Outsourcing Challenges

The playwright George Bernard Shaw once remarked that “England and America are two nations divided by a common language.” In the microcosm of the private equity world, Shavian wit and wisdom also applies, though more to custom and behaviour than to terminology used.

On this side of the pond, general partners appear to be much more reluctant to outsource their back offices to specialist providers than their peers on the other. According to figures from the “big four” accountancy firm PricewaterhouseCoopers, penetration of third-party administration in the UK private equity market remains surprisingly low, with just one-third of general partners preferring to outsource.

Bill Kennedy, head of finance at Aberdeen Asset Managers Private Equity, which recently brought its back office in-house, sums up the mood. Kennedy says: “There is a lack of outsourced administration providers who actually know what they’re doing in the private equity market.”

He adds: “The reality is that you can run the back office of a private equity company quite cheaply. It’s a lot easier and probably also cheaper to simply hire a good accountant.”

However Kennedy’s view is by no means universal. In theory there are plenty of advantages to using third-party administrators. One is that the costs of doing so can be taken out of the fund, whereas if fund administration and accounting is handled in-house, the management company ends up footing the bill.

Also, outsourcing frees up GPs to focus on their core business of investing. In theory, outsourcing the back office – including the administration of capital calls, distribution notices, investor reporting, financial accounting, investor queries, the hosting of board meetings etcetera – to a specialist provider gives GPs more time to look for opportunities and to nurture their portfolios.

There are real advantages for limited partners too. A robust reporting platform can give better and more up-to-the-minute information than a small to medium-sized private equity house is capable of delivering in-house. LPs are also increasingly seeing the merits of web-based reporting, something specialist providers such as US-based Investment Café are more likely to be able to provide than an individual private equity fund.

However, Europe’s GPs remain surprisingly sceptical, with many believing it is better to retain their back-office functions in-house. Some, including Rod Selkirk, head of private equity at Hermes Private Equity, have questioned the economics of outsourcing, believing it is cheaper to perform these functions in-house. This goes hand-in-hand with concerns from GPs and some LPs that they would lose the ability monitor the minutiae of service quality if back-office functions are carried out by third parties.

One of the most common concerns is that specialist providers simply cannot keep their staff, which may have something to do with the fact administration can be boring and repetitive work.

James Yates, partner responsible for finance and administration at European private equity group Industri Kapital, says if you are going to outsource, one of the first things you should do is check levels of staff turnover at the would-be provider. He says: “There’s a lot more money in the asset class than there was five or 10 years ago, and I believe this has accelerated the rate of staff turnover.”

Jon Moulton, founder and managing partner of Alchemy Partners, says his group outsources administration to specialist providers in Guernsey, Mauritius, the Cayman Islands and Bermuda. “All these locations are suffering from similar pressures – particularly rapidly rising costs,” says Moulton. He says that the salaries of fund accountants in tax havens have risen “threefold in the last 10 years”.

If a private equity fund is considering going down the outsourced route, what should it be looking out for when weighing up potential candidates?

Alchemy’s Moulton says: “Before I do anything else, I would make sure that they have the capacity. I would also look at having a sensible contractual arrangement with them.” He also warned against being seduced by what may at first appear to be competitive rates. “The danger is they’ll quote you quite an attractive price, but by they time they hit you with additional charges for an endless wall of extras, it may well be too late.”

Human relationships are also obviously going to be critical if the partnership is going to endure. Sam Robinson, director of SVG Advisers, says GPs must assess whether they’re going to be able to form strong working relationships with the people at the top of their prospective partner firm before signing up. “If it looks likely that this is going to be impossible to achieve, it would be better to look elsewhere.”

“You’re going to have to rely on the senior people within the outsourcing company to ensure they deliver the quality of service you want. You have to be in a position where you trust someone to sort things out if they go wrong.”

Because of “the widespread buck-passing” he has experienced with some providers, Robinson says he generally favours a hierarchical rather than a flat organisational structure within third-party firms.

Robinson also recommends that, when sizing up potential partners, the GP’s finance chief should go on an extensive site visit. He believes the CFO should be accompanied by an accountant and an IT person from the private equity firm – who should be encouraged to spend time with equivalent specialists within the putative partner.

