Financial technology: The new normal

The future of private equity fund performance reporting is as follows: Managers upload portfolio company data to a cloud-based platform where it is collated into a central database that offers a comprehensive picture of a fund's activities; the data flows automatically into a valuation mechanism that feeds into a dedicated application to be accessed by LPs as and when required. 

The process is seamless, rapid, detailed - and a world away from what many Asian GPs currently offer.

The finance team at a small to mid-cap private equity firm in the region might amount to a couple of people equipped with a $100 accounting software package and a pile of Excel spreadsheets. Data points are calculated, manually; a report is produced and circulated among LPs, either uploaded to a web portal or sent by email, hopefully within six weeks of the quarter ending; LPs extract the data, sometimes manually, and reconfigure it to their own format so like-for-like comparisons can be drawn with other portfolio GPs.

Among the more established firms, there is a gradual shift towards technology platforms that allow more automated and integrated portfolio management. But this doesn't mean communicating the results to LPs is any easier. Different firms use different formats - while the quality and quantity of information also varies - so LPs can't extract data at the push of a button.

"Standardization will come," says Tarek Chouman, managing director for Asia and the Middle East at eFront, a software solutions provider. "If LPs pressure GPs to report in a specific open format, it will be hard for the GPs to say no - either because a particular LP is important to them or because many LPs are asking for it. And if the GP can report in one format to all LPs, it might be just as happy."

Time for change?

The prevailing dynamic in fundraising - there is more demand for capital in Asia than LPs are willing to provide - suggests that this pressure, if applied, would be effective in many cases. There are also platforms available that offer the kind of uniform, vendor-agnostic channels that facilitate the transfer or more information more quickly.

While industry participants generally accept the inevitability of uniform reporting standards, and acknowledge the improved corporate governance and operating efficiencies that should accompany them, they remain cautious about the speed and extent of adoption.

"Most investments in China are minority deals and it is often a challenge to obtain the level of detail you get in a mature market like the US," says Stephen Tang, CFO at Lunar Capital, a mid-market China buyout firm. "We are gradually seeing improvements as younger, well-educated professional managers come up the ranks and appreciate the need for quality reporting. But it's not going to happen overnight."

One LP adds that the beauty of private equity - and the better-than-public-market returns it delivers - in part lies in its opacity and the ability to uncover managers with qualities that might not be reflected in the quality of their reporting.

"PE started out as a cottage industry and in Asia at least it's still a cottage industry," he says. "We have massive amounts of information coming to us from all angles and among the smaller funds there is zero standardization. If the asset class is going to become more democratic, with individual investors putting in $5,000, then of course there needs to be more regulation but until then all we have are guidelines."

These guidelines fall into two camps. First, the International Private Equity and Venture Capital (IPEV) board was created in 2005 and charged with creating and promoting investment valuation guidelines for the industry that are compliant with international and US accounting standards.

Second, in 2009 the Institutional Limited Partners Association (ILPA) issued a set of principles to improve alignment of interest, governance and transparency in private equity. The idea was to go beyond accounting compliance and provide standardized guidelines for the preparation of financial statements.

It duly released templates for GP-LP communication on capital calls, distributions and quarterly reporting. Another template - a due diligence questionnaire to be issued to GPs during the fundraising process - has been published in draft form.

From theory to practice

ILPA's next step is to release a data exchange template - in open source XML taxonomies so it is available to all - that can be used as a platform for information sharing.

The AltExchange Alliance, which was set up earlier this year by a group of LPs, GPs and service providers, has a similar objective but a slightly different way of achieving it. Whereas ILPA has set down guidelines, AltExchange allows GPs to choose what level of information they want to disclose in different categories. Its platform validates that files adhere to the agreed standard format and releases a validation certificate to the GP, who then distributes it to LPs. EFront is contracted to provide the validation platform.

"LP clients would say to us, ‘We are very happy with the technology you are providing, but we don't receive data from GPs on a timely basis and to a level of detail that allows us to make the most of the technology,'" Chouman explains. "Data was therefore a blocking factor in our ability to sell analytical solutions on top of core portfolio management solutions so what we have tried to do is make communication as consistent and comprehensive as possible."

From an LP perspective, the desire for more detailed information on a timelier basis can be traced back to the global financial crisis.

Ray Haarstick, CEO of software solutions provider Relevant Equity Systems, recalls working with a listed investment firm that had a combination of direct real estate holdings and positions in GPs. It took six months for all the managers to disclose the extent of their write-downs and the firm's stock plunged from $55 per share to $8 per share during this period.

Private equity is expected to follow the path first trodden by hedge funds and mutual funds 20 years ago when databases were standardized to track performance, leading to the creation of benchmarking systems and rankings of the best managers.

Previous attempts at benchmarking date back to the public market equivalent (PME) measure of returns, which was devised in the 1990s as a hypothetical investment vehicle that mimicked private equity cash flows, but ultimately dismissed by many as unreliable.

