The importance of good reporting from fund administrators has grown markedly in recent months, as the private equity industry itself has grown. “Private equity fund administration is now a global business with a very high profile. The changes in the private equity landscape mean that the range of stakeholders we serve is much greater: it includes not just the fund professionals but politicians, unions, and all kinds of investors. We have to be able to provide good solid reporting for regulatory purposes as well as tax,” comments Iain Stokes, head of private equity at the Guernsey office of Mourant, a fund and corporate administration specialist.
Bill Morrow, managing director and chief operating officer of the independent private equity investment firm Mid Europa Partners, agrees. “Given the importance of the tasks involved, outsourcing fund administration has allowed for considerable gains in efficiency. It’s no longer enough to do the deals and make money: communication is a priority as well and there has to be a world-class infrastructure in place. The key factors in reporting are timeliness, accuracy, and availability of core information, and we judge fund administrators by their ability to provide all this.”
Clearly there is now demand for improved reporting which covers a wider scope than previously. As Stokes points out, this includes ad hoc reporting around the valuation of an investment; the purchase and sale of partnership interests in a fund; adding a dimension of transparency to investor relations, among others.
“Private equity is a fast-moving business,” says Anthony Cecil, a partner specialising in private equity at KPMG in London. “What you have is a small number of high value transactions which need to be closely followed. When you want information, you want it quickly and in a reliable and useable form. So it is not surprising that LPs are demanding more and better reporting from GPs, and that the latter are making increasing use of the resources provided by outsourcing.”
There can be friction between the GP and the LP over reporting issues. Says Connie Helyar, a director at the Guernsey-based fund administration specialist International Private Equity Services: “There can be variation in the relationship between LPs and GPs. Historically, the larger and more successful a GP becomes the more dictatorial they tend to be towards the LPs. Smaller groups tend to be more flexible as they have to work harder to attract investment. In our experience the issues largely relate to financial information or valuations. Some of the bigger institutional LPs have a quite prescriptive way of reporting to their own internal management and this is usually what drives their requests. Sometimes the GPs give in to demands but often they don’t.”
Helyar points out that one issue that can arise which causes conflict is the requirement to report fair value in valuations. “It has sometimes proved difficult to get auditors to agree with the GPs as to what fair value actually means. “Fair value” directly affects the valuation of assets; there is often a difference of opinion or some argument between the GP’s and the auditor’s view of what fair value actually is. It is a matter of getting everyone to agree what is meant by it. This has been particularly difficult for venture capital portfolios. Obviously when GPs and LPs don’t agree on the numbers, this puts pressure on the fund administrator who can get caught in the middle. Generally the administrator plays quite an important role as go between the auditors and the GPs.”
David Bailey, the London-based managing partner of the Guernsey-based outsourced fund administration specialist Augentius, agrees. “The fair value issue can become quite a bone of contention as best practice under IFRS is only just becoming established. It’s a subject of debate for the auditors as well, so one can imagine how it affects fund managers.”
Then, LPs can be particular about aspects of reporting. Helyar continues: “Capital account statements are also very important to LPs. We have experienced one or two issues with the way certain audit firms prefer to see these set out which has not always been to the liking of the GPs or the LPs.”
There can be variance in the nature of demand for information, says Helyar. “Some groups put more emphasis on providing a wordy update of the investment with less focus on detailed numbers. Then others insist on providing both. It is often true that the demand for more detailed numbers will depend upon whether the CFO is driving this function within the GP group or whether it is another part of management.”
There is of course considerable increased pressure on the regulatory side for better quality reporting: the requirements of Basel II, on the one side, and for those who must comply with it; and of Sarbanes Oxley on the other side of the Atlantic have made the quality of reporting a key issue for banks and funds. Investors also require correct reporting as they themselves must remain sure of remaining compliant. Transparency is today an essential requirement for any firm in financial services, so fund administrators must be capable of providing it.
The quality of reporting has had to see a great deal of improvement, and the fund administrators have taken the necessary steps. “GPs expect a lot more. Every fund now does quarterly reporting, which was not necessarily the case before, and GPs are very keen to provide LPs with good quality and detail. Many GPs take great pride in this, and many consider it a matter of pride,” says David Bailey of Augentius. “What we have to provide now is lots of colour charts and graphs, with a high level of user-friendliness and communication.”
