Comply or die? GPs, technology and reporting standards

It is a daunting shopping list for a nascent GP: $100,000 and upwards in annual licensing fees for a specialist fund management software package; another $200,000 to install it, set up the dashboards, establish a user hierarchy with different levels of authority, and configure the system to produce reports in a desired format. And don't forget the cost of the hardware required to run the software and the salaries of the staff who oversee what goes in and what comes out.

At this point in the process, you may not have raised any new capital at all.

If you've done previous investments, inside or outside a formal fund structure, the data might need to be input, which means copying and pasting information from a variety of sources, ranging from Excel spreadsheets to PDFs to emails. The software vendor will usually be happy to help out with the more laborious aspects of system migration, but it will cost you at least $2,000 per day.

No wonder many GPs prefer to put off technology upgrades until they have a few funds and a steady fee-stream under their belts. CDH Investments and Hony Capital are about as blue chip as local Chinese private equity firms can get, each with about a decade of history and $6 billion-plus under management across at least seven funds. Yet, they only considered transitioning to better software relatively recently. Hony opted for eFront while CDH is still assessing its options.

"When they come to us, most Chinese GPs have been using Excel and reached a level where they find it too limiting in terms of security or multi-person use," says Tarek Chouman, eFront's COO for Asia and the Middle East. "They might be fundraising, and one of the selling points is their willingness to be more professional and follow best practice."

Big picture

The challenge facing fund managers everywhere is that their investors' definition of best practice is changing. Burned by the global financial crisis, LPs reexamined the size of their allocations to private equity and the terms on which these allocations are made. The relative scarcity of capital swung negotiating power back in the investors' favor and they drove home their case not only for a better economic deal, but also a more transparent one.

The Institutional Limited Partners Association (ILPA) crystallized these concerns into a set of principles intended to deliver alignment of interest, governance and transparency. Suddenly there was a standard by which fund managers could be held to account. Compliance has therefore become a tool of the trade - a means for GPs, old or new, to press their case with institutional investors in the US or Europe, or an excuse for investors to up the ante.

It asks questions about how far Asian GPs, less familiar with best practices that are already becoming ingrained in the West, are willing and able to go to please their investors. More broadly, it opens up the debate of what really constitutes effective communication with LPs.

The classic criticism of younger Asian GPs' attitudes towards compliance is that they are beleaguered by chronic short-termism. Everyone knows how to spend money, but few think about how to distribute the proceeds.

"Fund managers in China don't talk about how they plan on growing their business in the long-term, it's all ‘We did 10 deals and got a 2x return and we have 10 more,'" says Michael Li, Asia Pacific product head at Citi Private Equity Services, Citigroup's fund administration unit. "No one thinks about what if there is a claw-back at the end of the fund. Capital calls are the easy part, but distributions are more important - it's how you get paid."

He adds that China has two unhelpful characteristics: it is young market, so few - if any - managers have been through a full fund lifecycle; and it is a hot market, and while returns are strong there are fewer questions or complaints.

As a result, there is insufficient investment in fund infrastructure, particularly on the back office side. This manifests itself in a number of ways. First, technology is outdated. Non-automated systems are time-consuming and security is a headache. They also put information beyond the control of the fund manager, which means less flows back.

If a PowerPoint presentation is sent out to 500 prospective investors by email, it is gone forever. Using a dedicated software platform at least allows the GP to track who has viewed the document and for how long - details that can be fed back to the investor relations team for reference when making follow-up calls.

Data overload

Of course, an LP doesn't necessarily appreciate receiving a PowerPoint presentation in the first place. "You get a PDF or PPT from a manager and you re-enter the data into your database and see how it matches up against everyone else," says Andre Boreas, director of alternative investments at IntraLinks. "Could this data be viewed across the platform more securely? Does it facilitate further analysis?"

Boreas previously served as CIO for a large family office in the US and recalls a deluge of information, with GPs submitting files in different kinds of formats and according to different standards. One fund manager might send over a PDF containing a breakdown of investments by sector, with telecom rolled into the technology numbers; another manager prefers to use Excel and separate out telecom.

Second, Asian GPs are typically run on pretty tight budgets and many don't have enough back office staff. The star dealmakers that dominate an emerging Chinese firm are not bean counters and, regardless of the supporting technology, they might not be suited to fund administration.