However, institutional investors that want to calculate the opportunity cost of committing $10 million to a GP versus putting the same sum into NASDAQ-listed equities, for example, will not be put off. They have tools to make these calculations, and they want data to feed into them.

"Right now private equity is reporting on a quarterly basis. Hedge funds used to be quarterly but now it's monthly and it will probably end up daily," Haarstick says. "I think the writing is on the wall that private equity at some point will start sharing data and let investors see what their investment in a particular fund is worth on a day-to-day basis. The big money wants more visibility."

Frequent engagement

Some global private equity firms, typically those familiar with reporting models in other areas of asset management, already have the ability to deliver information on a daily basis, although crystallizing it into a formal valuation is complicated because a senior partner must sign off on the document. Further down the food chain, GPs are under pressure to deliver their quarterly reports within a few weeks as opposed to the traditional 45 days after the quarter ends.

When asked how they feel about speeding up the reporting process, the array of responses given by Asian managers illustrates the difficulties in bringing the industry together under a common approach.

Lunar tries to report within 15 days of the end of quarter and claims that its disclosures largely conform to the ILPA guidelines. This is possible because the firm has fewer than 15 portfolio companies and is the majority shareholder in several of them, so obtaining financial information is relatively straightforward. Contrast that with Qiming Venture Partners, a China-focused VC firm with more than 70 portfolio companies. The quality and quantity of information provided may equal to Lunar but it takes a lot longer to compile.

"For VC firms with large portfolios, it would normally take up to one month to complete all the valuations and analysis, so reporting on a monthly basis would be difficult. For private equity firms with a smaller number of portfolio companies, it is easier," says Grace Lee, Qiming's CFO. "Also, the data we use to value investment is more subjective in nature compared to mutual funds and hedge funds. You really need time to do a good analysis."

The situation is further complicated by the blurred lines that exist between the different subsets of private equity in Asia. In the US the delineation between buyouts, venture capital and mezzanine are reasonably clear while certain China growth funds have been known to do everything from Series B rounds to cornerstone investments in IPOs.

Another frequent observation is that the ILPA guidelines are based on US investment models that don't necessarily suit Asian private equity. Buyouts dominate the industry in the US but of the $65.3 billion deployed in Asia last year, these transactions accounted for just 42%. Growth and PIPE deals contributed 27% and 22%, respectively. In China the split was even more balanced: 30% buyouts versus 33% growth and 31% PIPEs.

Lunar uses a KPI reporting template for its majority-held transactions that is similar to the ILPA standard. According to Derek Sulger, the firm's managing partner, when a similar template is applied to a China growth deal, it would be difficult to answer more than 5-10 of the 100 or so questions posed.

PIPE deals present another set of challenges. Hong Kong-listed companies are required to report every six months, with each report published no more than three months after the conclusion of the financial period. Any information that goes beyond what is available to public investors cannot be shared as it is price-sensitive, so a GP investor must wait for the official disclosure - and then conduct its own analysis for the quarterly report to LPs. In these situations, even the 45-day reporting window might be missed.

A request too far?

The ILPA provisions on quarterly reporting recommend disclosure of a combination of GP-level and portfolio-level data packages. In addition to a summary letter offering an overview of performance and developments that could impact an investor's risk exposure, the GP should provide a balance sheet, information on operations and cash flow management, a capital account statement, and an investment schedule explaining portfolio valuations.

The supplemental reports should also include a snapshot of the operations and performance of each portfolio company: acquisition details, current financials, valuation methodology and expectations.

In the view of Relevant's Haarstick, ILPA is overreaching in some areas and asking for too much information. He cites the due diligence questionnaire as a particular concern.

This document is circulated before an LP commits to a fund and, among other things, it requests a considerable amount of detail on investment strategy and process. Would a manager be comfortable revealing his secret sauce - and his deal pipeline - before an agreement has been reached?

"They want to know who your portfolio company contacts are," Haarstick says. "By handing over this level of detail you risk being circumvented. Investors could go into those companies and do their own rounds."

There are situations in which LPs ask for large amounts of information. A large fund-of-funds operating primary, secondary and co-investment platforms will have multiple uses for portfolio company data and the ability to slice and dice it accordingly.

LGT Capital Partners, for example, has more than 40 people in its back office in Switzerland and Ireland devoted to disseminating information that comes from numerous sources and in various formats. The ultimate objective is that an investment professional in Hong Kong tasked with pricing a secondary deal can do a keyword search and identify the relevant data points. A large direct PE investor in Europe or the US may not have the same specialized resources.

"If there is a team of 3-6 covering the whole world for private equity and maybe infrastructure and real estate as well, it might be difficult for them to do what we are able to do," says Doug Coulter, a partner at LGT. "If we didn't have those 40 people we wouldn't be able to do it."

The reality is they aren't digging nearly as deep - a streamlined reporting system simply allows these small teams to conduct comparative analysis of GPs more easily. Haarstick has yet to see compliance with ILPA guidelines for quarterly reporting or capital and distributions notices appear in partnership agreements.

