What’s next for fund administration

The private equity industry is emerging from the downturn in deal-making that took place during the global financial crisis. After sharply rising from less than $100 billion in 2003 to $500 billion in 2007, US leveraged buyout deal values collapsed to less than $20 billion in 2009. The surge in global liquidity in the years before the crisis created what many believe was a “golden age” for the private equity trade. But the decline of global real estate prices and of markets for mortgage-backed securities and collateralised debt obligations abruptly shut off liquidity taps, restricting credit to private equity.

Despite the general decline in risk appetite and valuations in public markets over the course of the financial crisis, investors kept their faith with private equity. According to a recent survey from Preqin, fully 65 percent of respondents said that they intend to maintain their allocations during 2010, while a further 22 percent actually expect to increase their allocations this year. Over the longer term, the majority of investors intend to either maintain or increase their allocations over the next three to five years.

While deal markets in 2010 have begun a tentative recovery, with new launches and markedly improved prospects over one year ago, the outlook for private equity – an industry largely defined by the credit environment – is not easy to predict.  One thing seems certain; the private equity market that existed amid the great risk rally of the past decade is unlikely to return any time soon. We can already observe a shift in the industry’s center of gravity, with limited partners increasingly in the driver’s seat, dictating deal terms and defining many aspects of general partner operations, fund administration and day-to-day business.

Structural impediments to growth

Even as economic recovery takes hold and deal activity inches upward, prospects for new fundraising are being inhibited by structural factors inside the industry. GPs today are sitting on a mountain of capital that was committed during the boom years but remains uninvested. This “dry powder”, which may total up to $1 trillion, set aside for buyouts, venture capital and real estate, may take several years to deploy.

Another industry constraint is the restrained appetite for new deals on the part of limited partners such as pension funds, endowments and other institutional investors. While investors in industry polls have expressed continuing interest in private equity investment and the uncorrelated returns that it can offer, for many LPs, their allocations to PE remain at the upper-end of their allocation limits.

The culprit here is the “denominator effect”, by which the proportion of total allocations dedicated to private equity shot up as the value of LPs’ public equity allocations plunged in the market crash of 2008 and 2009. This effect left many institutional investors over-exposed to private equity, short-circuiting their carefully optimised portfolios. While this phenomenon abated substantially with the recovery of equity markets in 2009 and 2010, many LPs are waiting until public markets recover further before allocating fresh capital to private equity.

It’s safe to say that the financial crisis has changed the way that institutional investors interact with general partners. In the years before the financial crisis, LPs were content with GP reporting that gave a general overview of investments and risk. Today, by contrast, LPs are much more interested in the fine-print details. Within LP organisations and boards, risk management has taken on a new primacy. They want their private equity investments to come bundled with high-value, timely and granular information on investments, performance and risk exposures.

And of course the nature of LPs continues to evolve. Increasingly, these investors represent large pension and endowment structures and so have an inherently greater appetite for investment detail. Private equity, for these institutional investors, is becoming a mainstream strategy, offering long-term, uncorrelated returns, reduced exposure to business cycle risk and a durable track record across multiple investment cycles.

The move to third-party administration

In the wake of the financial crisis, general partners are increasing the speed of their migration to third-party administration. Post-crisis, the industry expects to see fewer mega-buyout deals and an increasing proportion of activity dedicated to more nuanced deal types in selected industries and geographic regions. This means that general partners will need to broaden their offerings to accommodate a variety of private equity activity. Third-party administrators, because they have experience with many different kinds and sizes of deals in multiple jurisdictions, can bring forward niche expertise and knowledge of regional idiosyncrasy.

As recently as three years ago, consultants were estimating that only 15 percent of private equity assets were administered through third-party entities. Today, this proportion has doubled to the realm of 30 percent of assets. Generally speaking, this trend is more advanced in Europe than it is in the United States. In Europe, GPs make greater use of onshore/offshore structures and so use third-party administrators to avoid having to self-administer in multiple jurisdictions.

The decision to employ third-party administration is largely driven by the practical fact that private equity chief financial officers find it difficult to keep up with the accelerating demands of managing fund administration in-house. Leading third-party administrators tailor administration to the needs of individual funds. In some cases, they provide support and targeted deliverables; in others they assume all the duties of a fund chief financial officer.

Third-party administration is also being driven by limited partners and regulators that are increasingly demanding that funds provide greater transparency, information access, robust operational infrastructure and reporting capabilities similar to those found in traditional public equity investment classes.

As private equity enters the mainstream, general partners encounter mainstream expectations for service delivery and clarity. Investors in mutual funds, institutional asset management and hedge funds express vast demands for information. Increasingly, limited partners in private equity also want to “interrogate” their information. They want to cut and dice, model and interact with their data in multiple ways.

Industry-leading administration

The decision to outsource administration doesn’t come easily. For good reason, general partners are concerned about the security of their proprietary data, accountability, cost efficiencies and stability. Historically, the quality of third-party administration has been variable. In consequence, a second wave of industry migration is underway. The first decision to outsource is largely a matter of industry momentum. Post-crisis, investors want the surety and checks-and-balances that a third-party administrator can provide.

But given the new diversity of deal structures and the aggressive migration of deal activity around the world, LPs are undertaking a flight to quality among third-party administrators. General partner engagement of third-party administration is a substantial commitment. The relationship can be “sticky” and GPs want to know that their administrators will offer industry-leading service, will evolve this service over time and, most importantly, will be in business several years down the road. In this regard, the balance sheet of the third-party administrator’s parent corporation has become a major component in the decision.

As with the custody and administration of public market investments decades ago, private equity administration today is undergoing a winnowing, with powerful forces driving consolidation. As demand for detail and timeliness in third-party administration has accelerated, administrators are climbing a steep growth curve and encountering expensive industry and regulatory demands for operational infrastructure and technology. Today, limited partners’ request-for-proposal processes include detailed questionnaires focusing on infrastructure, fail-safes, backups, audits, and an increased emphasis on diverse client references.

This proliferating complexity has triggered administrators to merge in an effort to leverage global scale. What has emerged is a new animal – a massive, multi-market, multi-strategy private equity administrator that can deliver state-of-the-art infrastructure and high-value services all over the world.

In a difficult fundraising environment, GPs want to be able to tell clients and prospects that their administrator has infrastructure, jurisdictional reach, embedded knowledge and a strategic oversight of private equity that is truly global. And as private equity has become increasingly intertwined with other strategies (for example with hedge funds participating as limited partners), GPs can benefit from employing administrators that deliver services from within a multi-solution alternative investment administration framework.

The recovery in private equity will be nuanced, with activities in particular industry sectors, deal sizes, formats and regions growing at different rates. Global scale administrators with experience in different investment styles and regions, and with personnel experienced in various types of activities, can add value by cross-fertilising ideas and best practices.

Large administrators, built from merged legacy institutions, bring a diversity of professional perspectives and cumulative years of experience. They appear well placed to offer global scale, a breadth of service offerings, cumulative years of experience and deep knowledge of industry-leading services and infrastructure. These administrators understand that private equity is being used in concert with other alternative and traditional investment strategies, and that many best practices in the administration of those investments can be brought to bear in the administration of private equity.

This communication is directed at professional clients (this includes eligible counterparties as defined by the UK’s Financial Services Authority) who are deemed both “knowledgeable and experienced” in matters relating to investments. The products and services to which this communication relates are only available to such persons, and persons of any other description (including retail clients) should not rely on this communication.

George Sullivan is executive vice president and global head of State Street’s Alternative Investment Solutions Group. Iain Stokes is a senior managing director in State Street’s Alternative Investment Solutions Group.