RECESSION and the credit crunch have had a significant impact on the balance of work being carried out by fund administrators but – and breathe it softly – some are now seeing hints that a new investment cycle is underway.
Just as one swallow does not make a summer, neither do one or two robins on the lawn necessarily herald the thawing of as chilly an economy as any business person alive and still active can remember. And yet…
“As an administrator, we track across 70 clients by type of activity, and we’re seeing the first real signs of the investment cycle ticking up,” says Kevin Brennan, chief executive at Ipes, the specialist provider of private equity fund administrative and managememt services.
Brennan joined Ipes in January 2007 so has spent much of his incumbency thus far dealing with the changing demands made by Private Equity players in the credit-crunch induced recession whose roots stretch back two years to the first inklings of the sub-prime crisis.
“Clients are more actively looking at prospects again and the buyout process is beginning to show signs of recovery. The amount of time that we are spending on the buying cycle is now starting to edge up. There is also activity with follow-ons. Those that have existing portfolios are beginning to invest again in those companies.”
From fund administrators’ point of view, the recession story has so far been one of a palpable decline in launches, fundraising, investing and divesting
Nicola Walker, Head of Private Equity Services at Schroders in Guernsey, says: “We’ve seen no funds falling off, but there has been a decline in launches. I wouldn’t say it’s been huge. People are still trying to raise funds, but they are taking a lot longer because of the current climate.”
Which is why Kate Stallard, head of private equity, infrastructure and real estate sales at fund services provider Northern Trust, is expecting next year to bring stronger activity, barring more shocks to the economy.
“Some GPs who might have considered launching funds this year have made decisions to push them back to 2010 as they concentrate their time on managing existing portfolios and looking after investors.”
Funds being launched at what is hopefully the bottom of the recession are more modest than the large buyout funds of recent years, says Matthew Wood, whose recent appointment as managing director at Mourant International Finance Administration’s Guernsey office came at a challenging time for the industry.
“More smaller niche funds are appearing to take advantage of lower asset prices,” he says. “For anyone who can raise capital, it’s potentially a good time to invest, but also to keep some powder dry for future opportunities. That has a knock on effect on fund administrators.
What are these niche funds focusing on?
Says Kate Stallard at Northern Trust: “SMEs are faring the weather well. I seem to be working more and more with environmentally biased projects. Whether they be sustainable technology, or hybrids between environmental companies and larger infrastructure projects, that’s definitely been the emphasis to a number of the pitches that I’ve made over the past six months.”
Some of the movers behind these new funds are seasoned private equity professionals jumping ship as the prospect of carried interest from their existing activities recedes or evaporates.
“We are seeing activity with spin-outs, people jumping out of larger funds and starting up or having the desire to do so,” reports Kevin Brennan at Ipes. “It’s focusing on slightly different investment sectors such as cleantech and emerging markets, which are now very prominent.”
As large deals and fund sizes more or less fade from memory, fund administrators are happier than ever to do business with niche players.
Says Matthew Wood at Mourant: “We have to diversify. We can’t just sit here and wait for leveraged buyout funds to appear. Those days are over for the foreseeable future. There are credit opportunity funds appearing, litigation funds, energy funds, and niche private equity players. Spin-outs need our help too. They won’t necessarily be taking a finance professional with them. Start-ups and spin-outs are great opportunities for us, and who knows, maybe one of the future big players will develop as a result of these times.”
Is a trend towards smaller funds and more cost-conscious customers denting revenues, margins and cash flow at fund administrators?
“These smaller funds still need quarterly reports, statutory annual reports, cash management and day-to-day administration, just like big ones,” Matthew Wood points out. “Smaller funds pay the bills as well, so they are good opportunities for us and, in many ways, smaller funds appreciate the work that we do because they may have less in-house expertise than bigger players in the market.”
Nicola Walker at Schroders says: “We haven’t had people asking us to reduce fees, though I’ve heard that some private equity firms are accruing fees but deferring payment until such time as the funds are making distributions.”
“Increased scrutiny from clients is the best way I can describe it,” says Kevin Brennan at Ipes. “As an administrator, if you ever bill in an indefensible manner, you’re in trouble. If bills are honest and reflective of activity, it’s not been an issue.”
The balance of activity within the package of services offered by administrators has shifted in recession as complex financial engineering around transactions has dwindled and GPs have gone back to a more traditional focus on value creation within portfolios.
“If we’ve not been involved in the investment cycle, we’ve been involved more on some of the distress side, dealing with the impact of the cycle – secondary processes, investors transferring interests, and so on,” says Kevin Brennan at Ipes.
“We’ve been helping GPs with an increase in investor communication,” says Kate Stallard at Northern Trust. “There’s been a decline in reinvestment by LPs, an increase in LP default rates, and an increase in the resource constraints of LPs. We’re supporting GPs in providing much more transparency around those portfolios.”
Matthew Wood at Mourant widens the picture. “We spent the first six months of this year doing a lot of extra work for LPs. They wanted additional reporting. Lawyers, on behalf of LPs, were querying terms of limited partnership agreements. We had a few LPs in some of our funds under administration default on commitments. Some investors had sold out to other investors in secondary transactions. In some cases there were investment managers picking up LP positions. It became that in the good times many investors had signed up to LPAs without considering the detail. Retrospectively, they are now querying it.”
“Investors are on the telephone and emailing us regularly asking more questions or for specific data, and that means us working more closely with investment managers to provide that. So these conditions have been an opportunity to provide extra work, and we’ve had extra revenue sources as a result of specialist reporting and doing work for LPs.”
