September 2016 • www.privatefundsmanagement.net
FINANCE • LEGAL • COMPLIANCE • OPERATIONS • TAX
DELIVERING GROWTH PRIVATE EQUITY MANAGEMENT IN AN ERA OF TRANSITION
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With this book, find out: • What the current and future trends are, and how they'll impact the fundraising environment. • Best practice for fund restructuring. • How to deal with technology management that's not part of a CFO's day-to-day-role. • A blueprint for a robust and secure cyber-security programme. …plus much more
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Senior Editor, Private Equity Toby Mitchenall Tel: +44 207 566 5447 [email protected]
Americas Editor, Private Equity Marine Cole Tel: +1 212 633 1455 [email protected]
Special Projects Editor Graeme Kerr Tel: +44 203 862 749 THE PRIVATE EQUITY [email protected] The growth conundrum Contributors Nicole Miskelly Many of the world’s most influential return profile of that investment could Victoria Robson Claire Coe Smith investors have been articulating what has shift dramatically. Design and Production Manager been known for some time: it’s getting Another component is the management CFO & CTO DIGEST Carmen Graham Tel: +44 207 167 2039 harder to generate returns across the board. team on the ground; on p.6 we explore [email protected] Chinese sovereign fund CIC, for the development of one of the key figures example, said recently it had taken a in effective value creation: that of the New ways of adding value to the firm, the fund and the portfolio company Head of Advertising Alistair Robinson Tel: +44 207 566 5454 number of steps to bolster returns amid portfolio company CFO, or as General [email protected] “ever-growing downside risks” in global Atlantic’s Bob Swan calls them (p.8), ‘chief With this book, find out: Advertising Manager Anthony Hackett markets. Singapore’s GIC followed suit, capital allocators’. Tel: +44 207 566 4273 reporting slowing returns over the last Slow global growth is not the only thing • What the current and future trends are, and how they'll impact the fundraising environment. [email protected] year, caused by “all-time” low interest causing private equity firms to rethink and Subscription Sales • Best practice for fund restructuring. EMEA rates, high asset valuations and an retool their operations. On p.22, Shannon Alexis Savvides • How to deal with technology management that's not part of a CFO's day-to-day-role. Tel: +44 207 566 5458 uncertain outlook for economic growth. Stafford of The Carlyle Group describes [email protected] ADIA, too, has reported diminished a global tax landscape that is changing • A blueprint for a robust and secure cyber-security programme. Asia Pacific Andrew Adamson returns against a “backdrop of slowing more dramatically than at any point in Tel: +852 2153 3848 global growth”. The California Public her career. The continued implementation …plus much more [email protected]
Americas Employees’ Retirement System has been of BEPS ensures that the pace of change Andre Anderson forced to defend its performance amid will not slow. Similarly the regulatory Tel: +1 646 545 6296 [email protected] “challenging” conditions. environment is getting no less challenging Customer Services While this is an issue that cuts across for private equity firms. On p.26 KKR’s Fran Hobson Tel: +44 207 566 5444 all asset classes, private equity will not global CCO Bruce Karpati talks us [email protected] be spared. So how on earth can general through the lengths a firm must go to in An Nguyen partners satisfy investors in this world order to remain compliant, particularly Tel: +1 212 645 1919 [email protected] of lower returns expectations? For this with his former employers: the US For subscription information please visit special report, PFM partnered with Securities and Exchange Commission. www.privatefundsmanagement.net Deloitte to look at just what is required to Geopolitical developments – including Group Managing Editor deliver growth in this era of transition. Britain’s exit from the EU (see p.10) and AVAILABLE NOW Amanda Janis [email protected] The answer is a surprisingly simple one: the forthcoming US elections – are also Order your copy of this essential title today: Editorial Director portfolio company EBITDA growth. The on