“Private equity firms have to do more work with fewer resources and with more cost pressures,” says Sekon Kaalund, head of business development for JP Morgan Private Equity Fund Services. “So they’re turning to outsourcing. They’re taking a ‘white board’ approach and asking themselves ‘Are we in the business of generating returns for investors, or are we in fund administration?’. Outsourcing allows them to leverage best practice,” he says.
Although fundraising has dropped sharply in the past 12 months, down from $107bn in the first half of 2008 to $47bn in the same period for 2009,
JP Morgan has grown from a business with $25bn funds under administration in 2005 to more than $200bn today. “The pipeline is very healthy,” says Kaalund. JP Morgan has fund administration offices in London, Jersey and Sydney, Australia, with further outposts due to open in Luxembourg and Hong Kong. “We can service clients in multiple domiciles,” Kaalund points out.
Overall, JP Morgan is banking on an uplift from increased demand for outsourced fund management, given the currently small percentage of the industry that uses it. Only around 15 per cent of US private equity firms outsource administration, but according to State Street, this is likely to rise to at least 50 per cent in the next few years. It anticipates a ‘wholesale adoption of third-party administrators for systems, control procedures, custody and lending services’.
The US fund administration market is dominated by offshoots of large financial institutions such as JP Morgan and State Street, with their hefty financial clout and wealth of client relationships, whereas the European industry is characterised by more entrepreneurial firms such as Mourant and Alter Domus, or companies that have sprung out of private equity firms such as International Private Equity Services (IPES).
The majority of these firms are headquartered in the Channel Islands, where they can benefit from the fiscal regime, along with other advantages, as Julie Jones of IPES explains. “Overall, the demand for fund administrators offshore has grown in the last 10 years. IPES was one of the first players on the scene in 1998 and today there are more than 50 regulated fund administrators on the island. This wealth of high quality, skilled resources helps to ensure Guernsey is an attractive jurisdiction for investment funds.”
Even where funds are domiciled in jurisdictions such as the Cayman Islands, they may choose to be administered in Guernsey, Jones notes. This can involve understandable issues to overcome. “As with any cross-border activity, administering funds domiciled in other jurisdictions is not without challenges,” she says. “These range from the purely logistical, such as sharing documents with investors spread across the globe and convening meetings with individuals in different time zones, to understanding and working within subtly different regulatory regimes. But modern technology has gone a long way to mitigate the logistical challenges, in many cases filing can be made electronically and the internet enables information to be shared with investors easily and in real time, while conference calling means meetings can be held at any time of the day or night.”
As elsewhere, the level of investment seen in Guernsey has certainly fallen in recent months, but on the other hand, the number of inquiries regarding distressed funds has risen. Whether this will lead to administration work is not yet clear, says Jones. “It remains to be seen whether this will lead to such funds being established and if this will translate into administration work, but it’s something we are confident we can handle. A large part of our work is process driven and thus our experience and knowhow can be applied across a broad range of funds – for instance the type of funds we currently work with include real estate, mezzanine, buy out, VC and funds of funds.”
Jones’s colleague at IPES, CEO, Kevin Brennan argues that the economic downturn has brought with it an increase of business from transfers of interest, meaning that it has had a roughly neutral impact on the firm’s business levels. “We track activity in the business very carefully,” he says. “And we’re seeing the first signs of a lift in the investment cycle. Between early July and mid-August there was certainly movement, with funds looking at investments and signs that things are beginning to pick up. Deal analysis is more active, particularly in the technology sector.”
Brennan notes that the size of potential investment is now far below the peak of late 2007 and early 2008. “We’ve gone back 10 years to the spin outs and start ups,” he says. “The activity is in small buyout funds, emerging markets and in industry sectors such as cleantech. It will be some time before the cycle return, since it takes five to ten years for these kind of investments to mature.”