Similarly, most GPs AVCJ spoke to have yet to receive a litany of unreasonable data requests from their investors outside of the fundraising process. There is a demand for headline numbers that explain how an investment in a retailer is performing, but not a store-by-store breakdown.

Sulger says Lunar has yet to see too much demand for portfolio data beyond what is currently disclosed. However, if the firm is going to the trouble of fulfilling specific requirements, he wants LP to respond proactively.

"We have a good relationship with our LPs and trust most to have this information because we feel they can add value," Sulger says. "We want to avoid providing it to LPs or outside parties purely interested out of morbid curiosity with limited value add. We give the information to people we trust will look at it, analyze it, understand it in the appropriate context and give valuable feedback."

Limited resources

The primary concern for most small to mid-cap GPs is not so what information they provide as how they can provide it. On one hand, the owners of portfolio companies are often unaccustomed to detailed reporting and have to be taught to collect the right information. On the other, the private equity firms themselves might struggle to implement the systems required to compile and communicate these data.

The likes of eFront, SunGard and Relevant are relatively new additions to a China private equity landscape that was - and to a certain extent still is - dominated by Microsoft Excel. It is not just a matter of software but also people and broader corporate culture.

"If you use this software you need dedicated people," says Qiming's Lee. "You can subscribe to the full model but if you are only using three elements then it's a waste of money. Most larger funds not only spend money on software but also invest in additional head count to utilize it. Smaller funds might have sophisticated models but the difficulty in doing this front-end to back-end seamless reporting is manpower."

In some cases, private equity firms have gone through painful year-long implementation processes only to find that they can't fully adapt to a new way of working.

CFOs tend to run the new system and Excel in parallel during implementation just in case something goes wrong and it is not unusual for this dual approach to remain in place. Managers speak positively of the speed and automation of these systems, whilst warning that it can work against you. Certain parameters are pre-programmed so that numbers can be swiftly translated into KPIs, but checking each step to identify potential errors is a protracted and frustrating process.

"If different sets of numbers come out the assumption is that Excel is right because the fund has been using it all along and you can trace back exactly what went in," says one GP. "That's a big concern for a CFO - you don't know whether you are right or the system is right."

Viewed in a positive light, these are nothing more than teething problems that will be addressed as the industry matures and private equity firms, from senior deal makers to junior analysts, buy into the need for more efficient reporting. This should occur naturally as businesses scale up, additional funds are raised, and there are a larger number of portfolio companies, at different stages of their respective investment cycles, to look after. Internal teams will be expanded or services will be outsourced - either way, it means an additional cost.

And this is essentially the cost of fundraising. Regardless of whether the movement is led by ILPA, AltExchange or another platform, the wheels are already in motion.

The more in-demand GPs in Asia may be able to set their own terms on fund performance and portfolio reporting longer than most, and the extent to which LPs' dream of perfect harmonization is very much open to debate, but a manager's ability and willingness to disclose information is now among the criteria upon which he is judged.

To give an extreme example: If a GP is looking to raise Fund III and the senior executives are buying yachts and neglecting to invest in systems that allow them to communicate more effectively with investors, the likelihood of re-ups diminishes.

"Established platforms give more comfort to investors because they have the systems in place," says Mounir Guen, CEO of placement agent MVision. "Transparency has become a huge aspect of investor reviews and one that they use to assess whether you are institutional or not. The days when smaller firms had the flexibility of working with internally-generated reports are gone."

SIDEBAR: ILPA quarterly portfolio company reporting checklist

Standard schedule of investments
• Company name
• Security type (debt/equity)
• Number of shares
• Fund ownership percentage (fully diluted)
• Initial investment date
• Fund commitment
• Total invested
• Current cost
• Reported value
• Realized proceeds

Supplemental schedule of investments
• LP ownership percentage (fully diluted)
• Final exit date
• Valuation policy
• Period change in valuation
• Period change in cost
• Unrealized gains/losses and accrued interest
• Movement summary
• Current quarter investment multiple
• Prior quarter investment multiple
• Since inception IRR

Company profile
• Summary company data (name; initial investment date; industry; headquarters; company description; fund ownership percentage; investor group ownership percentage; enterprise valuation; securities held; ticker symbol; investor group members; management ownership percentage; board representation; board members; investment commitment; invested capital; reported value; realized proceeds; investment multiple; gross IRR)
• Investment background
• Initial investment thesis
• Exit expectations
• Recent events and key initiatives
• Company assessment
• Valuation methodology
• Risk assessment/update

Detailed company data
• Financial results (y/y % growth; LTM EBITDA; EBITDA margin; total enterprise value; TEV multiple; total leverage; total leverage multiple)
• Investment structure (units; total invested; reported value; realized proceeds)
• Capitalization (rate; maturity; at closing; at period end; covenant threshold; covenant headroom; total net debt; equity; enterprise valuation)

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• Topics
• Fundraising
• Financials
• Technology
• LPs
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• Financial Services
• Technology
• LPs
• Fundraising
• GPs
• Lunar Capital Management
• LGT Capital Partners
• Qiming Venture Partners
• ILPA