the radars of both investment and Philip Borel [email protected] lion’s share of the money multiples that operations professionals within private www.privateequityinternational.com/cfocto Head of Research & Analytics LPs demand will come from growing equity. Both events look likely to impact Dan Gunner portfolio companies’ profitability, which the business of private funds management. [email protected] is why firms of all sizes are focused on Private equity firms are today operating Publishing Director [email protected] Paul McLean disruptive growth companies and genuine in changing world. Fortunately this is [email protected] operational improvement. A component typically where they thrive. Group Managing Director London: +44 (0) 20 7566 5444 Tim McLoughlin of this is operational due diligence, as New York: +1 212 633 1073 [email protected] explored by Deloitte’s Kamal Mistry on Enjoy the supplement, Managing Director – Americas p.12; if a firm doesn’t have an accurate Hong Kong: +852 2153 3848 Colm Gilmore [email protected] picture of very specific elements of a Managing Director – Asia target’s operations – such as its technology Toby Mitchenall, Chris Petersen [email protected] infrastructure or supply chain – then the Senior Editor, Private Equity SPECIAL OFFER TO SUBSCRIBERS: Order your copy today quoting SUBBK15 and receive a 15% discount September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 1 xxxxxxxxcontents • •SEPTEMBER XXXXXXXXXXX 2016 • DELIVERING GROWTH
3 EXPERT COMMENTARY: p. 6 Heading in the right direction Challenges to growth loom but plenty of evidence suggests private equity is up to the task, writes Frank Fumai, partner at Deloitte 6 CFOs: Seeking a new superhero The CFO of a PE-backed company has an increasingly crucial part to play in creating value to a secure a successful sale
8 More than just counting the beans The CFO’s role is a multifaceted one, focused on both day-to-day activities and a business’s long-term goals, CFO says Bob Swan, operating partner at General Atlantic
10 Preparing for life outside the EU The UK’s vote to leave the European Union has plunged the private equity industry into unprecedented uncertainty. What can GPs do to prepare for Brexit?
12 EXPERT COMMENTARY: Remodeling underway Pivotal position: The chief financial officer needs to be Financial engineering is no longer enough to keep ahead a forward-thinking leader who can drive change of the competition. Now the focus is on operational due diligence, writes Kamal Mistry, principal at Deloitte Consulting 22 Maintaining tax neutrality is becoming harder 15 M&A trends: Beyond Brexit The tax landscape is facing its most dramatic changes in Private equity-led M&A activity cooled in the first half a generation, says Carlyle’s Shannon Stafford of the year… but only slightly 24 Growing pains (and how to avoid them) 16 Diligent dealmaking Rapid growth brings a whole set of new challenges In-house counsel at private equity firms are at the for GPs. Experts give their tips on how to scale up forefront of negotiations as deal terms evolve. Adam successfully Fliss, deputy general counsel at TPG Capital, explains the current M&A pinch points 26 Responding to the regulatory environment The SEC’s increased focus on private equity is forcing EXPERT COMMENTARY: 18 GPs to embrace a whole new level of transparency, says Life beyond spreadsheets Bruce Karpati, KKR’s global chief compliance officer In today’s pressure-filled market, private equity firms need to invest in more advanced technology solutions. 28 The world of compliance Luckily, IT is becoming more affordable than ever, From the US to Australia, a wave of new regulation is writes Roland Waz, principal at Deloitte Consulting being felt across the private equity industry
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2 private funds management • DELIVERING GROWTH • September 2016 expert commentary • OVERVIEW
among investors. Cambridge Associates’ US Private Equity Index, a proxy for industry returns, has beaten the Nasdaq Composite, Russell 2000, and Standard & Poor’s 500 indexes consistently, from 1990 through to the third quarter of 2015. Private equity funds have earned a reputation for increasing fund profitability through favorable deal terms, easy access to capital and financial engineering.