Communication at the highest level is indeed the key to providing the services now demanded from both GPs by LPs, and by GPs from outsourced fund administration. “GPs now routinely demand the production of annual reports, specialised reports, and a wealth of related materials,” Bailey says.
In fact, according to Bailey, the same trend that affected the hedge fund industry some years ago is now coming to private equity.” That has been the case for many years in hedge funds where investors as a matter of course will carry out due diligence. We are now slowly beginning to see this in private equity: an absolute demand for quality reporting and administration that can be subject to the highest level of scrutiny by investors. The LPs are beginning to wake up to this.”
LPs are also beginning to wake up to the fact that GPs may not be able to do the work themselves. Given the fact that good quality professional administrators are available through outsourcing, GPs often find it easier to do the work themselves,” Bailey points out. “It’s not really their job, and many GPs are not qualified to provide reporting at a professional level. They want to focus on deals, which is what they are supposed to be doing. And in this way they can leave the administrative tasks to others. We are seeing an increasing flow of LPs paying attention to what we do and a few but an increasing few even doing due diligence on the fund administrator before they make investments, which is what happened with hedge funds. We expect the trend to grow, and that more and more LPs will follow this route. After all, many investors in private equities are also in hedge funds.”
There is a kind of ‘magic circle’ of a small number of offshore outsourced fund administration firms developing, those which have both the know-how and the back-office infrastructure to provide the level of quality demanded internationally today. These are capturing the lion’s share of the complex international business. The expertise and know-how required to service big international deals across jurisdictions are making it tougher for new entrant firms to compete in this complex market.
The cost structure is certainly on the side of the outsourcing choice. The cost of a third-party administrator is most commonly borne by the fund, not by the GP. Moreover, the outsourced fund administrator can offer lower costs, because he can make economies of scale. Most of the fund administrators work offshore, and the biggest challenge they have to face is the ability to hire enough qualified personnel. The pool of talent that is permitted to work in Jersey or Guernsey is necessarily relatively small compared with that of the Continent or the UK. Of course, most offshore fund administrators also have offices in London and New York.
But the demand for quality on the part of LPs and GPs must be met by very capable personnel on the outsourced fund administration side as well. “There has to be a truly capable and responsive interlocutor on the outsourced fund administration side,” says Cecil of KPMG. “Funds find that the quality of the account manager on the fund administration side makes all the difference to the quality of response they receive.”
There are of course still funds that are reluctant to outsource their administration. These are often funds that are afraid of losing control of part of their operations. They are, however, not always prepared for the level of internal organisation demanded today in reporting, and they can be overwhelmed by the demands of investors.
Many funds have taken the middle path of outsourcing part of the reporting, perhaps just the back-office aspects of fund management. These funds usually have their own internal personnel for the reporting tasks, and use the outsourcing fund administrators for support. The outsource fund administrator becomes a kind of ‘halfway house,’ a structure providing administrative services to LPs. “There are an increasing number of businesses springing up around the industry offering this type of service, so there must be a perceived need for it,” says Helyar of International Private Equity Services.
Some funds, of course, simply do not have the infrastructure in place that the demands of reporting require. They are then all too happy to outsource to professionals who can offer the knowledge and support that they need. Several observers notice a danger of administrative service companies making the ‘stretch’ to full scale fund administration without having the necessary qualified personnel available. This is an area where funds should be cautious, as the two skill sets are hardly congruent.
“It’s not just a matter of servicing one fund or providing support for a few deals,” says Stokes of Mourant. “It’s rather a question of creating a long-term relationship with a given GP in which the GP can be certain of your reliability and professionalism. You will then become the partner of that GP in a whole series of funds,” Stokes insists.
Each LP is a large institution in its own right, with its own reporting needs. “Some of these can be quite prescriptive, as LPs demand individual formats,” Stokes continues. “Fund administrators have to achieve a level of professionalism in which they can adapt easily to very different requirements from different organisations. It’s not a homogenous environment.”