With private equity focused more on costs, portfolio management and investor relations, fund administrators believe they have been given an opportunity to sell the outsourcing message more effectively.
“Because people have been less busy doing deals, we have found that they have had time to sit back and look at their fund administration and any other functions that they might outsource, and to look at price, service levels and so on to see if they’re happy,” explains Nicola Walker at Schroders.
Recession has exposed fraud and the consequences of weak risk assessment to the scrutiny of regulators and politicians who are responding with more and tighter controls of many facets of the finance sector. This is creating still more selling propositions for fund administrators.
“The Madoff incident perversely helped the administration industry,” says Matthew Wood at Mourant. “It’s forcing investment managers to have a look at how they administer their alternative investment funds. The administration of Private Equity funds is perhaps higher priority than it was a year ago, and they’re turning to specialist providers like ourselves.”
The upshot, says Wood, is that although fewer funds are being raised, the likelihood of them outsourcing to third-party administrators such as Mourant is “probably higher than before”.
He believes this to be an added attraction to the small funds being set up now. “We administer some of the great and the good in the Private Equity world, and smaller funds want to buy into that experience. It’s very hard if, for example, you run a 100 million euro alternative energy fund to invest in Spain, to employ a large back-office department where you can have proper segregations of control and give state of the art investor reporting – outsourcing is therefore a more logical choice.
“Investment managers will look to outsource to give their investors comfort. Indeed, I have met a couple of investment managers who have asked us to be part of their road show to meet potential investors because it shows the importance they attach to investor reporting.”
In EVCJ’s 2008 Support Services supplement, we noted that some funds were outsourcing from the start because of a need for speed, for example in setting up distress funds as recession creates opportunities.
This is still the case, says Matthew Wood. “We have a couple of clients with existing funds who want to set up some new ones very quickly. In Guernsey, the Registered Funds regime enables that, and in a number of cases, we have done exactly that. Similar examples apply in other jurisdictions and we can set up funds very quickly because of our expertise. However with the current state of the markets I would say that for the majority of clients, the flash to bang time is actually longer now because it’s taking longer to raise capital.”
The industry’s sales pitch remains familiar. Outsourcing allows private equity house to focus on its core value proposition, developing portfolios. Fund administrators can take on the increasingly burdensome requirements as regulation increases. They have invested heavily in technology to provide efficient and clear reporting to GPs and LPs. They also offer a degree of independent oversight underpinned by a strong corporate governance foundation and can do so globally.
While administrators may feel that their case has been strengthened and their value to clients has been proved in recession, the big question is whether private equity industry will now be more likely or more willing to outsource mid- and back-office functions.
Kate Stallard at Northern Trust says: “One trend I am seeing that there are a number of managers launching or looking to launch products next year who haven’t utilised
administrative services before, and who are now seeing the advantages of the additional support and value we can provide to the stakeholders of the fund, leaving GPs to focus on their portfolios.”
Matthew Wood at Mourant reckons: “You’re not obliged to do it, but it’s regarded as a good thing to do. More private equity firms are outsourcing. But whether there’s a sea change or not, I don’t know. People are definitely considering it and, of course, the fund will pick up our fees so it does remove a cost from the investment manager’s P&L in these cost-conscious days. And that’s got to be quite an attractive option.”
Kevin Brennan at Ipes warns: “Fund managers are looking at internal costs and asking the question, and administrators are promoting outsource. But I don’t think the rationale has led yet to a decision point being reached. Even with the funds that we’re engaged in, I see reticence. What that says to me is that a lot of Private Equity fund managers do not yet see a compelling argument for outsourcing.”
What could change that? “I think administrators have to change the proposition,” says Brennan. “Administrators have to put time, work and effort into the product that we’re looking at, particularly making use of technology, and improving the experience of investors. If ever you look at a shared process with fund managers, the great one to tackle is the sense of control. So working on technology that links the manager much more closely with the administrator is key to that.”
The great caveat in any current forecast is lingering uncertainty over the speed, breadth and sustainability of economic recovery. There was encouraging news in August when it emerged that the French and German economies had unexpectedly grown in the second quarter of the year. But the eurozone contracted for a fifth consecutive quarter.
In presenting its recent quarterly inflation forecast, the Bank of England effectively poured cold water on the notion of a strong UK recovery in 2010, stating that it could be ‘slow and protracted’.
So sightings of those robins on the lawn, while welcome, are also being viewed with caution as some economists continue to talk about the possibility of a W-shaped recession.
“I don’t know if the bottom of the cycle has been reached,” says Kate Stallard at Northern Trust. “Historically, investments made in downturns produce the best returns, but I do believe there are probably more write-offs to occur. I wouldn’t like to say how many.”
For Stallard, prospects of a marked uplift in the cycle will depend on banks starting to extend more credit so that PE firms may engineer their portfolios and be able to launch new funds.
Considerable uncertainty remains over when that may happen, with the Bank of England is warning that it may take years for UK banks, consumers and government to rebuild their balance sheets. The banking sector remained in “a very bad way” and it could take “several years” for its balance sheet to be repaired, he said. Indeed, he went so far as to say that he hoped recent more positive news from the banking sector would not have investment bankers thinking that it was “business as usual”.
All told though, the noises coming from fund administrators are more upbeat that they would have been, say, six months ago.
“In the past few weeks, we do feel that that things are settling down, and we hope that it will bring another cycle of vibrant fundraising,” says Nicola Walker at Schroders.” I’m not saying it’s over, but I think we’re getting there, and I think that we’ll see a more upbeat industry in September.”