The overall number of investors remains pretty static, Brennan believes, whereas they are now spread across a larger number of smaller investments. And these smaller players are more inclined to seek support from outsourced fund management, he argues. IPES and other outsourcing fund management companies are now seeking to close the gap between client and investor, principally through using new technology. “We can publish information to investors through web-based technology, which brings the investor closer to the client (ie the fund manager).
Yet while there is this push to internationalise services and to capitalise on the opportunities of new technology, Brennan is cautious about the prospects of working more widely in the United States. “We have no current strategy for moving into the US,” he says. “It is a quite separate market and you have to be more US-centred in your style,” he argues. “US companies have a certain cultural stance, they prefer US employees and there is a level of xenophobia. Things are done very differently in Europe.”
At Alter Domus, Dominic Jones prefers to segment the industry in a different way. He views the Anglophone jurisdictions of the Channel Islands, Cayman Islands, Hong Kong, UK and US in one camp and then the ‘civil law’ centres of Lichtenstein, the Netherlands, the Dutch Antilles and some others, in another, with a different client base.
Yet the industry is in general quite fragmented, says Jones. “It has grown tremendously in the past ten years, but this growth has not been driven by outsourcing, but by the use of jurisdictions for tax and regulatory issues. It’s been a reactive process, as firms have required administrative operations in these jurisdictions. We’ve ended up with a fragmented industry, without any one mega fund joining the dots. A lot of expertise and experience has been garnered by these operations, but nobody has properly invested in technology to do full business process outsourcing.”
Demand continues to grow among private equity fund managers for greater sophistication by outsourced providers, for companies who can tie together activities in the various jurisdictions in which they operate, according to Jones. He believes the funds are becoming increasingly interested in acquiring (or at least investing in) the outsourcing firms, as M&A pressures mount.
“There is also a trend towards integrating the front and back offices of clients and administrators,” says Jones. “Instead of both sides having different databases, these can be shared and accessed securely. So you can have full insourcing and full outsourcing, or you can go anywhere along that line. So for example if someone goes on maternity leave, you can go to one end of that line, and then switch back.”
More often, in today’s environment, an administrator needs to operate across many different jurisdictions, Jones explains. “We may be dealing with a UK limited partnership, with a feeder fund in Germany or France, a carry structure in another jurisdiction and a target asset in Italy. Suddenly you are dealing with four or five structures. If you can put all this onto a simple IT platform, you can have enhanced operations.”
Jones has ambitions to move his company onto a more global stage, including greater amounts of US work. “I think the US and European split should break down in time,” he says. “Around 80 to 90 per cent of what we do in the US and Europe is the same, with the move towards fair value, to applying the IFRS, to dealing with the alternative funds directive, we are all becoming more global. The execution will be difficult. It is going to take the commitment of clients and administrators to achieve and some competitors have had to close down operations after opening them. People need to ask themselves whether they are right to expand into another jurisdiction if they’re not delivering 100 per cent in their current jurisdiction.”
Where European firms have a competitive advantage is in complex structures, says Jones. “In the US they don’t deal in multi-currency deals so often. London is more international and has a different approach.” In contrast to the large financial institutions that dominate the US market, Jones argues that companies such as Alter Domus and Mourant can act more quickly and are more comfortable with the offering ‘soup to nuts’ services. US firms are less equipped to provide this, concentrating more often on treasury services, he finds.
The smaller European operators can address the needs of private equity firms in a more personal, tailored way, says Jones. “We understand the technical issues and talk the language of accountants, lawyers and CFOs. We actually provide a quasi-CFO role in some cases. The large banks are less geared up to do that.”
Jones believes that there will, nevertheless, be some consolidation in the European fund administration sector in the coming years, following the historical path of mergers and acquisitions since the emergence of ‘mom and pop’ operations in the Channel Islands a decade ago. There are now around 50 fund administration companies working in the islands: Jones believes this will whittle down to five or 10. “The market is certainly retrenching, some firms are concentrating on specific sectors such as biotech, or geographical sectors such as Central Europe. In general, there will be more sophistication and more demand for reporting. There could also be more consolidation in alternative assets altogether. There are a lot of synergies in closed end funds, where you can provide the same platform.”
