The Future of Private Equity: New Opportunities, New Challenges

Feb 3 2017 | 7:41pm ET

OPPORTUNITIES TEMPERED BY OBSTACLES

One side effect of the rapid growth in the private equity market is a talent shortage. In addition to demand from the growing ranks of GPs, many LPs are attempting to build expertise internally.

This lack of expertise extends beyond investment roles to include other functions as well. Many GPs already struggle with rising middle office costs, and a shortage of knowledgeable personnel places them in an even more difficult position. 

With an increasingly complex web of regulatory challenges facing many private equity firms, it is not surprising that compliance is most commonly cited as the most pressing operational challenge.  GPs with global operations face particularly acute challenges. The Alternative Investment Fund Managers Directive (AIFMD) has exhaustive reporting requirements for private equity firms in Europe. Form PF is now required by the SEC of certain firms in the U.S.  FATCA obligates firms to provide accountholder information to the IRS, while the U.K. equivalent regime, commonly referred to as U.K. CDOT, performs a similar function for Her Majesty’s Revenue and Customs in the U.K.’s crown dependencies and overseas territories. The rollout of OECD CRS is more than just an enhanced version of FATCA and firms cannot just simply upgrade their current systems. 

As daunting as these changes are, however, more lay ahead. There is the potential for tax reform. The rules for marketing and solicitation continue to evolve and the definition of accredited investor is up for debate. Most firms recognize that compliance will continue to become more complex.

Data management has also proven to be a vexing challenge for many firms, particularly as they face growing pressure for customized reporting. Data in many cases resides in silos and private equity managers appear to be lagging their hedge fund counterparts in integrating and using data from various systems.

Some hedge funds are, for example, looking beyond data management to think about the additional value that can be extracted from data. Predictive analytics are being called upon to turn data into actionable insights that will allow fund managers to improve risk management and performance attribution. Investing in data analytics, in other words, has the potential to boost operational efficiency and create a competitive edge.

Many operational challenges are caused or exacerbated by recent structural changes in the market. Most industry participants agree that the most obvious change has been the rising level of transparency. There is more visibility into risk, operations, performance and valuation than ever before. Almost half of LPs also noted greater recycling of distributions, although GPs were less likely to point this out as a trend. All of this is happening against a backdrop of lower fees. Fee pressure and transparency demands from large institutional investors are changing how data and reporting are handled across the industry, pressuring the bottom line at many funds.

The growing number of strategies managed by some firms is further stressing their operating infrastructure. Compliance, for example, is rated the single most challenging aspect of managing a more diverse set of strategies. Scalability is also proving a challenge, a problem that more firms will need to address if the market grows as quickly as predicted. Interestingly, GPs are least concerned with the quality of outsourced services available to them or any potential challenges involved in administering loans.

ADAPT BUSINESS MODELS TO NEW REALITIES

Faced with all of these choices and challenges, what can GPs do? One issue that any firm doing a strategic review needs to resolve is whether it should diversify its investment activities or remain focused on a narrower slice of the market. A specialized business model is widely viewed among survey participants as more competitive than a diversified approach. Nevertheless, it is interesting to note that perspectives can differ by type of stakeholder. GPs, for example, are the most likely to tout the value of a specialized model. Many consultants agree that specialist firms are likely to be most competitive but they are also more likely to be proponents of a diversified business model, with almost one out of three saying diversified firms are likely to be more successful.

Many view a specialized business model as conferring tangible benefits ranging from better deal flow, higher returns and more value-added post-transaction. On the other hand, the appeal of a diversified approach is easy to understand in a broader industry context, where a wider range of investors are interested in alternative investment strategies but prefer to keep the number of relationships at a manageable level. This is true of even the largest and most sophisticated LPs. CalPERS made a very public shift in 2015 toward fewer GP relationships in a bid to lower costs and reduce administrative complexity (not to mention keeping up with internal due diligence efforts). 

Specialized buyout firms are not going away, but we are likely to see more and more diversified, hybrid, multi-strategy managers. They are the embodiment of the confluence we’ve seen across the investment landscape over the past decade; these complex organizations require a larger array of systems, platforms and processes to handle their various strategies, vehicles, securities and investors.

In addition to investment focus, GPs are finding their traditional (and often manual) processes under pressure from growing business complexity. This is a critical issue for GPs facing deeper due diligence with less leeway that begs the question of which functions should be performed externally. Compared to other asset managers, private equity firms continue to perform many more functions in house. Outsourcing has made inroads, but it continues to be relatively rare in most areas outside of custody, tax and accounting. 

Some firms find that their existing staff does not possess the requisite expertise, but they face a talent shortage even when they try to locate and hire the necessary personnel. Working with an outsourcing firm can provide not only the required experienced staffing likely to lead to a reduction in errors, but it can also save time and potentially money. What can be a laborious and distracting chore for private equity firms can be done accurately, efficiently and cost effectively by experts who are equipped to do it on a daily basis.

Improved workflow and more scalable processes are also compelling reasons to partner with outside service providers. Even firms that already possess operational expertise and infrastructure benefit from the enhanced ability to manage data, monitor complex investment strategies, handle customized portfolios, and improve investor reporting.

THE WAY FORWARD

All indications are that the global private equity business will continue to grow as it becomes more firmly embedded in the investing mainstream. Attractive returns, wider availability and a greater selection of strategies and vehicles will all contribute to this next phase of growth.

There will be no shortage of opportunities for GPs, but they will also face challenges as the industry evolves. The good news? There have never been more investors clamoring for private equity in their portfolios. The bad news is that these investors—who are more informed than ever before—are also more demanding. 

This is not a time for “business as usual.” Regulators and investors in particular are expected to pressure fund managers to improve their systems and processes. As GPs face greater competition and heightened scrutiny, they run the risk of falling short of newer standards for excellence. As the stakes continue to grow, important choices need to be made regarding investment focus, data handling, outsourcing partnerships and myriad other factors that could ultimately mean the difference between success and failure.

SEI is a leading global provider of investment processing, investment management, and investment operations solutions. To download the entire paper, please visit www.seic.com/PEtrends

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