The driving forces behind change and development in the provision of fund administration services to private equity firms sound familiar, very familiar indeed. In fact, they are mostly identical to the driving forces behind the outsourcing of fund administration services in the mainstream investment world.
One, the need for fund managers to seek out new ways to improve efficiency, and offset cost pressures. Two, the need to access better technology without incurring unsupportable new costs. Three, the increasing size and complexity of the private equity investment industry.
Connie Helyar, CEO of International Private Equity Services, lists increased competition, the arrival of web-based systems, different accounting rules and a move towards more international standards, the growing focus on corporate governance and anti-money laundering requirements amongst her list of drivers.
Other factors adding to a sense of urgency in the industry include the growth in pension funds, changing investment patterns,and increasing complexity in regulatory and disclosure requirements. While no-one would pretend that investment operations outsourcing can eliminate these issues entirely, many believe that it can certainly help. "It's a question of cost and focus, sticking to the knitting," says David Bailey, head of products and business development at Ansbacher Fund Services in London. "The trend to outsourcing is growing as more and more private equity firms review whether to do it in-house."
"Potential clients today focus more on systems than they have done in the past," comments Paul Guilbert, Guernsey-based head of private equity at Northern Trust. "Administrators need good, robust, integrated systems. Those take a lot of time, and money, to build." He estimates that only a third of private equity firms currently outsource, suggesting there is much more growth to come.
Robert Caporale, head of JP Morgan's fledgling private equity fund services arm, points to the creation of his business as a clear illustration of how developments in this market niche reflect those that have already taken place in the more traditional investment arena.
"The private equity market is growing by the day, fundraising is booming, and structures are becoming more complex," he comments. "In 2004 pension plans had around 4% of assets allocated to private equity. In 2005, that almost doubled to 7% as institutional awareness of and comfort with private equity grows."
"The private equity market place is exploding with recent metrics quoting private equity assets under management in excess of Hedge Fund assets under management," adds David Aldrich, head of securities industry banking at The Bank of New York. "The latest quote from the 2006 Galante PE & VC Directory states total private equity AUM approaching $1.6 trillion ($1.17 trillion in the US and $424bn in Europe), as compared to total hedge fund AUM of $1.3 trillion. The pace of change is accelerating at a record pace especially as a direct result of the recent proliferation of new hybrid alternative investment vehicles that possess components of both hedge & private equity instrument types. Due to the recent convergence of private equity and hedge funds, many of the major competing hedge fund administrators are now offering complementary private equity fund administration services. This essentially broadens their alternative investment servicing capabilities by servicing this new complex, emerging asset classes."
With new investors demanding higher levels of disclosure and transparency on returns and underlying investment performance, sustained underinvestment in infrastructure is taking its toll. This is opening up new opportunities to the world's leading custodian banks that could scarcely have been envisaged when their own industry began its prolonged consolidation and infrastructure building in the early 1990s. "Private equity CFOs want to hire one firm that they trust to handle all of their accounting and operations requirements," says Robert Caporale. "Our services enable private equity managers to focus on what they do best: building investor wealth."
Launched in November 2005, JPMorgan Private Equity Fund Services provides middle and back office outsourcing of fund administration services such as fund and partnership accounting, tax support and reporting services to private equity firms and limited partners.
The newly structured business is targetting medium-sized and large private equity players. Robert Caporale claims to have had early expressions of interest from the world's top 25 firms, as they consider the viability of outsourcing administration that has traditionally taken place in-house. "One has already committed to us," he says. "The pace of change is accelerating."
Matt Wood, business manager at Mourant in Jersey, says that there would appear to be two streams of private equity developing, and this has implications for administrators. He divides the industry into funds that are sub-$1bn, and are regarded as small or medium players, and large funds that are in excess of $1bn. Fund administrators are having to tailor their activities to suit each, he says.
"The large growth in the private equity market and the introduction of funds greater than $10bn - which five years ago would have seemed unheard of - has meant liquidity is at an all-time high. Other specialist funds have appeared such as fund of funds and secondaries, mezzanine and debt funds often with similar structures as pure private equity plays. They provide the administrators with increased challenges as there is often considerably more activity with these funds and a requirement for specialist software such as interest tracking software to monitor bond coupons, and call and distribution software."
Administration changes as quickly as the industry it services, and is definitely becoming global, says Matt Wood. A lot of developed countries with a private equity industry just do not have the structures in their own jurisdictions which the private equity industry use, such as the limited partnership. He predicts that over the next five years European countries and middle east countries will produce similar structures in an attempt to promote the industry within their borders. "This is likely to be a driving force for further globalisation of the asset class," he argues. "In the meantime, Guernsey and Jersey as offshore jurisdictions are adapting quickly to requirements of the industry. Both have over the past two years or so introduced special expert fund regimes, enabling the administrator to take responsibility for due diligence on a fund rather than the regulator. A new fund will thus be approved within days rather than weeks as previously."
While the US industry has been slower than Europe to adopt the outsourcing model, it is rapidly catching up with massive growth in the administration industry, says Matt Wood. By way of illustration, he cites the growth in Mourant's New York office from two staff to 20 in under a year. New Mourant offices in the USA are likely within the next year, he adds.
Other developments taking place in the industry go beyond the purely operational. Matt Wood highlights KKR's recent $5bn flotation of units in a Guernsey Limited Partnership on the Euronext Amsterdam stock exchange as an innovative use of public money for private equity. Guernsey is seeing a flurry of activity with at least 10 other large buy out firms racing to imitate the KKR product, he reports, generating a lot of activity for Guernsey administrators and law firms.
A multi-jurisdiction presence is becoming ever more important for the administration industry, he observes. "More than ever the busy general partner wants one point of contact with the administrator who may then have to deal with offices in Luxembourg, Guernsey, Jersey, London and even New York. These jurisdictions are likely to reflect the nature of the ever more complex structures being used and the increased demand for services such as US tax compliance for investors."
The picture is not, however, universally rosy. More than one observer suggests that economic conditions and the over use of leverage within the private equity industry coupled with the prospect of an increase in interest rates may lead to difficult markets for the industry. A decrease in growth for the PE industry would have consequent knock-on effects for the administration industry and could be unsettling, especially for less well established administrators. There is also a distinct risk that the growth in size of private equity funds, and their creeping institutionalisation, might kill the very energy and entrepreneurial spirit that makes them so attractive to investors.
And not everyone is convinced by the arguments. Philip Shuttleworth, finance director at ECI is sceptic al on the merits of outsourcing. He agrees that the market is growing on the back of the growth of the asset class, but ECI handles all of its own administration needs in-house, and has no current plans for switching to an external provider. "Where services are properly priced rather than priced as loss leaders, the costs of in-house and external provision are similar, if not higher, " he says. "As efficiency gains are eaten up by the supplier's profit margin, it is no cheaper than running your own back office. So it comes down to the services they provide, and the amount of management time you save. In theory, as administration is the core business of the outsource providers, their controls, efficiency and turnaround times will be of a high standard. However, a serious weakness in the model is the lack of flexibility when ad hoc requests need to be made of the administrator. Migration, too, is a major exercise, and it is just not obvious to me what the big wins are. The decision is probably more balanced for new funds that don't already have an infrastructure and don't have to deal with migration. Even with new funds, however, a number of these are still making the decision to do their own administration in-house."