A new phase of growth Now the industry’s talents are truly being tested. In the wake of the global financial crisis and market tumult, the holding periods for many funds have extended well beyond traditional norms. Gains from recapitalizations and other financial engineering strategies have mostly been had, thanks to historically low interest rates. Regulatory oversight Heading in the right direction is escalating, demanding more attention from fund leaders. Challenges to growth loom but plenty of evidence suggests private Meanwhile, increased competition equity is up to the task, writes Deloitte partner Frank Fumai from the likes of crowdfunding sites, VCs and public corporations has dramatically shrunk the pool of available s I was wrapping up a panel at • Industry assets under management investment targets. While the number of the recent PEI CFO and COO swelled to a high of $3.6 trillion US companies has barely budged over Forum in New York, I asked in 2015, excluding venture capital, the past 20 years, the number of private theA 500 members of the audience for according to Deloitte estimates based equity firms has grown by a factor of questions. Within a few seconds my iPad on Preqin data; 14 (see chart on page 5), according to screen was full of them. How will the • Since the end of 2005, assets have risen Census data. industry deliver above-market returns by a robust 13.7 percent compounded As a result, investor capital is piling when the easy gains have been realized annual growth rate; up on the sidelines. Uncalled capital, or and regulatory pressure is increasing? • The amount of capital raised by dry powder, has risen at a 9.2 percent How will firms compete for deals in a private equity funds has grown at a 4.6 CAGR over the past decade. That’s market that’s getting more crowded by percent CAGR over the past decade; twice as high as the rate at which money the day? Should we expect lower returns • Institutional investors surveyed has been raised. The pressing questions from private equity going forward? The by Preqin report increasing their volume of tough questions was telling: allocations across the board in recent private equity is concerned about years; they plan to commit the same meeting increased expectations from amount of capital or increase their It’s not just regulators and investors alike. allocations in 2016. the pace of growth Despite its challenges, the industry is that’s likely to change still one of the best draws for investment Private equity’s outperformance over capital: long periods explains its popularity in the coming years
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 3 expert commentary • OVERVIEW
intensifies and appreciation is harder to come by. At the same time, we’re likely to see the growth rate of uncommitted capital settle at 6.3 percent CAGR.
A stronger support system This significant shift – with dry powder overtaking unrealized value as the industry’s biggest driver of growth – could present a big opportunity for private equity funds who figure out how to put money to work in this intensely competitive environment. How should private equity firms respond? Based on our experience at Deloitte, we’ve identified a standout trait that successful private equity firms share in this environment: a best-in-class Fumai: the industry’s talents are truly being tested support system. Specifically, we see general partners strengthening their core capabilities when it comes now is: Will investors remain patient to technology and operational due Those [private as the industry addresses these diligence. equity leaders] that challenges or will they seek other Take technology investments, alternatives for their capital? which are primed to rise. Technology don’t revisit and The answer may hinge on whether spending was once seen as a drag on revamp their tried- private equity investors are willing to returns, so many PE firms limited reset their expectations for returns. their investments to offline solutions and-true formulas An analysis in a recent Deloitte report such as spreadsheets. In an article on may find it much suggests that they will. The industry is page 18, my colleague Roland Waz embarking on a new phase of growth, chronicles how increased competition more difficult to one we believe will see AUM grow at for deals, investor demand for raise capital in a 5.2 percent CAGR from year-end information and transparency, and 2015 through 2020 in the most-likely other factors are pushing PE firms the future scenario. If realized, that would be a to elevate technology’s importance. significant stepdown from the run rate While priorities vary by firm over the past 10 years. size, business focus, and existing Our research also shows that it’s technology infrastructure, he sees not just the pace of growth that’s four areas attracting the most dollars: likely to change in the coming years. modernization of core applications, The composition of that growth will cloud HR and finance solutions, change as well. Gains in unrealized investor portals, and data analytics value expanded at 16.7 percent CAGR platforms. over the past decade, contributing Another way for private equity heavily to asset growth. We expect firms to boost returns in today’s that rate to slow to just 4.7 percent environment is to make major over the next five years as competition operational changes in portfolio
4 private funds management • DELIVERING GROWTH • September 2016 expert commentary • OVERVIEW
companies. While this approach can deliver bigger returns, it carries bigger Ratio of US companies to private equity firms risks. On page 12, Deloitte principal Kamal Mistry outlines the reasons why GPs shouldn’t be tempted to 1992 2002 2012 short-change operational diligence despite the pressure to move quickly Number of private 293 on deals. In an environment of equity firms* 1,571 increased competition and diminished 4,110 returns, more thorough diligence on the target company’s operations and Number of US companies 17,390 market positioning can find potential 3,627 for each private 1,393 pitfalls and spot alternative ways to equity firm deliver value.
