Time to revisit the in-source/outsource decision?

 

The effects of increasing regulation, investor information demands and cost sensitivity are causing PE houses to reassess their back-office strategy and functions in terms of service providers, systems and the overall in-source/outsource decision is once again ripe for revisit.
 

Against a backdrop of extensive regulatory and market change, many private equity firms are experiencing heightened pressure to deliver greater transparency, better reporting and tighter accounting controls. A host of regulation – the Dodd-Frank Act, the Alternative Investment Fund Manager’s 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, either directly or through their service providers. GPs are now at a crossroads and must decide whether in-sourcing or outsourcing is the right decision. This article further explores the key factors and external drivers that will impact this decision.

Key factors to consider

There are a number of factors to consider when deciding whether to outsource back office functions. 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, administration fees have generally been paid from fund resources and not management fees, so in most cases outsourcing is a better financial deal for the GP. Limited partners (LPs), however, are increasingly unwilling to foot the outsourcing bill and GPs are engaging in tough negotiations with LPs with regard to outsourcing expenses. In the future, fixed fee bases may not work and may move in line with management fees to reflect a contingent element based on future upside. Some GPs are keen to add staff instead of outsourcing administrative functions keeping a close eye on costs, not paying third party profit margins and to help increase their substance from a tax perspective.

For GPs that continue or choose to in-source they will need to enhance or amend their back office processes and invest in new technological infrastructure to support them. This diverts attention and resources from the main business of running a private equity fund – sourcing and executing deals. However, the slow-down in market activity is leading many firms to revisit this decision, as there is currently surplus resource to redeploy.

Alternatively by partnering with an external provider that has an established track record, proven technology and honed processes, GPs can take advantage of more flexible, scalable administration solutions. Indeed, the use of an independent administrator is becoming a key checklist item for some LPs when considering where to allocate their capital.

Regulation

Executives in private equity firms are increasingly recognising the growing burden of regulatory compliance.

Under AIFMD, many private equity firms in Europe will for the first time be required to appoint a depositary. This is one of the more contentious areas of the Directive, not only in relation to increased costs for EU managers but also in relation to future working relationships between general partners, administrators and depositaries. The depositary may incur onerous legal and fiduciary obligations to oversee the management and administration of the fund. In order to fulfil these obligations the depositary will place significant information and control requirements on the fund. Similarly AIFMD’s requirements to functionally and hierarchically separate portfolio from risk management, to achieve independent valuation and meet the intensive transparency requirements across emerging regulations are causing GP’s to reconsider their current operating models.

Given this new environment, many GPs are beginning to evaluate whether these requirements are best met by outsourcing to a specialist provider. This is particularly true in relation to the increasing data requirements, both systemised and ad hoc, of both investors and regulators which may be best served by specialist technology platforms.

Technology - economies of scale

Tax authorities are reaching further afield in their bid to raise revenues. Since the beginning of the financial crisis, we’ve seen a number of challenges raised where ‘substance’ has been at the heart of the issue, such as: (i) challenges to tax residence of funds and GPs; (ii) claims that investment adviser activities create permanent establishments for the fund or the GP; (iii) focus on ‘fixed place of establishment’ for VAT purposes; and (iv) some challenge around treatment of carried interest.

Going forward, non-tax issues, such as AIFMD, may regulate for substance requirements. Indeed, the overall effect of adapting to the new world will be to increase GPs’ administrative operations within the finance centres they use, as both regulators and tax authorities want to see more evidence of ‘substance’ in their local activities. However, managing risk through substance, while really important, need not negate the need to outsource.

Taxation

Tax authorities are reaching further afield in their bid to raise revenues. Since the beginning of the financial crisis, we’ve seen a number of challenges raised where ‘substance’ has been at the heart of the issue, such as: (i) challenges to tax residence of funds and GPs; (ii) claims that investment adviser activities create permanent establishments for the fund or the GP; (iii) focus on ‘fixed place of establishment’ for VAT purposes; and (iv) some challenge around treatment of carried interest.

Going forward, non-tax issues, such as AIFMD, may regulate for substance requirements. Indeed, the overall effect of adapting to the new world will be to increase GPs’ administrative operations within the finance centres they use, as both regulators and tax authorities want to see more evidence of ‘substance’ in their local activities. However, managing risk through substance, while really important, need not negate the need to outsource.

Market trends

Consolidation in the fund administration market has stepped up considerably over the past three years and continues to be an area to watch. It is driven partly by regulatory changes and related technology requirements. Some small players are likely to fall by the wayside – those that partner or merge to avail of the opportunities offered by regulation are likely to do best. A number of notable deals over the past three years have helped shrink the fund administration industry: JPMorgan Worldwide Securities Services (WSS) bought the private equity administration services business of Schroders; BNY Mellon acquired PNC’s global investment servicing business; and State Street acquired Jersey-based Mourant International Finance Administration (MIFA) in 2010, and Morgan Stanley Real Estate Fund Services and Goldman Sachs Administration Services in 2012.

GPs are driving recent trends towards multi-jurisdictional presence. These trends are set to continue in response to increasing globalisation and regulation of the industry.

While fund administration today is dominated by a handful of large, global banks, they have so far underserved the private equity segment. The turmoil in the banking industry has created an opportunity for an independent firm that can focus on client needs, particularly funds of moderate size, and can offer a customised approach instead of a standard menu of services and pricing.

At the end of the day / In the final analysis

For the GPs, it is about evaluating the real cost of running their business, anticipating the impacts of changing regulatory and investor requirements, and choosing an effective end-to-end operating model that best serves their future business needs. While the outsourcing model is very familiar to the European market, it is comparatively new to the US market where there is still some way to go before many GPs would feel comfortable relinquishing the control and direct oversight they have over their own administration. Ultimately, facts and circumstances will dictate the appropriate solution for individual managers and it is important that they focus on that assessment now. In the tough fundraising climate, investors call the shots and GPs cannot risk falling foul of regulatory, tax and reporting issues or damaging hard won investor relations – all of which lead to a drag on returns.

For bespoke administrators, the challenge is to maintain the momentum they have built and to identify ways to maintain their niche foothold and close relationships in servicing GPs. Market research carried out by PwC in 2012 indicated that quality and responsiveness remain key to success in this business and the ‘right team’ combined with the ‘right systems’ will generate business. However, critically, they need to remain competitive as the larger administrators produce increasingly more compelling PE-specific servicing solutions and operational platforms to support them. Larger, international administrators must demonstrate that they can be flexible, client focused and accommodating – which is always a tough balance to strike in a business which fundamentally demands scale and standardisation