At Mourant, Iain Stokes feels the industry is moving away from the ‘vanilla’ third party administrative role of previous years, to providing greater information ‘up the food chain’ as he puts it. “There are now expectations that both limited partners and general partners will be able to dial into a system to access information and run reports on it.” The straight forward accounting function will become more ‘industrialised’, with lower margins, as the industry matures, says Stokes.
“It will separate the men from the boys,” he says. “We will have to add value, to develop multiple touch points with clients, as they become more sophisticated and operate in more jurisdictions.” He argues that it is incumbent on the industry to sell its message to the US market, particularly in the light of the Madoff scandal, that employing a third party fund administrator provides checks and balances that will reassure investors and regulators, and “reduce the scope for fraudulent or errant behaviour,” says Stokes.
The ability to win new work from US clients rests on this regulatory push, according to many industry figures. Iain Stokes at Mourant argues that the credit crunch (along with the accompanying scandals of Madoff and Stanford) has brought the outsourcing trend into the spotlight. “Those administrators who can respond to the changed circumstances have a great opportunity,” he says. They need to focus on governance and regulatory issues, on top of the historical accounting services.
Kevin Brennan at IPES believes that conforming to the highest US-led standards is now crucial for all fund administrators, wherever they are based. “This pressure will only increase,” he says. “A regulation like SAS70, which is US-centric and deals with corporate governance, is like a kite mark. It’s important that you report to the highest international standards. It’s a transparent way to promote yourself to clients and the investment community.”
Jack Klinck, State Street’s global head of alternative investment solutions argued at the bank’s presentation of its report Private Equity at the Crossroads that the industry is leading the way towards new, more transparent operations and technology. “We think there is a fundamental shift occurring, whereby LPs will have much more leverage over their GPs,” said Klinck. “We are seeing more negotiation around fee structures, fund sizes and other terms than ever before. This is a powerful market force at work, which is perhaps more powerful than any regulatory force. The industry is well ahead of the regulator on this because of investor pressure.”
The European Commission’s draft directive on alternative fund managers is likely to increase the pressure towards outsourcing, according to Klinck. Yet for European outsourced fund administrators based in the Channel Islands, the directive could prove troublesome, as it challenges the concept of offshore tax havens.
“The EU directive has a long way to run,” says Iain Stokes at Mourant, “but the Channel Islands have been in the spotlight for a number of years. I think this is unjustified, because Guernsey and Jersey are both very well regulated, they’re on the OECD ‘white list’ [of investment jurisdictions], yet we have to deal with the perception that we have something to hide. So we have to lobby at different levels, to be proud of what we provide to clients.” The directive is not due to come into effect until 2011, but there are fears that a ‘fortress Europe’ mentality and a political agenda may force fund administrators to operate from the European mainland.
Stokes argues that the structures offered in the Channel Islands are ‘totally tax transparent’, but he and his fellow fund administrators nevertheless have to battle against public perceptions. Partly in response to these concerns, Guernsey recently introduced ‘Registered Funds’ and ‘Qualifying Investor Funds’ schemes, hoping to reinforce the island’s reputation for strong corporate governance standards and a stable investment environment. In addition, its location in Western Europe, between the time zones of the US and Asia, is a bonus, says Paul Duquemin at Bachmann Fund Administration in Guernsey. “It has a reputation for political and fiscal stability, a well educated workforce working in a mature industry that has been administering funds for 40 years.”
Although there are likely to be changes to the EC directive before it is enacted, it is expected to deal with financial disclosure, asset valuation and leverage levels. “The challenge this presents for an administrator is one of scale and resource,” says Julie Jones at IPES. “Dedicated fund administrators such as IPES are in a fortunate position, whereas smaller, in-house teams may struggle to meet the increased demand for data.”
Just one more reason to believe that outsourced fund administration should continue to expand.