'Triple-A' private funds

A new era of transparency and reporting could open the door wide enough for one innovative group to craft a Moody’s type-service for buyout funds. The benefits for star managers could be greater exposure to LPs and making it easier to negotiate management fees, writes Nicholas Donato.

An interesting thought was brought up by an EU-based fund of funds manager in a recent conversation with PEM. He raised the point there is no Standard & Poor's or Moody's for private equity funds.

The manager was speaking from his vantage point as an investor inundated with marketing pitches from the 1,500 or so funds expected to come to market by year’s end. But his dual hat as a fund of funds GP makes the suggestion particularly interesting. A comprehensive performance review of funds in market would marginalise his role. One of the strongest attributes a shrinking fund of funds industry retains is the ability to cherry pick funds for investors.

His fate however is not sealed – attempting to implement an independent credit-rater of funds is no small feat.

For one private equity houses would have to be willing to agree to such an initiative. And there are just as many reasons why they would be willing as they wouldn’t. Successful firms without the advantage of having a brand-name would gain greater recognition as a top-tier operation. In a digression on management fees, Bela Schwartz, chief financial officer of The Riverside Company, said his firm would certainly support the idea. A few columns of performance metrics and other firm data viewed alongside their respective rankings would make it easier to negotiate fees with investors, said Schwartz. A GP could in theory justify a high management fee by pointing to their independent “triple A” rating score.

The upshot is finding industry-wide support. To hand over sensitive fund data to an outside organisation that has not yet established their reputation in the asset class is a big confidentiality risk with perhaps little reward. Those at the bottom quartile of the industry would likely shy away from submitting performance figures, making an exhaustive performance review of funds available more difficult.

Volunteered data may however no longer be necessary. Transparency measures in the US under Dodd-Frank and the Alternative Investment Fund Managers directive in Europe may open the door to an eventual third-party judge of funds. Morningstar, a Chicago-based research company, has in the past attempted to crack the private equity sector, according to a source close to the group. Morningstar offers quantitative ratings of hedge funds, mutual funds and other asset classes. The plan to score private equity was later scrapped due to the difficulty in assessing illiquid assets and limited access to data. But a filing with the US Securities and Exchange Commission could potentially be enough to go on.

Some innovative solutions to rank private equity funds have already been developed. The HEC School of Management in Paris and Dow Jones joined forces two years ago to size firms up in terms of their “competitive fitness” going forward.  The research scores firms on ten different criteria including the ability to take access cheap debt financing and uniqueness of strategy. Silver Lake Partners, Warburg Pincus and Nordic Capital grabbed the gold, silver and bronze respectively in this year’s fitness rankings released in mid-May.

But until a quick and easy guide for funds is developed, limited partners will have to continue combing the books and marketing materials to find the best deals. A crucial endeavour as private equity has such a wide dispersion of performance. Or, alternatively, investors can always identify a reputable fund of funds, of course.