The drive for data Source: Deloite Centre for Financial Analysis. We’re already seeing evidence that *Excludes venture capital firms. these efforts are bearing fruit. Empowered by new technology platforms and information, leading private equity firms are strengthening For an industry that relies on their ability to compete for deals patience to succeed, private equity is and unearth new sources of returns. counting more than ever on investors’ Importantly, their investors are being forbearance. There’s a new sense of rewarded not just by the performance urgency to the performance questions they have come to expect but also investors are asking. “Give it time” through increased transparency isn’t a sufficient answer. Private equity into the underlying investments and leaders need to branch out from the strategies that make it possible. traditional way of doing things and Just a few weeks ago, Deloitte find new opportunities for growth. hosted a meeting that included Those that don’t revisit and revamp finance executives from a number of their tried-and-true formulas may find the largest PE firms. One of the most it much more difficult to raise capital revealing observations to come out in the future. of the meeting was just how varied Investing in technology and due their processes and approaches are diligence capabilities are two ways for obtaining investment information private equity firms can find new from their portfolio companies, opportunities and keep investors summarizing it, and reporting it to engaged. But other approaches will investors. While no one firm had a almost certainly be needed in the silver bullet, it was clear to me that months and years ahead. This industry each finance department was very has a long track record of funding focused on developing as efficient a promising companies and capitalizing process as possible, one that doesn’t on disruptive ideas. Now it’s time overly burden portfolio companies for private equity to transform the $3.6trn while yielding useful insights for business of private equity. Investors Industry assets front-office analysis or financial expect no less, and neither should under management reporting purposes. we. swelled to a high in 2015
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 5 analysis • IN THE BOARDROOM
CFO
Seeking a superhero for the office The chief financial officer of a PE-backed company has an increasingly crucial part to play in creating value to a secure a successful sale, writes Graeme Kerr
nspirational. Forward-thinking. and the evaluation of geo-political risk Adaptable. Strategic. If you It’s a catalyst role. such as Brexit.” thought the chief finance role It’s about leadership It also requires charisma: “Private Iwas just about number-crunching, and influence equity firms ask themselves whether think again. The CFO of a portfolio the CFO can inspire the people around company is increasingly seen as pivotal Sanford Cockrell them to drive the change.” in securing an exit, and the job is Nadja Essmann, head of the CFO evolving to reflect this. practice at private equity recruiter PER, A report by Fortune 500 recruitment The CFO role is especially pressurized says you have to be a jack-of-all-trades. firm Robert Half Finance 2020: Closer at private equity firms where the drive “PE firms are looking for a smart Than you Thinkuncovered a clear shift is to strip portfolio companies back to generalist with a very broad range of in the priorities of a CFO from the the “core essence of what can make technical skills, someone who can solve need to meet accounting and reporting value,” says Luke Davis, vice-president problems with a hands-on mentality standards to a more hands-on role at Robert Half. and very good presentation skills.” where keeping pace with technology, “That requires the CFO to be a Consultancy firms have noted a harnessing big data and meeting forward-thinking leader who can cope similar transformation in the role. regulatory demands are becoming the with external change, changes with Deloitte runs a CFO program that main priorities. technology, changes with regulation helps train finance executives to cope
6 private funds management • DELIVERING GROWTH • September 2016 analysis • IN THE BOARDROOM
with the multiple challenges faced applied, and confirm whether the The pressures on a by the modern CFO of a PE-backed strategic decisions are supported by the portfolio company. financials,” one private equity investor PE-backed CFO Strategic thinking forms a core part told Deloitte. of the program, which is specifically As is the ability to perform under tailored to the exacting demands the spotlight. “Lack of confidence in placed on the CFOs of a company the CFO is never sustainable. It is acquired by a private equity firm. relatively common for us to make a “Overnight, you are fundamentally in replacement,” said another investor. a different organization where you’ve For the CFOs themselves, the task got to manage against a different set is all-encompassing. “The CFO is the of metrics that stack up against future glue – involved in everything and the exit scenarios,” says Sanford Cockrell, point person throughout the exit,” said 59% the global leader of the Deloitte one CFO of a PE-backed company. of CFOs expect to program. And it’s not just about improving achieve a multiple of Cashflow, rather than earnings, the bottom line. It’s demonstrating 10 or more on exit become king, and the CFO’s role is how you have done it. “The B+ CFO transformed into becoming “hyper- analyzes and presents financial focused” on forecasts and projections. information. The A* CFO takes this “The question becomes ‘what are the further to present the information in critical processes than can be improved the most attractive way,” said another to maximize cash