Investor confidence is hard to gain and very easily lost. In an increasingly competitive and regulated environment, institutional investors expect ever higher standards of operational excellence from fund managers.
Fund managers are frequently compelled to invest in more complex capital structures with new and emerging asset classes. This original research by Houlihan Lokey and Citco in association with pfm surveys global industry leaders to benchmark industry best practice in two important areas for private equity and related asset classes: fund administration and valuation best practice.
Fund administration
After the financial crisis of 2007-08, there was an increase as well as a standardization of the requirements for institutional investors, and whereas excellence in the traditional reporting function was measured by consistency, timeliness and the ability to offer a prompt reply, now the requirements are much more advanced.
Independent valuation
In calculating valuations, critical for managers and investors to assess fund performance, outsourcing to an external expert is far less prevalent. But, just as funds have responded to investor and regulator pressure for greater transparency and improved reporting in other areas, it seems the same forces are being brought to bear on GPs to change their behavior in this area.
Independent third party valuation is an obvious way to provide additional comfort and clarity to investors. This view is mirrored in the survey where a significant majority of GPs believe the provision of independent portfolio valuations makes them more attractive to pension funds and endowments. These are the investors that dominate the limited partner universe in size, sway and scrutiny.
Third party independent valuation, which is already common in the US due in part to the investment conditions laid down to by large US LPs, looks to be spreading to Europe.
While European GPs cater to the demands of those same US investors and take on third party input, their European LPs are very likely to get used to the comfort and assurance an independent valuation provides.
PROFILE OF REPSONDENTS
A total 100 private equity, real estate, debt, infrastructure, venture capital and secondaries firms responded to the survey questions. The majority (52 percent) describe themselves as middle market, while the second largest group of respondents are real estate funds (16 percent).
Survey analysis
Among fund managers there is a strengthening emphasis on ensuring corporate governance through fund administration best practice. That the survey reflects this should come as no surprise.
Post-financial crisis, fund administration including portfolio valuation has come under increased scrutiny from regulators and investors requesting greater transparency and accountability. Compliance is a day-to-day issue for managers.
The US Securities and Exchange Commission leads the way among regulators monitoring industry compliance with rules governing controls and procedures. With its expanded oversight of alternative investment funds, its growing investigative capacity and examination of firms, the private equity industry has come under scrutiny as never before.
In Europe, the transformation of the fund landscape due to the implementation of the Alternative Investment Fund Managers Directive has also increased the weight and complexity of rules fund managers must first get acquainted with and understand, and then adhere to.
Supported by regulatory focus on investor safeguards, limited partners are also asking increasingly detailed questions about fund administration practices in their due diligence. Market bellwether the California Public Employees’ Retirement System is among investors pushing for greater transparency. As large funds like CalPERS become pickier about which managers they invest in, GPs seeking their capital must meet their benchmarks.
In addition to external forces emphasizing fund administration best practice, a buoyant fundraising environment is allowing firms to raise ever-bigger vehicles and launch new products with more complex investment strategies. Fund managers themselves are seeking ways to efficiently deal with the rising volume of back and middle office tasks.
Reflecting these increasingly intricate compliance demands, survey respondents – who are predominantly partners or C-suite executives at private funds investors – reported most GPs use a third party fund administrator to assist with back office management. Survey participants represent a range of private fund types and sizes from $100 million to $5 billion based around the world, indicating the practice is widespread. Most view outsourced fund administration as a value-added service, and fund administration in general as critical to business planning.
An independent view
The PEI research and analytics team interviewed Dr Cindy Ma and Milko Pavlov of Houlihan Lokey on the survey results, independent valuation and its role in fund operational excellence.
In the context of private equity, infrastructure, real estate, debt, and venture funds how do you define ‘independent valuation’ and what is its importance to investors?
Independent valuation is a process performed by an experienced professional in the field of valuation, who is not part of the asset management function and their reward is not linked to the performance of the investments being valued. The party performing the valuations is independent if free of any conflicts of interest.
