Pressure builds for private equity outsourcing

Against a backdrop of extensive regulatory and market change, many private equity firms are under mounting pressure to deliver greater transparency, better reporting and tighter accounting controls. A host of regulation – the Dodd-Frank Act, the Alternative Investment Fund Managers Directive (AIFMD) and the Foreign Account Tax Compliance Act (FATCA) – coupled with greater demands from more sophisticated investors in the post financial crisis environment, are focusing attention on the transparency, quality and timeliness of information provided by general partners (GPs). The days of relying on one person and an Excel spreadsheet are long gone.

Regardless of the approach taken by GPs, ongoing compliance costs will increase, whether GPs pay for them directly or through their service providers. GPs are now at a crossroads and must decide whether in-sourcing or outsourcing back office functions is the right decision. This article explores the key factors that GPs need to look into when making up their minds.

Key issues to look into

When deciding whether to outsource back office functions, GPs have a number of issues to examine. These include: the quality of personnel, best use of resources, intellectual capital (dependence on one key individual), credibility and independence, industry perspective and cost. While economies of scale might point towards third-party administration as the more cost-effective solution, this is not always the case or the right solution.

Historically, the private equity fund has generally paid administration fees rather than the GP, so in most cases outsourcing was a better financial deal for the GP. But limited partners (LPs) are increasingly unwilling to foot the outsourcing bill and are negotiating hard with LPs on the topic of outsourcing expenses. In future, fixed fee bases may not work. Instead, they may move in line with management fees to include an element that depends on future upside. Some GPs are keen to add staff instead of outsourcing administrative functions. They believe building in-house capability means they keep a close eye on costs and don’t pay third-party profit margins. What’s more, this helps to build their substance from a tax perspective.

But GPs that in-source administration will need to enhance or amend their back-office processes and invest in new technological infrastructure to support them. Doing so will divert attention and resources from the main business of running a private equity fund – which is sourcing and executing deals. Even so, the low level of deal making means many firms are looking into the in-house route, as they have surplus staff they need to redeploy.

Yet partnering with an external provider that has an established track record, proven technology and honed processes brings benefits. GPs can take advantage of more flexible, scalable administration solutions. Indeed, some LPs now place great emphasis on whether a GP uses an independent administrator when conducting due diligence.

Regulatory reporting

Given the growing burden of regulatory compliance, many GPs are beginning to evaluate whether a specialist provider might be best placed to perform this complex task. In particular, they’re asking whether specialist technology platforms might be in the best position to deliver the data that both investors and regulators require – on both a regular and ad-hoc basis.

Appointing a depositary is one of the AIFMD requirements that imposes the greatest administrative tasks on the GP.  As the depositary will assume onerous legal and fiduciary obligations when overseeing a fund’s management and administration, the depositary will require significant information from the fund, as well as requesting a high degree of oversight and control. GPs are looking into whether they should outsource the task of delivering this information.

More broadly, AIFMD’s requirement that a GP must separate portfolio from risk management is making GPs look again at their operating models. The purpose of these AIFMD requirements is to achieve independent valuation and meet the regulators’ demanding transparency requirements.

Factoring in tax issues

In the five years since the financial crisis, tax authorities have reached further afield in their bid to raise revenues. As they’ve challenged tax structures, the question of whether a GP or LP has ‘substance’ in a certain country has generally been at the heart of the issue. Evidently, the more operations a GP or LP has in that country the more ‘substance’ it has.

But AIFMD might have the effect of reducing the tax authorities’ anxiety over ‘substance’. Indeed, adapting to the new world of regulation will increase GPs’ administrative operations within the finance centres they use, so building ‘substance’ in their local activities. So, managing risk through substance, while really important, need not negate the need to outsource.

Weighing up the decision

Another benefit to working with an outsource provider is the opportunity to leverage its advanced technology and reporting platform. All leading administrators have invested heavily in these platforms, which help to improve service and efficiency across both traditional and alternative asset classes, and allow LPs access to self-serve data.

Little by little, GPs are accepting the benefits of outsourcing administration and regulatory reporting, although only a few have completed their analysis of the new market place and made decisions so far. While the utopian vision of a ‘light-touch’ front-end system interfacing seamlessly with a robust, complex administrator platform is edging closer, it’s still some way off.

A variation of this article first appeared in the September 2013 issue of Financier Worldwide magazine. ©2013 Financier Worldwide Ltd. All rights reserved. Reprinted with publisher's permission.