Regulatory reality

The private equity industry is facing a number of regulatory changes, in the US, Europe and beyond, that will change the scope of how GPs manage their firms.

Operational excellence, it might be said, will be measured based on a more rigorous standard. At press time, the US Senate was days away from making SEC registration a reality for most private equity firms, which will force most managers to face regular inspections by the SEC, designate a compliance officer, and explicitly outline how to deal with potential conflicts of interest, among other requirements.

On a recent June afternoon in New York, Private Equity Manager sat down with seven veterans of the private equity market to discuss these and other challenges, and to compare notes on what firm managers can do to steer their franchises to success through the rougher waters.

Going RIA

Registration was very much on the minds of our roundtablers, although one participant worried that too many US firms are “in denial” about the challenges ahead. PEM’s roundtable participants discussed how becoming a Registered Investment Advisor would bring many changes in the way private equity firms use technology, address staffing needs, and deploy language in marketing presentations.

Among the many changes that registration brings, perhaps the least anticipated revolve around permissible marketing language. Panelists agreed that the marketing function faces a big challenge once a firm registers with the SEC. The language used in marketing materials and presentations must be scrutinised to assure that the firm is complying with SEC guidelines.

“The marketing issues are huge,” said John Malfettone, a partner, COO & CCO at Oak Hill Capital Partners. “When you have investment and investor relations professionals going out with pitchbooks to conferences or client meetings, there are things you think are innocuous, but you can’t say them. For example, we can’t say we’re a ‘top firm’ or make qualatative comments. You need to prove what you say with quantifiable data. You can’t cherry pick deals; you can’t talk about just your three best deals. ”

“We’re not always in fundraising mode, but we’re constantly in investor relations/marketing mode,” said Stephen Hoey, partner, administration and chief financial officer at New York-based KPS Capital Partners. “My guys are always out there with a pitchbook presentation and now I have to say, ‘I have to look at that closely now.’”

Some managers will seek outside help to address the increased communications work load. Pomona Capital, a registered investment advisor, hired compliance consulting firm to review all marketing materials to make sure they comply with the SEC’s guidelines.

“Our marketing department was impacted the most,” said Celeste Barone, a principal at Pomona
Capital. “Every flipbook, every page of marketing that goes out for Pomona, [the compliance firm] reviews for us. That’s one of the things we utilise them for.”

Christopher Votta, a senior partner in the asset management practice at Ernst & Young, says he has heard private equity clients relate concerns about what SEC registration will explicitly mean for their marketing teams and the firm overall: “They are concerned with what form the registration will take and how the new regulations will be applied. We have a point of view on that. I think it’s going to be different. Our primary concern is helping our clients come up with a workable framework for their company.”

Votta adds that such changes are natural in a maturing industry: “As an industry private equity is relatively young in adulthood. It’s growing up.”

The costs

As with companies in most other industries, private equity firms are today needing to keep a closer eye on their own operating budgets, a discipline that our roundtablers know well. They compared notes on how they have sought to make their firms more cost-effective.

With the new compliance duties come new costs, said Malfettone. These additional costs come in a particularly challenging time for some private equity firms, which may be operating from a smaller fund and relying on a smaller management fee stream. Malfettone said his firm has taken cost-savings seriously and he has been pleased with the results:

“There are costs to registration, both monetary and frictional. Your role as CFO or compliance officer is to deal with the frictional costs. We launched ‘project cookie jar’ about a year ago. The project’s goal was for the operations team to find ways to save money, and we came up with $1.25 million. [It included] everything from excess space to looking at subscriptions to consolidating overnight packages. We asked questions like: do we need really need fresh flowers on every administrator’s desk?”

“We are constantly reassessing our costs,” said Marc Unger, chief operating officer and CFO at CCMP Capital Advisors. “We are going to save where we can, but we are going to spend when we need to spend.”

In a fee-focused environment, cost cutting can please LPs, but not always. Hoey relates the story of how “we went toe to toe with one of our larger investors. We purposely schedule our annual in person advisory board meeting to coincide with our annual investor meeting as a convenience for members of the advisory board. For some reason, after four or five years, they demanded that all their expenses be reimbursed. All travel, meals in transit, everything.

The fund already pays for lodging and meals at the meeting site. We told them the fund didn’t pay for anyone else’s travel and in-transit expenses, why should all other investors pay for yours?”

