Depending on the size of a private equity firm, there is a good chance that the CFO will have a lot more on his or her plate than the smooth running of a finance function.
“I love what I do and the people I work with, but the job requires you to think outside the box and to wear a lot of hats,” says Peter Lyons, managing director and chief financial officer of mid-market firm Leeds Equity Partners. Lyons’s small back- and middle-office team – it numbers four people in a firm of 18 employees – looks after “everything outside of the investment process.”
“We outsource our IT, but if someone’s computer doesn’t work, I am under their desk checking the connection. Then I could be running to an investor meeting, negotiating a side letter or participating in an investment committee meeting after that. There is a lot there beyond getting the audits done,” explains Lyons, who has been with the firm for 18 years and came from the world of public accounting.
Lyons is participating in a roundtable discussion in New York City alongside a fellow private fund CFO and three technical experts from advisory and accounting firm EisnerAmper.
It is clear he is not alone in having a multi-faceted “getting hands dirty” operations-focused version of the CFO role. Also at the table is Joshua Cherry-Seto, chief financial officer of Blue Wolf Capital Partners. He boils down the modern CFO role as covering three key functions of the chief administration officer, chief operating officer and the chief financial officer, before quickly adding investor relations to the list.
Even the temptingly straightforward “everything outside of the investment process” is misleading, with both Lyons and Cherry-Seto getting involved with portfolio companies at a number of different points.
Tax issues are a common touchpoint for both CFOs and their firm’s portfolio companies – the increased prevalence of flow-through investing makes for more complicated and more frequent tax reporting. Likewise audit (Cherry-Seto sits as an ex officio on all the portfolio company audit committees) and the implementation of management equity incentive programs. “As much as the deal team and CFOs of the portfolio companies should understand how incentives work, it is still not particularly familiar to either of those groups,” Cherry-Seto says.
INVESTOR FACING
One area in which the back and middle offices of firms are increasingly being tested is investor due diligence during the fundraising process. More than half of respondents to the pfm/EisnerAmper CFO Survey reported that greater investor due diligence had increased demands on the back office in the last three years. However, this trend does have a tendency to be overstated, says Lyons.
“Operational due diligence in the fundraising process is getting a lot of press but I have yet to see investors spend a significant amount of time digging into the area,” he says. “There are questionnaires but few follow-up questions. When people do on-site visits, they rarely sit with the operational people to discuss workflow and compliance. They want to know how the managing partner runs the firm, how the firm sources deals and makes investment decisions, and if the firm is raising more money than the last fund, can they manage the increase in capital?”
While operational due diligence may still be fairly checklist-based, that checklist is becoming more extensive and scoping in the external resources as well as in-house. “They are reaching out to the auditors more,” says Anthony Minnefor, partner-in-charge of EisnerAmper’s New Jersey and Pennsylvania financial services audit practice. “It’s normally a checklist question – often they just want to confirm that we are indeed the auditors – but three years ago I never would have got an email from a prospective investor.”
External resources are also called on to provide some of the more technical tax information that prospective investors now require. “When a client is raising a fund, I will get a call once or twice a week to get on the phone with an investor to answer a tax question that they don’t feel more comfortable answering,” says Simcha David, a tax partner at EisnerAmper with a focus on alternative investment funds. “We definitely get more calls from clients when they are raising capital.”
The middle and back offices of private fund management firms are growing. Many factors play into this. For example, Blue Wolf is looking to add to Cherry-Seto’s team in the form of a portfolio reporting manager to co-ordinate and facilitate the growing demands from investors and regulators around portfolio company reporting including valuations. After that, “employee number five for us in the back office will probably be a tax manager” to account for the increased tax work relating to flow-through income, from investor fundraising structuring, to investment structuring on the buy and sell sides, to ongoing portfolio and management company tax management and reporting.
“Tax management is rapidly becoming a fully integrated and strategic component of our business success and traditional tax service shops are struggling to fill the need for a strategic partner rather than a pure tax administrator, especially for smaller middle market managers like us who need the service provider leverage,” says Cherry-Seto.
A VISIT FROM THE SEC
Lyons’ firm was recently subjected to an SEC exam. The firm had been notified the day before Thanksgiving and the commission was on site at the firm’s offices by the first week of January.
The commission was interested in a number of things that were expected, says Lyons. Fund expenses were in the spotlight, he notes, with the examiners scrutinizing travel, going through flights to ensure those travelling somewhere for business came directly back – and did not tack on a personal trip. And if they did, that the fund was reimbursed for the fare difference.
When it comes to fees and expenses, “the SEC has done a lot of enforcement in that area,” says Venkat Rao, a director in EisnerAmper’s compliance and regulatory services practice and a former chief compliance officer for registered investment advisors and broker-dealers. The SEC views the treatment of expenses “through the lens of it being a code of ethics issue,”says Rao. “Even if it is $100 for a taxi ride, they will scrutinize it. The SEC does not have a materiality threshold.”
This can create a challenge for private fund managers, as an audit typically does have a materiality threshold. The challenge is making sure information is being accurately recorded, notes Rao, who asks the CFOs at the table how they approach the problem.
