a new geography; it’s how complex the administration of each fund entity has become. What do the LPA and GP side letters demand from the fund? Will there be a number of co-investment funds to manage as well? Given the current regulatory and compliance environment, does the firm have the internal infrastructure to give LPs comfort on matters such as cybersecurity? Many LPs are now requiring a level of detail above and beyond anything laid out in a LPA or even a side letter.

We see an increased level of outreach to us from GPs that currently perform fund administration in-house for many of the reasons mentioned above. And for those outsourcing already, we see increased focus by the GP’s team and their LPs to ensure that as their fund administrator, we stay on the cutting edge of regulatory developments, technology, and most importantly, service quality.

The truth is that fund complexity drives the requirements for fund administration. It’s not necessarily the amount of assets under management, since a firm managing $500 million and one managing $2 billion can have similar levels of complexity. For example, what does the new organizational chart look like? What additional ad hoc reporting is requested and how frequently do the requests come in? For a GP that has built a great operational team with an effective set of processes for their funds, the GP now sees that the complexity has multiplied. Their operating procedures, controls, and team in place today may not suffice going forward.

Today’s LPAs: More rigor than ever before
One of the ways GPs can determine if it’s time to start outsourcing is the number of side letters in the new fund, which require reporting and finance team responsiveness above and beyond what’s spelled out in the LPA. That means more time spent to meet the regular requirements of a fund, so in-house teams can get overloaded with normal fund operations. This many times impacts how the firm is able to focus its senior operations team to work on more strategic priorities.

Another recent development impacting the team includes the implementation of the ILPA fee template into the quarterly reporting process. This has the potential to multiply the work of an in-house team depending on the number of LPs requesting its adoption. GPs have contacted us concerned about their ability to service LPs as effectively as they have had in the past given this new requirement.

LP requests for access to co-investments can also complicate fund administration. Every time there’s a deal with a co-investment, that’s another vehicle to manage and service in addition to that original fund. Layer on top of that the requirement to account for expenses at the co-investment fund level to ensure SEC compliance and it is no surprise that GPs are stretched to levels never before seen. But the most taxing LP demands aren’t in the fund documents. They’re the ones that arise over the course of everyday fund activity.

Expect the unexpected request
Many of the GPs we talk to find themselves managing one-off requests that arrive unexpectedly and suddenly swallow up more of their team’s time. That leaves in-house teams always operating in a catch-up mode with little time to think strategically about ways to improve processes or even tackle the tasks they had planned to get done. GPs continuing to perform administration in-house will need to invest increased resources in people and technology to meet these new requirements.

So even if the LPA has modest demands, or the side letters are few, how able is the team to handle any other additional requests? Some CFOs argue that these instances demonstrate their team’s value to LPs, but as standard reporting requirements continue to rise, it’s hard to handle the unexpected requests alongside the expected ones with the lean teams so common in private equity shops.

With the increased focus by LPs on fund operations, now is not the time to be under investing in the firm’s infrastructure. The LP due diligence exercise of regulatory and compliance matters, cybersecurity, proper processes and procedures underscores the importance of the CFO’s team.

Compliance minded
For a firm that hasn’t been on the fundraising trail recently, today’s RFPs from LPs can come as a shock. The sections on operations/risk/compliance are exponentially greater than the last time the GP had to complete one. There are questions about compliance process and cybersecurity, areas that some GPs may not have the infrastructure to address, but that LPs now see as a prerequisite.

In many ways, LPs want the firm to operate as a regulated entity, with an institutionalized back office, able to answer questions about firewalls and safeguards to stop their information from falling into the hands of third parties. More than any particular piece of regulation or SEC guidance, it’s the overall climate that has LPs vetting the operational side of the firm right alongside the track record. In another sign of growing LP preference for the third party administrator model, the new ILPA due diligence document asks for the GP to name their fund administrator.

Top fund administrators have key attributes in place that put LPs minds at ease, including an annual SSAE 16 audit, cybersecurity compliance, independent quality control, and zero error tolerance. Indeed, LPs have been conducting intense due diligence on GPs and their administrators to ensure the GP meets enhanced requirements. We have regular sessions with LPs to address their questions – these days our conversations with gatekeepers and LPs have become highly focused on understanding effective procedures and controls, compliance throughout the accounting and reporting process, and instilling confidence in quality and timeliness of information delivery.

The human capital question
Even for the in-house teams that have a robust, capable staff, the increased demands of fund administration means that the CFO has to manage the risks inherent to that process. The reality of any business is that bigger teams create larger human capital risk. Private equity firms are often flat organizations on the operational side with fewer places for advancement, so turnover is a major factor.

The question lingers that if that fund accountant quits, how easy can their replacement be found? Does the rest of team have the capacity to pick up that slack? How does the GP ensure team continuity for the long term? Outsourcing provides the ability for continuity of service. At Gen II, we have built in redundancies and capacity within our dedicated service teams to ensure that we will be able to service clients at the highest levels and that GPs will always be able to meet LP demands.

The right service provider for the right time
There’s a growing roster of GPs that outsource, but not all service providers are the right fit for a GP, so what are some signals that it might be time to consider an upgrade? Any inability to meet the requirements of the service agreement is reason to review the relationship. And failing to deliver a report accurately and on time, even once, is unacceptable.

Another warning sign may be if a GP’s business is too large a part of the service provider’s overall client base. If that client is too big a share of the administrator’s business, the administrator may be straining to meet that client’s needs, under-investing time and effort in smaller clients. This presents a risk for GPs considering that administrator.

A third area of concern expressed by GPs is a high level of turnover at the administrator. Turnover is a huge Achilles heel for the fund administration industry, and administrators need to work hard to ensure that the key members of the service team are incentivized to remain within the organization.

The reality is that outsourcing fund administration shouldn’t feel like handing off this vital role to some vendor outside the firm. It should feel like engaging with a new partner with fiduciary responsibility, proper processes and controls, and a higher level of operational ability than previously experienced while mitigating the firm’s operational risks. The right administrator should be an indispensable and vital upgrade for the private equity firm.

One of the ways GPs are determining if they need to hire a fund administrator is understanding the requirements within a few key documents:

The RFP: Does the in-house team have the proper experience, certification, compliance, controls and technological infrastructure LPs have required?

The LPA: Can the in-house team meet the quality and timeliness standard of reporting and administration being negotiated in the new fund?

Side letters: How many are there? How many different templates and special requests, such as the ILPA fee template, will the team need to juggle?

This article is sponsored by Gen II. It appeared in the Yearbook supplement published with Private Debt Investor in December 2016.