Jack Klinck, head of global investment product services at Boston-based State Street, agrees that proper due diligence is essential. “That is paramount. We strongly encourage on-site due diligence visits, right down to meeting the accounting team and having a demonstration of the systems. It’s critical to test its functionality. Reference checks are also crucial. We encourage site visits so that prospective clients can kick our tyres, check our disaster recovery policies.”

These thoughts are echoed by Sue Bains, vice-president of global fund services at Northern Trust. She says she would “certainly encourage” a GP considering appointing an outsourced provider to do their own due diligence. “They ought to be checking they can work with the people and that the systems can support what they want to do.”

Given the recent arrival of megabanks including JPMorgan, Citi, and State Street into the private equity outsourcing space (see the Yanks are coming panel), GPs and LPs also need to be clear in their own minds whether their preference is for a “generalist” or a “specialist”.

According to Industri Kapital’s Yates, specialist providers are generally preferable. He adds: “If you do go to a large provider, you’d be better off going to one that has a specialist private equity unit.”

Robinson says: “If there’s a good specialist, it would be better to go for them. However, if all the specialist providers are bad at what they do, then it would be better to go to a generalist and effectively allow them to learn on your product.” He says, for example, that the leap from doing the back-office administration on a fund of hedge funds to doing it on a fund of private equity funds is not too great.

State Street’s Klinck insists, however, that it is possible to get the best of both worlds, and State Street has in recent months very deliberately created a dedicated private equity unit under the umbrella of the broader bank. “We recognise that the skills sets [needed to handle back-office functions in the private equity sector] really are different [from those in mutual funds]. This is why we continue to invest in our own private equity system. We have the best of both worlds, in that we are a specialist player that is looking to compete, but we are backed by a global brand and a global balance sheet.”

He adds: “As a regulated bank we can take on a number of banking services – including cash movements and the distribution of funds – which is something that a specialist player will probably be unable to do.”

In the mutual funds arena outsourcing contracts tend to be more complex and onerous than they are in the private equity space. Contracts in this are tend to last for five to seven years, much longer than those in the private equity market.

According to Klinck, average back-office outsourcing contracts in the private equity market last for three to four years. “Whether you’re a GP or LP your time horizon will well exceed a year.”

David Young, a lawyer at solicitors Maclay Murray Spens, believes it is essential for the private equity player to have a properly drafted contract with the outsourcer. He says: “A binding agreement must be put in place which sets out the services to be performed, service levels and remedies for any failure to properly provide the services. It should include monitoring and audit rights, to allow the firm to satisfy itself that services are being properly provided and identify potential problems at an early stage.

“Any cap on an administrator’s liability should be considered carefully by the private equity fund, as its losses could be significant if the administrator fails to properly provide the services.”

Given that information technology systems are the backbone of any outsourced provider’s work, any GP or LP should also give their prospective partners’ systems a thorough going-over before leaping into any relationship.

A common desire among GPs is that systems should be compatible with their own, basically so they can gain access and monitor what’s going on. Generally therefore, they lean towards providers that use standardised systems, such as Sungard’s Investran.

SVG’s Robinson says he would be very nervous about using a provider with customised or proprietary IT systems that would make it possible for them to input data without his knowledge. “You really want something universal that is compatible with your own systems.”

Most GPs dislike the idea of outsourcers with a one-size-fits-all approach to operating systems and processes, preferring bespoke systems, even if these are mounted on a commonly available backbone. Yates says: “Every private equity fund is different, its way of doing business is different, its investment strategy is different, so outsourcers can’t really expect a one-size-fits-all approach to be of much appeal.”

Once an outsourcing relationship has started, communication is critical to ensure it runs smoothly. Although the intensity of communication and dialogue will vary, according to levels of activity during the lifespan of a fund, it has to be there. Robinson believes the amount of contact needed is often a function of the quality and reliability of the work being done. He says: “If they’re very good at their job, then you should just let them get on with it. If they haven’t got a clue what they’re doing, then you’ll need to be in daily contact with them.”

But what is the best way of keeping an outsourcer on their toes, and ensuring they don’t take their GP and LP clients for granted? Robinson has the perfect solution. Rather than putting all your eggs in one basket, he says it is preferable to play one supplier off against another. He says that, under no circumstances, would he hand over SVG Adviser’s entire back office to a single back-office provider. “It spreads the risk to use at least three providers.”