Rules and standards: A new era of investor reporting

Now is the age of private equity 3.0. David Rubenstein, co-founder and managing director of The Carlyle Group, coined the phrase to describe an industry in transition.

Gone are the days of GP dominance, constant fundraising, big buyouts, mega IPOs and stellar fees. The strong returns that saw large numbers of investors flood into the class peaked in 2007 and collapsed on the arrival of the global financial crisis. In a more muted investment environment, LPs hold more sway. Terms are negotiated downward, PE firms must make higher equity commitments, and fundraising takes longer - an average of 20 months, compared to nine months in 2007. There is also more regulation, Rubenstein told the 2011 AVCJ Forum in Hong Kong.

Leading private equity professionals broadly agreed with the latter statement, noting that investor and regulatory demands have pushed the industry on the threshold of a more transparent future.

"Mature investor programs are looking to reduce the number of relationships they have, so they have become uncompromising. The bar is high and they will diligence you as if they've never met you before in their lives," says Mounir Guen, CEO of MVision. "And so they should."

The bigger picture

In a sense, the shift reflects sweeping post-global financial crisis regulatory change in the broader financial services sector, the biggest since the 1930s. Front and center is the Dodd-Frank Wall Street Reform and Consumer Act. First mooted in 2009, final rules were implemented in July, and compliance is required by March 2012.

With transparency having become the new mantra, as estimated 750 investment advisers, including private equity managers, will be obligated to register with the US Securities & Exchange Commission (SEC). This has triggered jitters because of the uncertainty around the wide-ranging impact it will have on industry practices, costs and profitability. Moreover, these will be felt far beyond the US.

"Many GPs, even if they are domiciled in Asia, will need to file with the SEC if they take American money, regardless of whether they have an office in the US," says Brian McDaniel, partner in international law firm Goodwin-Proctor's Hong Kong office.

There are three exemptions to this requirement: advisers managing less than $25 million of fair market value US assets; those pursuing a so-called venture capital strategy, which probably includes many players from the emerging growth capital segment; and managers with less than $150 million in assets under the control. The third exemption is realistically the only one likely to of broad use to larger private equity firms.

"The bad news is that even those advisers who qualify for the last two exemptions must still file a report with the SEC by March. And being fairly detailed, the process can be intimidating for new fund managers or those without substantial experience of dealing with the SEC," says McDaniel.

Funds will have to explain how many investors they have and specify whether they are individuals, trusts, broker-dealers, government pension plans, and so on. Private equity fund managers who have been operating unregulated for 15-20 years will have to get used to government officials visiting their offices and questioning the way things are done; collecting information for reports that may result in deficiency letters.

In addition to numerous conflicts of interest issues, the legislation seeks to clampdown on suspect marketing practices. This has an impact on relations with placements agents and other gatekeepers who solicit business on a GP's behalf and also on how fund managers promote their services directly. General solicitation and advertising are still banned, and they will be joined by certain activities that involve emphasizing investment track records.

There is some common ground with Europe in terms of marketing restrictions. The EU introduced its own response to the global financial crisis earlier this year with the approval of the Alternative Investment Fund Managers Directive (AIFMD). It requires fund managers to reach a certain level of transparency in order to access EU-based clients. As of 2013, a passport regime will come into effect whereby an EU manager approved in his home jurisdiction will automatically be approved for marketing in all other EU jurisdictions.

"Fund managers will have as much as two years to prepare before it becomes part of national laws on the continent," says Clare Chang, head of Asia private equity funds at International Administration Group. "After that, fund managers who will be marketing in Europe will need to make extensive filings, including disclosing their investment strategy if they are going to acquire a controlling interest."

Given the extra time and money compliance will entail, many GPs are trying to set up offshore structures outside the EU, particularly in the Channel Islands, Chang added.

Non-EU funds could pursue European investors undisturbed for at least the next seven years. The passport regime is supposed to be opened up to funds not domiciled or managed in the EU from 2015, but they will still be able to can enter the market via national private placement regimes - approaching investors on an individual basis in accordance with domestic regulations. Passive marketing, whereby an investor approaches a non-EU fund, will also continue to be permitted.

Indirect exposure

The tricky element for some investors with operations in the US or Europe is indirect exposure. Between 3% and 4% of US insurance giant Allstate Investments' $100 billion portfolio is in private equity, but as a captive LP that doesn't raise external funds the company doesn't have to comply with the new requirements.

