Brian Kelly, auditor partner for private equity at KPMG LLC, New York, said the rising number of what he called “pure play” private equity fund administrators has been “the advent of groups of people starting their own firms on the premise that, one, what they offer is cheaper for general partners, and two, they're more hands-on than your one-stop shops.”
The number of general partner funds has not dramatically changed over the years, said Mr. Kelly, but margins have thinned while the cost of operations has been rising dramatically, mainly the cost of creating and using the technology needed for back-office work and because of increased regulatory requirements. “Overall, it's cheaper to do the back-office functions externally.”
Cost is a concern for the managers and their clients. According to the eVestment survey, fund administrators were slightly more likely to pass on the added costs to investors through higher operational fees than to retain some of the costs themselves through negotiated lower fees.
Competition among general partners comes as institutional investors like the $176.2 billion California State Teachers' Retirement System, West Sacramento, and the $20.8 billion Yale University endowment, New Haven, Conn., have cut back on the number of funds in which they invest. That has put a new emphasis on general partners' cutting their fees to investors, said a pension fund executive who spoke on condition of anonymity.
“GPs are streamlining and putting reduced costs out there when looking for funding,” he said. “Not only do (limited partners) want good investments, if the costs are too high, (general partners) can forget getting the business.”
Still, pension funds and other institutional investors remain most concerned with investment returns when selecting a private equity manager, but those investors now put more weight on who — or what firm — handles fund administration.
The issue of valuation also makes back-office functions “critically important” for deciding in which private equity fund to invest, said William Atwood, executive director of the $14.2 billion Illinois State Board of Investment, Chicago.
“When I think of back office, I think of valuation, which is absolutely critical in private equity,” Mr. Atwood said. “You have to have transparency so that our staff understands what's going on with the fund. The investment people there can make the best investment choices in the world, but it doesn't do a lot of good if you're unable to accurately value it.”
Operational due diligence is conducted early in the RFP process, Mr. Atwood said. “If we're not confident about the manager's back-office functions, that's when we'll move on,” he said.
ISBI has a 5% target allocation to private equity. As a “general preference,” Mr. Atwood said, the pension fund board looks for established private equity funds with internal back-office functions. “We would not exclude a GP solely on the grounds that they outsource back-office functionality.
At the $12.1 billion Ohio School Employees Retirement System, Columbus, due diligence is conducted on the back-office operations of all alternatives managers, but “the initial due diligence review covers policies and procedures mostly related to outside service providers, valuation policy and cash management,” said Phil Sisson, investment officer-global private equity. The system has a 10% target allocation to global private equity.
While performance is still the ultimate determining factor in where pension funds and other investors make their commitments, a fund's operations carries weight with asset owners, said Jim Cass, managing director, SEI Investment Management Services, Oaks, Pa. SEI Investment Management Services, Oaks, Pa., which had $76.3 billion in private equity AUA as of Dec. 31
“It's more talked about than ever before” among pension funds, Mr. Cass added. “Private equity isn't just lumped into alternatives any more. It's now a specific asset class, with very specialist firms doing this. Private equity firms now have to worry about back-office functions more than ever.”
Added Kevin O'Neill, managing member and co-founder at Broadscope, Paramus, N.J.: “The due-diligence process now includes the (manager's) back office. We've met directly with potential (pension fund and other institutional) investors in funds in which we were the administrator. If you have a strong back office, it won't necessarily win an investor, but if the back office is weak, it's very likely ... (you) won't get the job.” Broadscope has $4 billion in private equity AUA.