Next the discussion turned to the issue of technology, and discovering the right mix of in-house and outsourced resources. For many firms, spending on technology is a necessary investment, and it can help a boutique turn into a more efficient and effective business.

“You don’t have to add people to get better,” said Malfettone. “I think there are ways to do it through technology.”

Outsourcing certain services may be the best way to upgrade a firm’s technology while staying within the budget: “We went from 30 people five years ago to 75 today and our network couldn’t handle it,” said Jon Rather, CFO at Welsh Carson, Anderson & Stowe. “Over the last six months we outsourced [our IT network] and focused on building more capacity. It alleviated the bottleneck for remote access. It couldn’t handle 30 people on the road dialing in. You really need the network infrastructure to support that,”

Some private equity shops, however, are keen to add staff instead of outsourcing, including KPS Funds. “We made the decision to keep the administration and accounting function in house,” said Hoey. “LPs liked that we kept it in house. People I have working for me I think are superior to those you would find in an outsourced situation. And as far as the firm goes, we added a person in charge of business development and an IR person for the first time. We’re filling out areas where we didn’t have people before.”

Vendor relationships

The discussion then turned to how to best monitor relationships with providers of professional services. Ojjeh and Votta from Ernst & Young described how a number of private equity firms have established what many call a Vendor Management Office. “A Vendor Management Office is set up to manage those [service provider] relationships. That enables for better budgeting, better forecasting. From an increased efficiency perspective, more clients have selected these tools,” said Ojjeh.

Given increased budget pressures, fund managers today are holding service providers more accountable for describing and justifying each charge back to the firm. “You’re managing your service providers in terms of budgeting, accountability, planning,” said Rather. “Those simple things make a big difference and set a tone. We use different firms and I think it’s good to have that competitive process.”

Rather continued that he has gotten into the habit of setting up monthly calls with each major service provider to his firm in order to better keep track of services and costs. “For the first time they have to stick to a budget,” he said. “It is a half-hour call. If they are going to exceed the budget, they have to call us. It’s a recognition that, ‘Guys, we’re watching you.’ You have to set up that accountability. It’s changing the mindset more than anything else, that they don’t have a blank check.”

CCMP today expects more cooperation from its service providers: “If costs are exceeding budget, then I need to know. There has to be a good reason and we should be able to talk about it. Communication needs to be open,” said Unger.

“It’s a partnership and you need to build that relationship. At the end of the day this is a relationship business at every level,” agreed Rather.

LP communication

The discussion then turned to how CFOs are handling an increase in limited partner requests for information. Panelists agreed that the frequency of requests has gone up exponentially especially for information pertaining to the performance of portfolio companies.

Regarding an increase in information requests, Hoey said: “We saw that in spades. We raised our Fund III in late winter/early spring 2007. Due diligence was minimal. We were going from a $400 million Fund II to $1.2 billion at that point. It was like a drive-by fundraising. We upsized Fund III by $800 million last summer [2009] and it was night and day. The level of due diligence and questions…they wanted to go back and look at Fund I detail and we’d ask, why now? And they’d say; ‘We have to.’ It’s that check-the-box thing. The level of information that [LPs] are required to gather has gone up exponentially over the last year. There is a lot more operational data they are requesting at the portfolio company level.”

The roundtablers all agreed that the increase in information requests can be viewed as an opportunity: “Servicing your investors is a differentiator,” said Rather. “And in this competitive fundraising environment, you need to differentiate. We hired the appropriate people, but simple things like responding to LP requests within a day makes a big difference.”

GPs need to remember that LPs are routinely under the gun. “You have to put yourself in an LP’s shoes,” continued Rather. “They are getting a lot more questions about how the companies are performing so we’re getting a lot more questions about operational data. And personally, I like that. That’s how you prove value. It does alleviate a lot of concern from the LPs, when you give them leveraged levels, operating metrics, organic growth. That alleviates their concerns and at the end of the day that’s what you want to do, to make those people comfortable in their jobs.”

Some CFOs attribute the uptick in questions simply to increased awareness of the asset class at the board level: “The LPs’ investment boards have become a lot smarter and they’re asking more detailed questions. Everyone is smarter in this industry. The important thing is to respond in a timely manner,” said Unger.

Additionally, keeping communication open and answering questions quickly is essential to avert “headline risk,” said Rather. “The worst thing that could happen to an LP is to pick up the paper and see something about one of your deals in it and they didn’t know about it.”