“Can i get some help over here?”… This could very well be the rallying call for LPs as the face challenges in unraveling their private equity fees. Ever since then SEC director Andrew Bowden’s “sunshine speech” in 2014, many LPs have begun to more closely examine the issues involved. From methodologies to costs and regulations, here are some points to consider:
1. Fee validation methodologies
As investors begin to contemplate a fee re-calculation and validation program, there are two distinct methodologies for LPs to understand:
A. Full re-model
A full re-model program normally entails re-calculating the historical fees, from either all the funds in the private equity portfolio or using a sample set of current funds. This methodology would have the GP provide the LP a full history of cash flows and transactions, so that the LP can re-examine, re-construct and re-calculate all historical cash flows, NAVs and waterfall processes. Using a historical, “point-in-time” analysis, though, could fail to pick up future quarterly discrepancies, specifically in the time between annual audits. This process also obscures the fact that fee calculations can change over the lifecycle of the fund. Fees charged during drawdown time periods might very well have a different methodology from harvesting or liquidation phases. It should also be noted that the GP needs to be heavily involved in this process, given the amount of historical data that needs to be collected.
B. On-going due diligence
An alternative methodology that alleviates these challenges and minimises the heavy lifting for both GPs and LPs involves implementing an on-going fee due diligence program. In this process, the review is continuous, wherein all managers are included (vs. historical sampling) and new allocations are incorporated into the program. This methodology is based on pro-rata, commitment-based calculations derived from existing reporting between GP and LP (i.e. capital account statements, cashflows, ILPA fee templates), so there are no additional requests from the manager.
2. Using analytics and tools
A fee reconciliation and validation program will encompass numerous variables, waterfall calculations, models, data sets, formats and time frames. Some of the specific issues that will arise will most likely include:
- the use of management fee offsets;
- interpretation of the LPA;
- variations in disclosure approaches by different managers;
- full disclosure of realised and unrealised carry amounts; and
- variations in accounting treatments.
A particularly helpful tool to process the substantial amount of information that must be examined is the utilisation of a scoring matrix to identify funds that are in compliance or not. Once variances are identified between internal calculations and the manager’s reported numbers, a score is assigned based upon the degree of differential. This allows for quick identification of issues that require further investigation. Scores are assigned across multiple categories including management fee, carried interest, and expenses.
Peer group rankings are another useful component of a fee validation program. Much like quartile rankings are used in private equity performance analysis, analysing fees vs. peers can provide additional metrics to identify non-compliance. Benchmarking across vintage year, geography and strategy – much like performance reporting – will allow for optimal apples-to-apples comparisons to find outliers. This is particularly helpful in establishing thresholds and tolerances in setting scoring parameters.
3. In-house or out-score?
When looking at implementing a new project, whether it’s a one-time event or an on-going program, it’s natural to consider whether to utilise existing resources or look for outside help.
LPs who are already collecting statements from their fund managers might very well decide that their internal personnel and systems are sufficiently up to the task. However, a number of questions should be asked before deciding to undertake a fee validation program internally:
- what is the experience level of internal personnel, particularly as it relates to understanding the components of fee calculations including waterfall methodologies, variations in carried interest charges and legal interpretation of expense categories?
- are there systems in place to capture, extract and interpret all the relevant data points? Can these systems scale as the private equity portfolios grow?
- which methodology would be employed? Historical, point-in-time or on-going due diligence?
- is there access to benchmarking and peer group data to facilitate analysis?
Costs can vary widely when looking to implement a fee validation program, even between point-in-time vs. on-going due diligence. The difference primarily lies in the effort needed in the various methodologies. The historical, point-in-time process involves having the GP provide the LP with a full history of cash flows and transactions, so that the LP can re-examine, re-construct and re-calculate all historical cash flows, NAVs and waterfall processes. This can be a time consuming and lengthy process with costs reflecting that fact. Conversely, the on-going monitoring methodology relies on current processes and existing documentation, leveraging a process based on technology.
Whether choosing in-house, historical or an on-going process, there is also the potential for a non-monetary cost in the form of goodwill with the LP’s fund managers. A heavy “ask” of GP involvement in the fee validation process can have various relationship “costs” in what is a multi-year and sometimes multi-fund commitment.
CalPERS’ recent announcement that it was unaware how much it was paying in fees for its private equity investments was a wake-up call for the industry. LPs have now realised, if they weren’t already fully aware, that their fund governance responsibilities need to include close examination of manager expenses across the entire portfolio. Regulators have taken notice as well, with at least eight U.S. States having proposed bills looking to increase fee disclosure from alternative investment managers.
The U.S. is not alone in the push for greater fee transparency either. The Financial Conduct Authority, as part of its recent review of the investment management industry, is also looking to establish a more comprehensive framework for fee disclosure and reporting across fund managers.
There is growing evidence that standardising around a specific set of data points and reporting protocols is gaining acceptance in the LP and GP communities. For U.S. investors, the ILPA is now on the second version of its fee template, and, by most accounts, this has been well received by the industry. Specifically from a European perspective, Invest Europe as well as the CIPFA and LGPS communities have been working on their own set of guidelines for greater fee transparency. The Swiss Funds Asset Management Association (SFAMA) has also issued its own proposal in reporting the Total Expense Ratio (TER) across all types of investment managers. Given the global nature of private equity investing, the hope is that the investor community will coalesce around a common set of standards.
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