Survival of the fittest funds

As private equity funds evolve, they will increasingly need the guts to be considered sustainable companies. By Joshua Herrenkohl

As the booming private equity real estate market matures, the Darwin effect is starting to affect prospects for its future. The time has arrived when most funds are thinking seriously about how they can sustain growth, improve their overall agility and stay competitive in markets in the US and abroad. At the same time, they are trying to earn the respect and confidence of the investor community by demonstrating that they are long-term players with the operational infrastructure and behaviors expected of sustainable companies.

Since the late 1980s, billion of dollars have been invested in private equity real estate funds. Respondents to a recent Ernst & Young survey of private equity real estate vehicles (Market Outlook: Trends in the Real Estate Private Equity Industry) collectively predicted that they alone would raise at least $18 billion (€23 billion) in 23 new funds last year. According to figures compiled by Private Equity Real Estate, funds worldwide raised approximately $60 billion in 2006. Both figures show that investment activity in these funds is far from waning.

In recent years, investors of all types have been increasingly attracted to private equity real estate because the funds have provided a higher return on investment than other alternative asset classes. Private equity funds are more loosely regulated and therefore enjoy a higher level of freedom and flexibility than that of other regulated players, like publicly traded REITs.

Unusually high returns in recent years have overshadowed the usual scrutiny, but the question remains: What happens when the returns ratchet down even a few points?

But along with success comes scrutiny, as investors begin to compare these private companies against their growing list of competitors. For the expanding cadre of gatekeepers who are choosing these firms on behalf of institutional investors, the fitness test for private equity funds more and more includes an assessment of the quality of their back-office operations. For example, do they have a formal system in place for handling recurring tasks, such as collection of asset-level data and incorporation of key information into fund roll-ups, one that can be evaluated and, if necessary, improved?

For years, funds have focused their attention on creating solid frontoffice operations. Of course, they cannot be faulted for concentrating on the “investorfacing” aspects of their business. As a result of unprecedented growth, however, many funds have largely ignored the task of building up something else that is needed to survive over the long-term: their “guts.” Many have gotten by with managing vital internal processes on an ad hoc basis, and relying on the strength of the front office to provide an air of overall stability.

As a result, the level of back-office support has not matched the growth of the firm and is often inconsistent with the billions of dollars of assets under management controlled by these funds. This organizational weakness is becoming increasingly evident through the discovery of incompatible and ineffective processes that could potentially put the business— and investors—at great risk.

Right now, for example, funds have a high level of dependence on outside third parties, for example joint venture partners or property managers, for gathering and reporting critical data. Often, the data is being delivered to the funds by parties with operational processes that are just as weak or weaker than the funds themselves, and who may not conduct business in a strong process-controlled environment.

An all too common example would be the misreporting, for several months, of a property's financial performance—either positive or negative—or, similarly, the inclusion of fees on the part of the third-party that the management or partnership agreement expressly prohibits. There may be few controls for ensuring that information is delivered in a timely fashion and in the right format—or even that the information is accurate and has been validated. Even worse, the poor control environment at many third-party operators can be an invitation to fraud. Various funds have experienced the adverse effects of such control and oversight inconsistencies with recent issues arising such as asset-level fraud and waterfall miscalculations.

So, while a high level of trust may exist between a fund and a partner, that relationship is not a safeguard from missteps. Those missteps can result in costly problems that are difficult and awkward to rectify.

The risks are not limited to third parties. The trend is unmistakable: Many private equity real estate funds suffer from communication and knowledge-sharing problems internally. From the acquisitions team to the asset managers to the portfolio accountants to the legal department, it is not unusual to find a lack of processes or standards that are documented and that everyone clearly understands. Even more common, few are regularly communicating about what they are doing and how they are doing it. It is typical for employees doing the exact same functions within the company, at the same or other locations, to handle their tasks using completely different processes—as inefficient as that “system” is.

It is vital for private equity funds to strengthen their control environment, because not having the right system of checks and balances in place means they cannot be confident about the accuracy of any data being gathered and reported.

The level of back-office support has not matched the growth of the firm and is often inconsistent with the billions of dollars of assets under management controlled by these funds. This organizational weakness is becoming increasingly evident through the discovery of incompatible and ineffective processes that could potentially put the business—and investors—at great risk.

There is another big reason why creating solid infrastructure and back-office operations has been put on the back burner by real estate funds. The market has been growing and evolving at such a dizzying rate the past few years that there literally has been no time for funds to think critically about how they perform daily tasks, such as accounting and asset management functions, or the timely and accurate gathering of data from joint venture partners. To date, they have simply assumed that if the books show they are making money then they must be operating at peak efficiency.

The unfortunate fact is that in spite of common sense, many funds have been loath to make the changes necessary to scale for growth. They have been using inefficient and redundant processes and ineffective technology to get things done, often on an as-needed basis. This behavior has not yet raised flags with the majority of investors, who seemingly haven't cared much about how funds do what they do, as long as the returns are good. Unusually high returns in recent years have overshadowed the usual scrutiny, but the question remains: What happens when the returns ratchet down even a few points?