"The question then becomes whether the sponsor is ready to build its own back office or prefers to use a third-party administrator," says John Fadely, a Hong Kong-based funds partner at Weil. "Since the reporting function requires such a different skill set from investing, hiring a back office often means bringing a new skill set in-house. It's often not feasible on day one unless the sponsor happens to be an institution."

Even if a GP is able to hire and retain staff with the relevant skill sets - not an easy task in China -resources aren't necessarily channeled in the correct way.

One executive with a Chinese private equity firm contrasts his operations with those at a typical Australian buyout shop. The Australian player may have only a financial controller or CFO and a handful of support staff, but they are all familiar with the systems and produce detailed reports. At the Chinese firm there are around 15 people in the reporting and compliance department responsible for several funds. The executive argues that improving the quality of reporting relies on employing better systems so that existing staff work more effectively.

"Getting up to the next level doesn't mean adding more people," he tells AVCJ. "We need to reorganize and have the existing staff do more value-added work. Right now it's just number crunching - they can provide data but it's all done manually."

Conflicting opinions

Compliance burdens have effectively seen Asia's private equity industry split down the middle. On one side are the refusenicks, typically managers with less than $200 million under management. They are country-specific and chiefly rely on domestic capital, the providers of which are not pressing for compliance with ILPA or any other standard.

On the other side are the willing adopters. This category may be dominated by GPs that are relatively young but it isn't restricted to them. Other GPs might be seeking to raise fund three or four, and the vehicle is either much larger than its predecessor or the manager is keen on adding some top-class institutional names to the LP roster.

"The big guys with a lot of money at stake who have the income to pay for a chief compliance officer are taking ILPA seriously," says Ray Haarstick, CEO and founder of Relevant Equity Systems. "When you start taking that institutional money, it's more stable and the commitments are larger, but it comes with requirements for more transparency."

Haarstick has heard estimates - taking into account a US cost base - that ILPA compliance requires annual investment of $1 million, which covers the gamut of expenditure on systems upgrades, salary for a chief compliance officer, and legal and audit advisory costs.

If a fund manager succeeds in winning a $50 million commitment that it wouldn't otherwise have got, the fees from that alone would cancel out the compliance costs. But is a smaller GP able to generate the fees that justify running a heavily resourced back office in order to meet the reporting needs of an LP that might already have a discount on its own fee contribution?

What this alludes to is the cyclical push and pull between GPs and LPs. Each side is trying to gain the advantage but the needle can only move so far before the terms become uneconomical - and unacceptable - to one party. If followed to the letter, the ILPA principles would leave GPs tied up in knots, but the reality is that they are one piece of a wider negotiation. The implied costs of compliance are therefore not what they might seem.

"The ILPA principles certainly encourage transparency and that's a good thing, but it only has a limited effect in practice," says Brian McDaniel, a partner at Goodwin Proctor in Hong Kong. "My experience is that transparency concerns don't actually feature strongly in the negotiation of legal documents."

Other industry participants offer a similar view. Issues such as the role of the Limited Partner Advisory Committee seldom feature in discussions, compared to mechanisms by which GPs call for and return capital to investors, as well as the timeliness and accuracy of information on portfolio companies. In each case - capital calls, distributions and quarterly reporting - ILPA has issued a template as guidance.

"Capital call notices and distribution notices are often cited" says Anthony Wong, a partner with White & Case. "LPs come back and ask if you can add a specific item here or a line item there, sometimes citing the ILPA forms but often explaining that the information is needed for their own internal reporting requirements."

Held to account

Put simply, investors want to know what is happening to their money. When a GP makes a capital call, the LP would want details of the investment cost-management fee-partnership expenses split, and where this leaves their balance of funds committed versus funds returns.

Regarding the back end of a deal, clarity is required as to what portion of the profit on a realized investment can be recycled by the GP and used for future deals rather than return to the LP. There is a general distaste for the US-style distribution waterfalls whereby GPs can start accruing carried interest before an investment has been fully realized, impairments and other expenses are resolved and capital is returned to LPs. The preferred approach is more like the European model, with unrealized investments valued at below market value and reserves held in escrow in case any of the carried interest must subsequently be clawed back.