However, the company must ensure that any manager to whom it allocates blind pool capital on an illiquid basis has correctly assessed the compliance situation. "[We have to check] that they are capable of effectively navigating through a changing world of regulation that is going to cause them to alter their business practices and potentially add expense to the operation side of their business," says Peter Keehn, Allstate's global head of private equity.

Meanwhile, an ongoing sense of uncertainty overshadows debate about the fine detail. The Volcker Rule, for example, remains a contentious issue, despite winning SEC approval in October. In order to limit risk exposure, the rule allows banks to invest no more than 3% of their tier-one capital in private equity and hedge funds and prevents them from owning more than 3% of any single fund. But there are concerns that lobby groups will delay and ultimately water down the measures, changing the compliance criteria.

This uncertainty has complicated investor reporting at a time when LPs are already leveraging their position of relative strength to demand more disclosure from fund managers. Are GPs able to cope?

"Investor relations is essentially about taking care of the people who gave the GPs the money to make responsible investments," observes MVision's Guen. "But because the GPs generally underestimated the volume and granular detail now demanded by investors, especially after a bad cycle, larger firms with 300-plus investors commonly have IR teams of 8-9 people who can't even tell you what time of day it is because they're so busy."

In addition to fielding questions about the potential impact of Dodd-Frank, IR professionals must cope with the very real impact of standards issued by the International Limited Partners' Association (ILPA), the European Private Equity and Venture Capital Association (EVCA) and the British Private Equity and Venture Capital Association (BVCA) among others.

Guen notes that one US statute threatens that all investors in a fund could be subject to tax if one individual isn't disclosed to the government. The burden of responsibility falls on the IR team - and at a time when private equity firms seem to be constantly fundraising, causing a spike in reporting pressures.

"During this period of [incessant] fundraising, there is a huge additional burden on the firm," Guen adds.

Standardized approach

The ILPA's Private Equity Principles, a second version of which was released in January, are supposed to help bridge the information gap between GPs and LPs. Backed by 130 organizations, including public and corporate pension funds, sovereign wealth funds and some GPs, the thrust has shifted toward standardizing these reporting demands in aid of increased industry data accuracy and efficiency.

The initial principles, issued in September 2009, took a broad approach to establishing an industry best practice framework for governance, transparency and the alignment of interests between LPs and GPs. The updated version goes a step further, unveiling a standardized reporting template - the first of five - for capital calls and distribution notices.

Most LPs are under different regulatory requirements, or indeed their own senior managers' requirements, to know precisely what is in a PE portfolio, but the ILPA's approach is seen as broadly constructive. Alstate's Keehn is a strong advocate of the focus on forms of reporting as it underpins so many of an LP's day-to-day activities

"It's very difficult for a GP to respond to a million different information requests from a myriad of LPs, each of which has a slightly nuanced way they want a manager to cut the data. That's far from efficient," he said. "Also, there's the historical stance of some GPs that they don't need to be bothered. It's just not practical in the age we're now in, where transparency is really required of everybody, whether they're in the West or Asia."

This is a positive for LPs and GPs alike. To the former, the principles hold out the promise of critical information on a timely basis to ensure effective risk management among many other needs. To they mean consistent data sets that should go a long way toward standardizing the reporting requirements, thereby easing the burden of those preparing and disseminating the information.

GPs might also like to consider the merits of standing out. In an environment where many LPs are reducing their allocations to private equity or at least cutting down the number of fund manager relationships, GPs are under pressure to convince their investors to remain on board. Compliance with regulatory reporting standards would do their case no harm. That is especially true of less mature private equity markets such as Asia, where there are widespread concerns around transparency and even fraud in local PE practices.

Gathering momentum

Standardization should gather momentum as the ILPA rolls out more templates. Although concerned about the implications of the Volcker Rule, Carlyle's Rubenstein has no hesitation in throwing his weight behind the principles approach. His expectation is that standardization will leave its mark on IRR and multiples of investment capital (MOIC) calculations - so that the industry really knows what top quartile means - as well as of partnership and subscription agreements.

Increased public dissemination of performance receivables will allow clearer oversight of private equity activity and perhaps pave the way for greater involvement from retail investors, who are currently bared from direct participation in private equity due to accreditation requirements. In the short-term, though, the reforms are just more efficient.

"A standardized approach to IRR and MOIC would be helpful in making the fundraising process easier," Rubenstein says. "And standardized partnership and subscription agreements would minimize the time spent negotiating, allowing more time to be spent investing the money."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Regulation
• GPs
• LPs
• The Carlyle Group
• AVCJ Events
• MVision
• Mounir Guen