But there is no question in any observer’s mind that poor quality reporting can hurt a GP badly. “Bad reporting, or poor handling of investor relations due to lack of information can hurt a GP and even make it difficult for the GP to raise funds in the future,” Stokes says.
Given the considerable and growing importance that LPs place on reporting, and the desire of GPs to fulfil this need, there is every chance that the outsourced fund administration industry will continue growing at a rapid rate for as long as the private equity industry continues to grow across Europe.
Fair Value in Reporting
The issue of fair value determination has become a fraught one in private equity, and one in which fund administrators are necessarily involved. There is a running debate both within the community of auditors and without in the private equity industry about how fair value can be determined for a private equity investment.
“Fund administrators have to negotiate controversies over the valuation of investments between all the parties involved,” says Connie Helyar of International Private Equity Services.
The principle of fair value measurement is more or less accepted as a means of valuing securities in the financial markets. But it becomes far more difficult to use when applied to investments which are not quoted on exchanges, in other words, where there is no clearly defined market mechanism to determine fair value.
To help work out all these difficulties, the industry has organised the International Private Equity Valuation Board (http://www.privateequityvaluation.com ). This board has developed International Private Equity and Venture Capital Valuation Guidelines under the auspices of the Association Française des Investisseurs en Capital (AFIC), the British Venture Capital Association (BVCA) and the European Private Equity and Venture Capital Association (EVCA). The first guidelines were launched in March 2005 to reflect the need for greater comparability across the industry and for consistency with IFRS and US GAAP accounting principles. Since then, the Board has maintained consultations on the subject with the noticeable participation of the International Accounting Standards Board.
The Guidance sets out the terms for valuations. Assets are determined by their list price, if they are listed on exchanges, or, if they are unlisted, fair value must be estimated. The Guidance defines fair value as “the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.” The objective is to estimate the exchange price at which knowledgeable market participants would agree to transact. The Guidelines provide a methodological framework for arriving at that number. These have been drafted so that they are compliant with UK GAAP, US GAAP, and IFRS approaches. They create a structure within which the valuation can be robust and easily definable.
But there is considerable controversy even over the fair value approach, although it is the one supported by International Financial Reporting Standards 26. The UK’s Accounting Standards Board criticises a suggested broadening in the use of fair value measures. The argument is that finding a hypothetical market participant is not useful, given that the market itself is imperfect. What a perfect participant will do in a hypothetically perfect market is not representational of what happens in reality, the counter-argument attempts to show.
Nonetheless, 32 private equity organisations around the world have endorsed the approach by the Private Equity Valuation Board. Nonetheless, there remains difficulty in reconciling the approach of IASB and that of the Board. There is an ongoing discussion between the two to find ways to bridge the gap.
Some say that the best approach to such a valuation is the consideration of entry and exit value: what market participants will pay for an asset. When a fund is realising value on its portfolio, the determination of what a given investment is worth is ultimately determined by the external market. The determination of value to report to investors between investing and realisation has been a subject for debate. But there is considerable difficulty in determining exit value in a young company that has not yet been around long enough to give the market a sense of what it is worth. This is particularly true if the company has not yet been through a second round of financing. But using entry value is also unfair in this case because the company is likely to have created some value since it got started, or since the investors came in.
One of the issues has been the notion of ‘entry and exit’ value which would mean values determined in practice by the markets. IASB has supported this approach, but the Board has not accepted it. The Guidelines avoided proposals around the entry and exit price approach. ‘Exit value’ would be a difficult parameter to apply, for example, to companies in early stages of development, where a second round of financing has not been put through. The ‘fair value’ approach recommended by the Guidelines is a simpler theoretical concept and encourages the valuer to consider the underlying value drivers. Fair value as a concept anticipates a market characterised by pure and perfect competition, where ‘entry and exit’ price should always be identical.
Fund administrators are necessarily involved in all this, as they have to provide the reporting on fair value. They have to ensure that the proper controls are in place around the valuation process, to make certain that a robust consideration of all factors has been made before the output is determined, and make certain that management is satisfied with the final determination. The actual valuation process should remain the responsibility of management and the external auditor.