Private equity firms embrace outsourcing

Private equity fund administrators are seeing more business from midsize institutional firms.

Along with the major banks like State Street Corp., Northern Trust Corp., BNP Paribas and Bank of New York Mellon Corp. that offer private equity administration services, new independent firms have joined the fray. Those include Broadscope Fund Administrators LLC, Gen II Fund Services LLC and LeverPoint Management LLC.

“I get the sense that a larger percentage of private equity firms are outsourcing” their back-office functions, with industry growth “similar to the growth of hedge fund administrators immediately after the financial crisis,” said Peter Laurelli, vice president and head of research at eVestment LLC, New York.

The shift to outsourcing is also being driven by more complicated investment strategies, higher flows into private equity, the need among asset owners for more accurate and timely valuation, and more domestic and international regulations. Plus, institutional investors like pension funds, in their requests for proposals from private equity managers, are including more detailed questions on how the managers handle their back-office functions.

“There is much more of a focus on back- and middle-office operations across all asset classes. And private equity is certainly included in that,” said David Sullivan, senior vice president and head of U.S. private equity fund administration at Northern Trust, Chicago. “(At) institutions like ours, there's an increased focus on private equity fund administration, and there are more niche providers than there used to be as well.” Northern Trust does not break out its private equity assets under administration.

Added David Fann, president and CEO of private equity consultant TorreyCove Capital Partners LLC, San Diego: “Operational review and back-office assessment have been a critical part of underwriting hedge funds for some time. More recently, due to increased investor requirements for transparency and the need to maintain regulatory compliance, the quality of a private equity firm's back-office operations has now become critically important.”

Assets under administration for private equity funds are increasing at a higher pace than hedge fund administration AUA, said eVestment's Mr. Laurelli. In an eVestment survey issued March 11, private equity fund AUA among 28 firms surveyed rose 15.27% in the second half of 2013, to a total of $879 billion.

Although that total is dwarfed by the combined hedge fund AUA of $3.79 trillion as of Dec. 31 among the 41 firms surveyed by eVestment, the hedge fund assets under administration rose 10.78% from June 30.

And while hedge fund administrators have been consolidating, the number of their private equity brethren has been increasing.

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.

At Arlon Capital Partners, a client of Broadscope which had $900 million in private equity assets as of Dec. 31, the decision to go to an external administrator was spurred by time and personnel restrictions, said Kelly Hurley, chief financial officer of the New York-based firm.

“As we evaluated the technology platforms, I realized that the evaluation, implementation and customization of any of the platforms would take time and personnel that I didn't have,” said Ms. Hurley. “I needed a "plug-and-play' solution, so I turned my attention to administrators. I knew working with an administrator would not only get me the technology solution I needed, but would also provide me with the people to manage and use the technology effectively.”

Ms. Hurley said she thinks outsourcing back-office functions is meaningful to investors. “I do believe institutional investors are focusing more and more on the back office,” she said. “I am able to confidently answer that we have very strong accounting and reporting practices in line with industry standards and best practices, leaving our team here time to focus on creating portfolio value.”