Shashi S of Viteos Fund Services explores the potential benefits of automation as fee structures become increasingly complex.
As the investor base in private equity funds becomes more diverse, so too do the operating models that meet their complex demands. More often the funds are fielding very specific requirements – whether it is certain risk parameters or regulatory constraints – which is creating greater complexity in fee and fund structures that are difficult to track effectively using the operating resources and technology many funds currently employ. While assets continue to swell, some managers struggle to ensure all of their investors’ reporting needs are met. Nowhere has this been more evident than in the fees which clients pay. Fund accounting is an area where it is most challenging to implement technology systems, mainly because of the growing intricacies of legal entity structures, historical data needs for existing fund conversions, specialized reporting and byzantine investor asset allocation calculations.
Management fees are at times adjusted to reflect special economic arrangements for LPs, in exchange for longer lock-ups, co-investing or big ticket sizes. Oftentimes, large commitments come with customised fee terms, which need to be meticulously recorded. These fee terms are frequently non-standardised, which introduces further strain on private equity middle and back offices, particularly those still using Excel or manual processes.
However, innovative fee structures are emerging. A minority of managers – including the UK-based Terra Firma – have entertained the idea of charging fees only when capital is invested following criticism that the industry is sitting on excessive piles of unspent cash, yet is still being remunerated for it. One report, for example, acknowledged that institutions were paying around $15 billion per year in fees but they only had a one in 10 chance of their money actually being invested.
Reforms to the distribution waterfall and carry are happening, with a growing number of managers adopting the European-style model. The European distribution waterfall, for example, is calculated at the end of the fund’s lifecycle whereas in the US it is performed on a deal-by-deal basis. The US-centric model has fallen out of favour, as institutions feel it encourages short-termist behaviour. In Europe, carry is not paid to the GP until investors receive distributions equal to their total capital contributions to the entire fund as well as their preferred return. As a consequence, more institutional investors are pushing their managers to embrace the European waterfall archetype, because they believe it is more equitable for the end client.
A compromise solution has also emerged with hybrid waterfall models now becoming more prolific. These hybrid structures require GPs to offer return hurdles on aggregate realised investment although this is counterbalanced by disbursements being issued earlier than when they would have been vis-a-vis the European model. The existence of all of these multiple and conflicting distribution waterfall methodologies does introduce new challenges to what ought to be a fairly straightforward process for the GP and LP.
Automation and outsourcing
When managers grow their funds without investments to support these additional workflows, operational issues begin to manifest. Automation – whether it is performed internally or by a competent third party – can help managers solve many of the operational and practical challenges in their businesses brought about by the new reporting requirements, fee demands and the increasingly complicated fund structures they are running.
Take reporting, automation can help managers source the relevant data, and feed it accurately into investors’ pre-defined templates, enabling for efficiencies to be realised as businesses’ scale upwards. Institutions are shunning email PDF reports in favour of real-time disclosure and matching visuals, accessible through handheld devices. Such disclosure formats are often unattainable when using antiquated technologies. Private equity managers who move with the times when it comes to report generation will remain relevant, as investors become more tech-savvy.