GPs care most about getting paid, so they might be willing to make concessions on potential conflict of interest disclosures or commit to a specific fee step-down schedule in return for a better deal on carried interest terms.

These are specifics and they are subject to extensive negotiation. A fund manager, whether in Chicago or Shanghai, will have more leeway if they deliver consistently good returns. What remains uncertain is the extent to which the compliance drive burdens GPs with information-generating responsibilities that aren't really of use to LPs.

The ILPA provisions on quarterly reporting recommend disclosure of a GP's financial statements, IRR, carried interest and fee payments, fund-level leverage, valuations and expenses. Another set of reports offers insights into portfolio company performance. Specialist software packages are designed to make all this data available at the push of a button, but industry participants caution that less is sometimes more. For example, a quarterly commentary that offers color on the portfolio and its prospects might have greater value for a time-challenged LP than reams of data.

"People are spending more time moving data around than making sure investors know what it means," says Citi's Li. "The quality of information is more important than the quantity. A service provider might claim its system can put out reports at a moment's notice but does that really help the client understand how to present a transaction in a meaningful way?"

Cutting edge systems and standards only get you so far. The ILPA principles are intended to smooth communication channels, but at the same time a fund manager has to convey its value proposition to LPs, and it might not be most effectively expressed in numbers alone. In this context, the shortcomings of ILPA are demonstrated in its compliance measurement system based on a GP's answers to a set of questions. By applying a numerical value to funds with different structures and remits, an LP risks coming to a misleading conclusion.

"It's a good thing for PE firms to be transparent as possible and the best firms recognize the value of their relationships with investors," says Goodwin Proctor's McDaniel. "They take affirmative steps to cultivate those relationships, often by making investment professionals available to talk about portfolio companies. This is far more important than having your deputy CFO put together a full breakdown of the firm's travel expenses."

The long view

Private equity will remain a people-driven business, but the industry's size and significance means it is being pushed into a clearer institutional framework - Relevant's Haarstick compares it to the tougher regulations imposed on mutual funds in the last decade. The ILPA principles will therefore remain a reference point even when the negotiating power swings back to GPs: the change in attitude they represent, if not the principles themselves, is seen as irreversible.

This is equally true of Asia as it is for the West. It could be argued that the ILPA principles, motivated by concerns in North America that funds were becoming so large, so many and so diversified that GPs were more incentivized by fees than carried interest, aren't as relevant to this part of the world. However, based on the current growth trajectory of Asian private equity, in the next 5-10 years the same issues will likely arise.

The larger these funds become, the more capital they will seek from Western institutions, the rise of Asian LPs notwithstanding. In a competitive environment, GPs will again need to prove their ability to meet investors' requirements on disclosure as well as performance.

"It's private equity 3.0," says IntraLinks' Boreas. "Previously, if you were a $500 million fund and had good returns, investors didn't look under the hood so much. Now you need the infrastructure, operations and client services. Investors will drag you over the coals so much more than before."

SIDEBAR: In short - The ILPA principles

Alignment of Interest

• Tougher distribution provisions to avoid claw-back situations (as well as stronger claw-backs)
• Management fees should cover normal operating costs only
• Transaction and monitoring fees should be charged to the fund, offsetting management fees and partnership expenses
• GPs should have a substantial equity interest in the fund
• Tax law changes that impact individual GP members shouldn't be passed on to LPs
• Fees and carried interest generated should be directed predominantly to professional staff and expenses related to the fund

Governance

• GPs should reinforce their duty of care, particularly concerning conflicts of interest
• Investments should be consistent with stated fund strategy
• GPs should prioritize diversification, in terms of holding period and industry
• A majority of LPs should be able to remove the GP without cause
• A key-person event should result in automatic suspension of the investment period
• Auditors should act in best interests of the partnership and its LPs
• LP advisory committee oversight should become industry standard

Transparency

• Fees and carried interest should be transparent and subject to LP/auditor certification
• Detailed valuation and financial information on portfolio companies should be available on a quarterly basis
• Investors in PE funds should have greater transparency on relevant information pertaining to the GP
• All proprietary information should be protected from public disclosure

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

• Topics
• Technology
• Regulation
• Greater China
• LPs
• GPs
• North America
• regulation
• professional services
• TMT
• LPs
• GPs
• ILPA
• China
• Asia
• USA
• Hony Capital
• CDH Investments Management