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August 09, 2016 01:00 AM

Private equity managers must shift mindset due to increased transparency demand

Jim Cass, SEI Investment Manager Services
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    Jim Cass is senior vice president and managing director at SEI Investment Manager Services.

    Following the 2008 financial crisis, regulators across the globe have increased their focus on valuation issues within the alternative investment fund industry by introducing different measures, such as Dodd-Frank in the U.S. and the Alternative Investment Fund Managers Directive in the EU. Regardless of the type of fund structure created or strategies managed, regulators globally have become increasingly interested in how an asset management firm's valuation policy is being applied to come up with a fund's net asset value, and where conflicts of interest may arise, particularly those that have the ability to negatively affect investors.

    However, the disclosures and added transparency some managers are providing aren't just driven by what a regulator wants; they are also driven by sophisticated institutional investors. Limited partners are now demanding more transparency into how private equity managers assign values to an asset, as well as seeking to get more involved in the overall valuation process. Institutional investors are seeking as much information as possible about not only the investment policies and processes but the underlying data applicable to the portfolio's holdings. Obtaining this information helps them make more insightful decisions not just regarding allocations to the specific private equity fund in question, but also how that investment fits into and correlates with other investments in the overall portfolio.

    Even though the demand for more transparency from both the LPs and regulators seems to be a big undertaking for many private equity managers, it is also presenting an opportunity for investment firms to gain a competitive edge by adopting a different operational mindset. Many are choosing to outsource valuation processes or partner with industry experts to gain a competitive advantage over their peers and demonstrate to investors that an independent set of eyes is involved.

    Given the long-term and relatively illiquid investment nature of private equity investments, it is no surprise that LPs are demanding more transparency to help them understand valuations and expenses before they allocate capital. To underscore just how important reporting has become to investors, a recent survey by Ernst & Young, called "Positioning to Win: 2015 Global Private Equity Survey," reveals that while “investors are generally satisfied with the reporting of methodologies and portfolio company events, [they] are also seeking to understand the key assumptions and inputs driving valuations.” Additionally, 69% of those surveyed pinpoint that transparency of information is top-of-mind when it comes to financial reporting.

    Although managing portfolios and delivering returns are clearly still critical to investors, private equity fund managers are facing a new competitive reality. One where they must take the extra step and combine strong/consistent performance with greater insight into how they manage those portfolios, while providing detailed valuation processes.

    Regardless of whether a firm offers managed accounts, offshore funds, or onshore funds, the valuation policy has to be consistent. Particularly with portfolios holding illiquid assets, managers need to provide a breakdown of where each of the assets lies within the FASB 157 guidelines (Level 1, Level 2 and Level 3). Given their illiquidity, all Level 3 assets are priced based on 'fair value' and LPs increasingly want to know how much has been independently verified by an independent administrator; a trend that is set to continue.

    Furthermore, regulators want to see that PE managers are sticking to their valuation policies. Should a manager deviate, for whatever reason, they need to be able to provide reasons for why they made certain choices when valuing those assets, particularly in cases where fair value assets are highly subjective. For example, a manager might have information about an asset that gives him/her a legitimate reason to price it at a premium, or discount it. Regardless, keeping track of valuation data, maintaining detailed documentation, and making sure that there is a clear rationale is becoming increasingly imperative.

    More and more, many private equity managers are choosing to outsource valuation processes to gain a competitive advantage over their peers and demonstrate to investors that they are unbiased during the process by involving an independent third party. The investors who participated in the Ernst & Young private equity survey agree with private equity firms' decisions to seek out valuation specialist agencies. According to the survey, 86 percent value the involvement of third-party specialists as it adds a level of consistency to the valuation process.

    However, not all private equity managers are responding to this transparency demand by fully outsourcing their valuation processes to external parties. Maintaining a firm's internal valuation methodology can be a difficult adjustment when working with third-party specialists, so there needs to be a unified approach, particularly when it comes to Level 3 asset prices. To create this unity and to ensure that the manager is adhering to the valuation guidelines included in the private placement memorandum, it is critical that both parties within the partnership price the asset in full accordance with the valuation policy that the fund has been approved to use.

    While regulations are a tailwind pushing managers to third-party specialists, their use may increase over time due to investors' requests. It is an added assurance and it demonstrates that private equity managers have the LPs' best interests in mind by having an independent specialist providing enhanced control of the valuation process.

    Fund managers are realizing that they are operating in the new normal where stringent requirements will continue to be enforced by the world's governing bodies. Yet most well-run private equity groups don't manage their portfolios to accommodate the regulators; they do it to accommodate what is best for their investors and provide them with the right level of transparency. Indeed, with LPs asking for the same things as the regulators, a lot of the operational policies are being put in place to do the right thing, to attract and retain investors while complying with all applicable regulations, not the other way around. Therefore, it is critical and a competitive advantage for private equity and other alternative investment managers to collaborate with their investors to strengthen the existing operational processes and improve the level of transparency together.

    Jim Cass is senior vice president and managing director at SEI Investment Manager Services.

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