Private equity is growing more complex every year – placing greater demands on managers and especially their back-office administrators. Service providers are being pushed to their limits in terms of what’s being asked of them, which can spell delays, inefficiencies and complications for clients.
In this article, we’ll look at why private equity funds – traditionally seen as less complicated structures – are becoming increasingly complex. And we’ll look at how future-focused industry leaders are developing and putting into place digitized solutions designed to accommodate fund complexity and process net asset values (NAVs) and other calculations for clients on demand.
“When you layer all these different elements on top of each other, you see how exponentially complex things can get in private equity under the semblance of being a much simpler structure.”
– Diego Lopez, head of vendor platforms for U.S. Bank Wealth Management and Investment Services
Historically, private equity investment took a relatively simple approach. Investors would gather capital and purchase a company. They’d eventually sell it, and the money would be returned to investors in a buyout fund. These were generally long-term, pro rata partnerships (5–7-year investments), so calculating fees and dividing earnings was clear and straightforward.
Over time, as markets became more regulated, private equity fund structures started becoming more appealing. Managers sought out innovative ways to maximize returns. And now, many funds that still fall under the purview and rules of private equity function in ways that more closely resemble hedge funds.
“We’re seeing more and more PE funds invest in marketable securities, loans – really any kind of investment they want – by using what we call a private equity wrapper,” says Diego Lopez, head of vendor platforms for U.S. Bank Wealth Management and Investment Services. “This keeps the fund structured in the private equity realm, even though its activity might not be traditional private equity activity.”
This expanse in application is similar to the way exchange-traded funds (ETFs) have also found a new role as strategy wrappers.
As managers pursue more innovative ways to use the private equity structure, other complexities come into play as well. Here are just a few:
• Rebalancing events
Any time new investors buy into a fund after its inception, that triggers a rebalancing event. The service provider has to calculate historic profits and losses (P&L) so that everything is correctly attributed between new and old investors.
“Sometimes there is complexity in what can and can’t be rebalanced,” says Diego. “And everything compounds even further when you have years and years’ worth of data that needs to be accommodated, rebalanced, stored and reported correctly.
• Data management
As private equity becomes more popular, more investors are entering the space. Lawyers often draw up agreements to assign specific treatments for certain investors. Multiply those additional steps by the number of investors, and it becomes a huge amount of data to manage.
“Frankly, a lot of the calculation ends up being a very manual exercise for the administrator,” says Diego. “You’re going into the portfolio. You’re bifurcating the needs. You’re balancing this and that because the automated tools can’t really do it properly, and it becomes a very time and labor-intensive process.”
• Carried interest
Another complexity with private equity comes in the form of carried interest, a tiered hurdle structure for calculating incentive. There are two styles of carried interest, each with its own unique nuances: hypothetical (European style) and deal-by-deal (American style).
• Hypothetical carried interest (European style): The investment’s value goes through a series of hurdles that allocates money and determines incentive. Generally, capital is returned. Then deferred return (interest) is allocated. Then, the general partner (GP) takes their cut. Then the remaining profits are split according to the agreement.
• Deal-by-deal carried interest (American style): Returns are calculated on each investment, requiring much greater effort on the part of the administration team.
According to Diego: “With deal-by-deal, every equity you buy, every dividend you receive from that equity, every bond you buy, every hedge you put on, every interest payment, every paydown – everything needs to be treated in a certain manner to figure out what is eligible for incentive fees.
• Tax calculations
Tax calculations add yet another layer of complexity. In general, private equity structures are treated as capital gains instead of ordinary income, which makes a big difference in terms of tax liability. Beyond this, experienced managers often open different entities within the same fund structure in different domiciles around the globe. This money is subject to different regulations and tax calculations, which means administrators need to be able to track all this movement in granular detail.
“When you layer all these different elements on top of each other, you see how exponentially complex things can get in private equity under the semblance of being a much simpler structure,” says Diego.
To accommodate the demands of today’s private equity investors, U.S. Bank has developed and started rolling out a home-grown, digitized, back-end technology solution designed to dramatically improve the efficiency of data storage and calculation – no matter how complex the fund. Learn more about this game changing technology enhancement and its benefits for you and your investors by following the article link below.
At U.S. Bank, we understand the value of partnering with a trusted third-party administrator to help you achieve your business goals, and we have the expertise and resources to support your private equity growth. To learn more about the comprehensive fund administration services offered at U.S. Bank, visit usbank.com/globalfundservices.
If you’d like more information about our PE digitization rollout, please contact our team. Additionally, be on the lookout for more information and articles on the subject throughout the year.