Most private equity real estate funds are finding there is an increasing need for some basic level of transparency. For some, transparency is a tough nut to chew. As many of these funds are private entities, there has largely been an air of secrecy about their inner-workings. Primarily for competitive reasons, they play things close to the vest. Some funds have been less than forthcoming about the returns on individual assets they own and other data that is considered proprietary. In today's post-Sarbanes-Oxley business world, this lack of transparency is not sitting well with many investors—especially public pension funds.

Overall, there is an increased demand for specific reporting requirements from an investor community that has become more cognizant of controls and wary about the lack of them. With increasing frequency, funds are encountering investors who want to sit down and spend time with the management team in order to better understand all aspects of the fund. What's more, these same investors are not shy about asking the fund for assurances that their money will not be subject to fraud, clerical errors or any other “avoidable” mistakes that might result in a huge loss if the proper controls aren't in place.

This trend continues to emerge and will no doubt continue. Pension funds, in particular, are pushing the envelope on this front. Some level of government oversight and regulation of funds is likely to come in the relatively near future. Therefore, it's important for all private equity funds to get serious now about beefing up their back-office operations so they can quickly and confidently assure others that they are a legitimate and well-run company.

That process can start with technology. It cannot be overstated that inadequate or obsolete technology for managing daily operations has the potential to result in hard times for a private equity fund. And while documentation errors may sound like a relatively benign occurrence, if those mistakes go unchecked for too long—years, even—the results can be devastating, not only financially, but also competitively.

The mismanagement of financials, such as accurately tracking a property's cash flow, can result in believing an asset is operating in the black, when it's really in the red. Even seemingly benign errors made in the all-to-prevalent spreadsheet can result in significant miscalculations. In truth, the funds are simply expecting too much from a simple program not tailored specifically for their business.

Unfortunately, part of the problem here is that technology for the private equity sector has not kept up with the pace of the market. To be sure, technology providers have been slow to develop better tools. But it is also true that real estate companies, as a whole, have been resistant to adopting new technology as it becomes available, especially compared to other vertical industries.

As an example, many funds typically use common spreadsheet programs to create complex “waterfall models,” which are used to determine how equity should be distributed to the various investors, often with different and complex ownership stakes. While spreadsheet programs may have been appropriate when funds were small, fund managers have not kept pace as funds have grown in size. Miscalculations within the waterfall model based on the terms of the partnership agreement are not uncommon; over the course of years, a fund could underpay millions of dollars to the partner. This situation arises simply because modeling in a simple spreadsheet program is a very labor-intensive, manual process.

Data security is another issue. If a waterfall model is saved only to an employee's laptop or saved to a server that is not appropriately backed up, then, should something happen to the laptop, the information is likely gone forever. Worse, if sensitive data were stolen, the fund, its investors and their business are all at risk. The reality check here is that private equity funds need efficient back-office operations to ensure that data is kept safe from corruption, and that only authorized personnel can access it.

No technology solution is perfect, of course, but automation of certain back-office activities using leading industry tools, such as a web-based fund accounting system or a data warehouse, can significantly improve a fund's overall efficiency and security. To be sure, technology providers that specialize in the private equity real estate space have been mediocre at best in deploying leading-edge tools to help funds address and manage their issues, but existing off-the-shelf solutions are finally maturing to the level required to support the industry's complex needs.

Intense competition in the US private equity real estate sector, and the fact that desirable properties are in increasingly short supply, is causing many funds to look to international markets for their future growth. Pursuing this strategy makes it even more imperative for a fund to have the right infrastructure in place so it can handle the higher dimensions of complexity required to do business abroad—not the least of which are issues like monitoring currency exchange rates, dealing with cultural and language differences, understanding varying business practices and managing differing perceptions of “timely and accurate” reporting.

Many companies are biting the bullet now rather than after the problems surface. Leading funds in the industry are scaling for growth with serious effort. Whether these initiatives involve full-scale integrated systems implementations, more targeted compliance-focused tool installations, rigorous leading practice peer benchmark studies, reorganization of specific groups to more effectively drive oversight and efficiency, or the undertaking of process improvement initiatives, these players are undertaking efforts to assess their overall corporate and growth strategies. They are then aligning their organizational structure, business processes, and technology to support their overall strategy. They are strengthening internal controls to at least be on par with the industry average and mitigating the possibility of error or, even worse, fraud. They are anticipating the difficult questions from investors, regulators and pension fund consultants; above all, they are formulating and implementing the answers.

Internal fitness is essential to a private equity real estate fund's ability to fuel and sustain its growth for the long term. Funds without solid back-office operations, leading technology solutions and adequate control and oversight of essential processes are susceptible to being left behind. Having the right infrastructure in place, and the necessary flexibility and adaptability built into the framework, is not only the glue that will hold a private equity fund together, it is the only way they will ever make the grade with investors as a “sustainable, long term business.”

Josh Herrenkohl is a Senior Manager in the Business Risk Services Group of Ernst & Young LLP. He may be reached at 212.773.3302 or The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.