“We tell our partners there is no materiality threshold for the SEC,” explains Cherry-Seto. “If it is not material, then we usually suggest the management company picks it up, because it is not worth the brain damage… like analyzing a $10 cab ride to split four ways, document and review. It is just not worth it.”
“You do a cost-benefit,” adds Minnefor.
Lyons notes the firm spends a lot more time allocating and documenting expenses than it did five years ago with 99 percent of the team’s expenses going on one consolidated American Express bill. “We have a lot of eyes on that bill and we have individuals go through it regularly to ensure the allocations are appropriate,” he says. “We don’t have a very complex infrastructure, but two or three years ago we put in place a fees and expenses policy that we ensure we update and train everyone on regularly.”
Regardless of the method of allocating expenses, it is the methodology that counts most when it comes to appeasing the SEC. “We hadn’t always taken the care to have that additional process, but now they appreciate that you have a clear, repeatable review and documentation process,” says Cherry-Seto.
“That was half the battle,” adds Lyons. “Showing them [the SEC] the level of detail you go through gives them comfort there is a process in place.”
SECONDARY CONSIDERATIONS
The areas of focus for the SEC weren’t all in line with Lyons expectations, he explains. For one thing, cybersecurity, which has been identified as a major area of concern by the regulator, was barely referenced at all. “They reviewed our policy, but I was actually really surprised that they didn’t ask if we do any independent testing,” he says. “Honestly: we were prepared for it to be a significant part of the audit.”
The second surprise was the interest the commission showed in secondaries transactions. Specifically what role the general partner played when a limited partner requested assistance in identifying a buyer for their stake in one of Leeds’s funds.
Lyons’ take is that his firm’s exam was “the tip of the spear” and that the commission is seeking a greater understanding of the process and whether the best interests of the investor are being served. “They were asking all the right questions,” he says. “I wouldn’t be surprised if the SEC comes out in the near future with something on secondaries, because they are clearly trying to learn about the process and what role the GP plays in that.”
The commission focused on a single fund stake sale process, digging into the details. “We had one particular investor who had asked us to help them do a secondary. We put them in touch with the parties that had expressed interest in secondaries in the past and had nothing to do with the negotiation process. There were a lot of questions about that – wanting to know exactly what role we played in the process.”
The process, continues Lyons, was instigated by the LP and they did all the work. “My understanding was that fund restructurings were something the SEC was more interested in,” says Lyons, “that is more about what I was expecting from the exam.”
It is something that Cherry-Seto has also been considering. “We are fiduciaries of our investors’ capital and we always want to be helpful, even if what they need is to get out of our fund.
“Yet LPs do understand these are illiquid securities and they have no right to liquidity. We have to be careful that, while we want to help our LPs, there isn’t a fact pattern that suggests we are a market maker.”
TOO MUCH INFORMATION
While the regulator is an important stakeholder in the activity of private equity firms, it is the LPs who matter most. And fittingly, they too call on the resources of the back- and middle-office staff with increasing regularity.
“Investors are asking for a lot more information to monitor their investment,” says Lyons. “With [the Institutional Limited Partners Association’s] expense templates, every contribution and distribution requires additional reporting. They are not complicated but they take time to put together and review.”
The idea that the introduction of a template – designed to standardize information requests – is creating more, rather than less, work comes as a surprise. In truth, this is because the ILPA guidelines have not yet been widely enough adopted to produce a beneficial effect, says Lyons.
“We are in a period where investors are happy with their own systems and people haven’t adopted the ILPA guidelines yet so you are still completing custom requests as well as the very detailed ILPA templates. Hopefully over the years people will migrate to one expense template, one capital call/distribution template, but right now that’s not the case.”
Cherry-Seto believes the size and scope of the ILPA template – designed to satisfy the needs of most investors – makes it “a fairly large template, where any given investor may only care about 20 percent of what is there. They took a kitchen-sink approach of cobbling together all the different requests of all their LPs.”
When investor requests do come in, there is often a need for dialogue to establish exactly what the LP is trying to achieve, says Cherry-Seto. “I am happy with a different request from every investor; because at least they are their requests and we can have a conversation about why they are asking for something and what they are trying to answer.” If a request is made purely because it is part of a template, then it is harder to establish exactly what is needed, if anything, other than to file a file or check a box he explains.
MVP
Much of the discussion of the CFO role relates to the smooth and continuous running of the firm; letting the investment team do their work without interruption. We need to comply with new data protection legislation? Ask the CFO. Need to upgrade to a new tech platform? Ask the CFO.
This is clearly not the end of it though. As the private equity industry develops, institutional investors are becoming as much interested in the efficiency of their investment partners as fund managers as they are in the abilities of the deal team to buy well, re-engineer and sell businesses.
“Pacing investments, making efficient use of a credit facility, timing distributions, making sure you are not leaving a lot of cash on the balance sheet … really figuring out if the firm is maturing and becoming better fund managers takes a little bit more digging. We are finding the more sophisticated investors doing that more often,” says Lyons.
At the forefront of these efforts is inevitably the CFO. Perhaps the “back office” deserves a new name: the engine room.
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