These are good times to be a private equity fund investor. Returns have been strong with distributions on the rise, both in the U.S. and Europe. Limited partners, for their part, have voted with their wallets that the asset class will continue to outperform. Indeed, fundraising continues to be strong, with over $213 billion raised as of August of this year. The industry is on track to capture the most assets since the high watermark set in 2007 when $519 billion was raised.
One area of weakness the industry is still grappling with, however, is the acceptance that transparency around private equity fees needs improvement. The industry has come under increasing scrutiny by regulators and legislators, both in the U.S. and in Europe, with a number of GPs having been fined for improper allocation of fees to their investors.
There are a number of significant “hot spots” that regulators and LPs have been looking at including broken deal expenses, monitoring costs, fee offsets and rebates, proper assignment of expenses (being assigned to the LP vs. the GP) and carried interest transparency. A lack of disclosure around different fee types, along with variations in waterfall calculation methodologies, however, makes the reconciliation process difficult for LPs.
The question, then, becomes, what can LPs do about it? As much as consortiums such as the ILPA and the FCA move forward with standardization, investors still face the very real challenge of having to reconcile the myriad fees and expense structures across their fund managers – both present and future. It can be a daunting process. Thankfully, there are a number of solutions.
There are three main considerations to validating fees successfully:
- How to capture, standardize and process fee-related information from fund managers?
- How often and at what frequency should fees be reconciled? And at what cost?
- What will the reporting output look like to allow for the efficient and timely determination of fund managers that are out of compliance?
With these considerations in mind, there are two primary methodologies in establishing a fee reconciliation program – each with different processes, GP involvement, data inclusion and costs. Much like evaluating any new process or system, decision points ultimately come down to what is going to deliver the highest ROI, given costs and risks involved.
Historical, Point-In-Time (PIT)
One approach to the fee reconciliation process is to perform a full recalculation of fees, usually from a sample of funds in the portfolio. This methodology is often thought of in terms of a historical, point-in-time (PIT) analysis as it is conducted as a one-off exercise based upon a set time frame. All fees and expenses are fully re-modeled, including re-calculation of waterfalls in order to reconcile carried interest provisions. Given the substantial amount of work and time associated with this process, a sample set of funds is usually determined in lieu of the entire portfolio (there are, in itself, various methodologies to determine which funds to include for analysis.) All financial and cash flow statements and transactional investment data will be required of the GP for review. This often necessitates additional requests to the fund manager through a multitude of proprietary templates.
Pros:
- While this methodology involves a significant amount of “heavy lifting” by all parties involved, if there are discrepancies, they will be identified given the full re-calculation methodology employed.
- Stakeholders – investment committees, Treasury, auditors, etc, - will be satisfied that the LP’s management has acted in good faith and in a fiduciary manner – regardless if errors are found or not. The LP can therefore “check the box” as it relates to interested parties.
- PIT, even though it is a “one-off” exercise, can expose weaknesses in a GP’s reporting given the detailed scrutiny of the fund’s financial statements during the process.
Cons:
- Given the amount of resources, time and effort needed with this methodology, it can be a very expensive and complex undertaking, even when limiting the universe of managers to be examined to a sample set.
- Doing a full re-calculation of all the historical fees for a fund means having to request a significant amount of information from the GP, including all of their financial statements, capital account statements and a full transactional history. Historical reporting using a standard template is even less prevalent.
- There may be goodwill costs incurred with the GP in addition to the financial cost of implementing this approach.
- Given the data required under the PIT methodology, GPs will be required to make a significant investment (both time and money) in providing it, particularly if it is outside of the reporting elements that were agreed to in the LPA. On this basis, not all managers will be prepared to accept the LPs requests.
Ongoing monitoring
The ongoing monitoring methodology takes a significantly different approach to fee validation. Where PIT designates a particular, historical time period using a sample set of funds, the ongoing monitoring takes a forward looking view of fund fees that can be applied across an investor’s entire portfolio of funds. The ongoing monitoring methodology is a commitment-based approach that leverages technology in identifying managers that are out of compliance. It does not require the need for a full history of data but rather utilizes current manager reporting. A weighted scoring process looks at relevant fee components and highlights discrepancies based on how material a variance is. This approach also utilizes benchmarking and peer group analysis for further validation. Once a material discrepancy is found, the issue is more closely researched and examined.
Pros
- Uses existing information to identify areas for further analysis, resulting in cost efficiency.
- No additional information requests are made to GP unless a material differential is found.
- As a fund progresses through their normal lifecycle, there can be changes in how fees are calculated. This might have been stated as part of the original LPA or through an addendum later on in the fund’s lifecycle. The ongoing verification method would capture such changes and be reflected accordingly.
- Can pick up trends and thus lets LPs be proactive in anticipating fee discrepancies among managers, fee types or strategies (ie: is there a problem with portfolio company fee offsets with smaller buyout funds? Are U.S. vs Euro-based funds handling carried interest differently?)
- Employing a systems-based approach to validating fees often provides more thorough and detailed output. The LP, then, can more quickly move through the data to find managers out of compliance.
Cons
- May not be suitable for older, legacy funds that are winding down
- Likely to need GP interaction when scoring mechanism identifies meaningful variances.
Despite the improvements GPs have made in their investment reporting, transparency around fees has not had the same level of advancements, and regulators on both sides of the pond are taking notice. The decision for LPs, then, becomes less the “why” and more the “how”. The choice of methodology will ultimately come down to how the LP will define success in their fee validation program and what “bang for the buck” they can expect given cost, time to execute and GP involvement.