In the private equity and real estate space, a large number of funds are closed-ended and so it is argued that valuations only matter at entry and exit. This may be true for the performance of the fund, but it is not ideal for limited partners that need to report performance on an on-going basis and to make regular capital allocation decisions. For them, having the portfolio marked at fair value is extremely important for financial reporting and risk management.
How would you describe the regulatory environment in Europe?
There are increasing regulatory headwinds in Europe, even though it has not yet reached the level of adoption observed in the US.
After the financial crisis in 2008, we saw more regulation imposed on financial institutions. However, as their balance sheets are shrinking and capital is moving to alternative funds, regulators are looking more closely at those managers.
The Alternative Investment Fund Managers Directive has been a driver of increased regulation in Europe with an often-overlooked focus area being valuation.
The Directive seeks to enhance the credibility, consistency, objectivity, and transparency of valuation procedures. Article 19 of the AIFMD contains an obligation for Alternative Investment Fund Managers to have procedures in place for the proper and independent valuation of assets, and to ensure that the net asset value issued by the Alternative Investment Funds is calculated at least once a year.
The impact of this directive is substantial, since it targets managers of all kinds of funds, including hedge funds, retail investment funds, investment companies, real estate funds, and private equity funds, which are marketed to investors in the European Union, irrespective of whether the management function is performed in Europe or elsewhere.
Regardless of whether an internal or external valuation approach is chosen, the AIFM is ultimately responsible for the valuation and must establish, maintain, review, and implement adequate valuation policies and procedures for each AIF it manages. The policy must be sound, comprehensive, and appropriately documented, and should set out the obligations, roles, and responsibilities of all parties involved in the valuation process, including the senior management of the AIFM.
The framework has been set, although the European regulators have not yet been as active with regard to enforcement as the SEC. Having a robust set of policies and procedures would be very beneficial in cases where various stakeholders have questions around the portfolio marks.
What would be the most commonly made mistakes that funds make in their valuation process?
A common mistake that funds make is not having an established valuation framework of policies and procedures in place with appropriate valuation personnel who are independent of the investment decision-making process. This can often lead to potential problems with transparency and/or concerns over independence and perceived conflicts of interest.
Fund administration: greater transparency
The PEI research and analytics team interviewed Nikolaos Perros and David Sarfas of Citco on the survey results, fund administration and operational excellence.
Prior to the financial crash, the most important word in private equity was always ’private’.Private equity is built on superior returns relying on asymmetric information, the discretion of the partners, and the acceptance of otherwise large institutional investors that the managers were controlling the process, in return for the aforementioned superior returns. Now limited partners are taking a different tack, their voices are louder and more meaningful, and their actions bolder.
What prompted this change in behavior?
The crisis of 2007–08 changed everything. The crisis created a panic environment, one that hasn’t yet been fully resolved, and the focus ofthe panic for alternative asset classes has largely been about the
quality of valuations and the sanctity of investment. There was a raw emotion that was circulating around the time of the crisis.
Most investors divide their careers into ‘before and after’ the crisis and would agree that it was the single biggest shift in market sentiment in a generation.
So how does this inform fund administration?
Following the crisis the biggest institutional players were effectively able to drive change in institutional investor response, and they were prompted by the returns to investors falling from the large returns that had characterized the pre-crisis period.
Following the crisis, LP committees got smarter and more determined in their approach, beforehand no one cared or was prepared to ask too many questions about an asset manager.
However, in response to a more forensic level of internal questioning and external regulatory scrutiny, institutional investor internal operations became more rigorous, with a sophisticated line of questioning over risk profiles. In addition, a sustained line of questioning emerged from institutional investors regarding:
Expenses and fees
Carry
Broken deals.
Perhaps a little simplistically, the initial approach of a number of the larger private equity houses can be characterized as: “I don’t want to lower my fees, but I can give my investors a greater level of transparency.”
Achieving Excellence in Private Fund Administration and Valuation is published on February 1. It is available to download at www.privatefundscfo.com
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