What’s good for the goose….

Now that prospective investors in private equity funds are approaching the due diligence process with the same rigour as GPs have applied to target portfolio companies, there are some important infrastructure issues a GP has to address. Steven Millner of DML looks at what a GP has to do to make sure an LP is going to be satisfied.

Just as due diligence on target companies is a critical phase for the private equity fund, so too is it becoming for investors assessing a prospective fund that is raising capital. Not only does this relate to an assessment of the GP’s claimed performance metrics. It also relates to how robust the reporting and administration systems are at the fund. Steven Millner, New York-based managing director at fund administration specialists DML, explains what this means for the GP community.*

 

The turmoil created by Enron, WorldCom and Tyco coupled with the terrorist attacks of September 11, 2001,have dramatically demonstrated that businesses must reexamine their financial reporting, governance and business continuity plans. Private equity firms are not exempt. Restive LPs and increased media attention almost certainly guarantee that the market will demand major changes.

 

There is simply too much capital exposed in the private equity asset class and growing, though not necessarily accurate, perceptions of “murky valuation standards,” “port-folio company melt downs,” “fund downsizing,” “lack of transparency” and sponsors with “mom-and-pop” back offices.

 

DML’s experience in dealing with a large number of U.S.and European private equity firms reveals that many senior executives at private equity firms today are, in fact, concerned about the quality of their firm ’s internal infrastructure. This should come as no surprise given the dramatic growth in private equity. From 1999 to 2001 alone, there were a record 528 new funds closed that raised $214bn of capital. As in many other growth industries, investment in infrastructure oftentimes lags revenue growth (in the case of private equity – the “build-out ” of the asset base). The private equity business has grown from a cottage industry to a mainstream asset class. This growth and the renewed focus on governance and quality of financial reporting has led to increased scrutiny and expectations on the part of institutional investors. There is also a concern of increased regulation. Harvey Pitt, the outgoing Chairman of the Securities and Exchange Commission, revealed in a recent speech that the private investment arena was under review by the Commission.

 

While certain aspects of private equity, like deal structuring and financing, are highly complex, the operations of a private equity fund are actually fairly straightforward. It is easy to understand why private equity managers seem to associate their business more closely with the operations of a small business, than with a multi-million/billion dollar investment asset manager. Most firms have traditionally been highly entrepreneurial organisations driven by the vision and skills of their founders. However, the significant fiduciary responsibility associated with investing substantial amounts of third-party capital creates a difference between the private equity fund sponsor today and a small business.

 

While sponsors are increasingly recognising the need to institutionalise their organisations, including re-examining the infrastructure and business continuity plans for their own operations, progress has been slow. This progress has been impacted by concerns about costs, trepidation regarding the ability to close future funds and the need to justify an appropriate return on investment, the current economic climate (including softer market conditions for new fundraising), more time spent tending to the needs of portfolio companies, reduced carried interest distributions to sponsors and LP pressure on management fees. In our capacity as private equity fund administrators, we have noted a substantial increase in the number of inquiries from the institutional investor community regarding processes, procedures and business continuity planning. Not surprisingly, requests on behalf of our new fund clients to complete gatekeeper checklists addressing reporting policies, procedures and infrastructure are on the rise.

 

Identifying, assessing and implementing change to a sponsor’s infrastructure is not unlike those processes a sponsor employs when vetting a potential acquisition. In fact, many of the resources necessary to improve a sponsor’s infrastructure substantially are often readily available within its organisation.

 

The key to moving forward is to accept the fact that infrastructure issues and business continuity planning should be a key concern of senior private fund management. At an implementation level, it is important to identify an individual or team of individuals with the proper level of authority who, while not involved in day-to-day operations, have significant operating experience. The individual or team must be empowered to make an assessment of business operations.

 

The following simple set of guidelines will help ensure that a fund sponsor’s infrastructure has the requisite fundamental processes and controls in place to meet the core needs of institutional investors.

 

Identify critical processes

Fund raising

Investor relations

Investment identification, monitoring and harvesting

Financial and investor reporting

Risk management

Technology

 

Take inventory of what you currently have in place.

You should have:

An organisation chart

A well-documented policy and procedures manual

Documentation regarding your technology platform

Business continuity plan

Job descriptions

Market-standard financial reporting processes and practices

 

Assess what you currently have:

Is the organisational structure appropriate for your business model?

Do your policies and procedures adequately address high-risk areas?

Is there a formal escalation policy?

Is compliance being maintained with your policies and procedures?

Is the technology system you are using well supported and backed up at a secure location?

Do you have the most up-to-date version of the technology being used?

Is knowledge of the technology and access to key information limited to

only one employee?

Make an honest assessment of your team.

Benchmark financial and investor reporting with other funds.

 

Reach out for accessible help:

Meet with your auditors. Inquire of them as to their views on your internal controls and financial reporting.

Speak to your professional team. Legal counsel and placement agents can be insightful.

Borrow professionals from your portfolio companies. By way of example, we know of a fund sponsor that enlisted the help of a portfolio company’s risk manager to develop the fund ’s business continuity plan.

Consider outsourcing.

Speak to colleagues.

 

Utilise multiple resources

There has been a concomitant growth in the number of available resources to serve private equity fund sponsors as the industry has grown. Industry groups are cropping up to enable private equity managers to have a forum to share ideas and experiences. When I started in private equity, Lotus 123 was the industry standard for private equity fund accounting and administration. Now, there are readily available software packages designed specifically for private equity fund administration. The expanded pool of advisors specialising in the private equity arena, including executive search firms as well as legal, accounting, communications and fund administration providers can be tremendous resources. Increasingly, outsourcing is being embraced as a best-practice solution for private equity fund administration.

 

Now is the ideal time to act

This is the time of year that funds close out their year-end accounts and the independent auditors commence their work. That makes it an ideal time for private equity sponsors to assess their internal infrastructure. The investment community is demanding action on these issues to ensure that sponsors and their portfolio companies are prepared for a range of formerly unthinkable scenarios. Firms with an institutional vision, will exercise leadership and heed their call.

 

*: this article has also appeared in the Winter 2003 Private Equity Report of Debevoise & Plimpton, Volume 3 Number 2