generation,’” says CFO. Cockrell. CFOs that successfully steer the “It’s a catalyst role. It’s about firm to a successful exit can expect leadership and influence. To be a big rewards. “Remuneration is usually CFO today, you’ve got to influence very highly incentivized with a an organization to make the necessary disproportionately large bonus,” says changes. Communication is key – not Ashley Crich, a manager at recruiter 32% just to the CEO and the board but to Morgan McKinley. Or as PER’s of CFOs have been in the PE sponsors.” Essmann puts it: “There are a lot of their role less than two years The dramatic impact that CFOs incentives in the bonus on the exit side can have on value creation comes out for CFOs.” clearly from interviews that Deloitte But recruiters confess that the conducted with more than 130 CFOs, multiple demands can make it a CEOs, chairmen and private equity difficult role to fill. Robert Half’s investors for a report published in Luke Davis recalls one private equity November called The Role of the PE executive saying that he was being kept Backed CFO: Maximising Value on awake at night worrying whether the Exit. CFOs at its portfolio companies were All agreed, without exception, that up to the job. CFOs can have a positive impact on “CFOs are at the heart of growth, the exit value, with 63 percent of PE and that means securing the right investors and 61 percent of CFOs person for the role is of crucial believing the impact can be material. importance, both for the sake of the 45% The individual responses shine a portfolio company and for the private of CFOs expect an exit light on the demands of the role. equity firm,” says Davis. within two years Deloitte PE-backed 2015 CFO research Vision is vital. “The CFO should “Getting the right CFO really can challenge the strategy and how it is save some sleepless nights.” Source:
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 7 on the record • GENERAL ATLANTIC
More than just counting the beans The role of the chief financial officer of a PE-backed company is a multifaceted one, focused on allocating capital for day-to-day activities and helping achieve a business’s long-term goals, explains Bob Swan, operating partner at General Atlantic
What are the main requirements but at its fundamental core, it is about the CFO of a private equity-backed effectively allocating capital against the company should have? best ideas that will yield the growth At General Atlantic, there are three prospects that the team is counting on. fundamental requirements that In the world of growth investing, a CFO we’re looking for in a CFO. First, needs to understand strategically where we’re looking for a CFO who is a company is headed. Sometimes you functionally extremely competent, who need to have the analytical capabilities. is operationally engaged and who is Sometimes you need to have the ability strategically part of the dialogue framing to assess the human capital of the firm. the strategic agenda for the company The CFO needs to be able to determine Swan: CFOs are tasked with going forward. Obviously, a CFO needs whether the company should be creating shareholder value to have all the functional skills necessary allocating capital organically to achieve to be in such a role in today’s dynamic its growth plans, or whether it should be environment, including financialallocating capital acquisitively to extend A CFO needs planning, accounting, tax and treasury, its reach through M&As or investments. and M&A. Secondly, we’re also looking In this position, the CFO also has the to understand for a CFO who’s very comfortable with ability to say no to those ideas that may strategically the operating dynamics of the business stretch the team too thin or may not where a company and in engaging with the operating achieve the growth aspects that the is headed team in a leadership capacity. So, not company is hoping and counting on. just a functional expert, but somebody who can bring those functional skills to What are some of the internal resources bear as one of the leaders of the business. that the CFO of a private equity-backed Finally, the CFO should also be able company has? to engage strategically with the chief At its core, a company may have a executive officer and the company’s chief accounting officer, a treasurer, a investors in charting a strategic course head of tax, a financial planning and forward. analysis executive, and either directly or indirectly, a team member responsible What is the most important role of the for M&A-related activity. How big CFO? those teams tend to be is really more At the most macro level, the CFO in a function of the size, complexity, and our portfolio companies is the ‘chief global characteristics of the company. capital allocator,’ who can look at a In addition to that, sometimes a CFO variety of different ideas and evaluate may take on a broader role other than those ideas to ensure that the capital the functional requirements of the job. they’re putting to work can help the For example, a CFO may have legal, team achieve its growth objectives. The human resources, or other operational role of the CFO is a multifaceted role, responsibilities that are part of his or her
8 private funds management • DELIVERING GROWTH • September 2016 on the record • GENERAL ATLANTIC
mandate, either directly or indirectly. At General Atlantic, we have roughly 65 portfolio companies in five different sectors across five geographies so the nature and the roles of our CFOs and their teams vary quite a bit.
How does the role of a private equity- backed company CFO differ from that of a publicly-traded company? The roles are fairly similar. At the end of the day, the CFO role is basically to create shareholder value and not just be somebody who’s counting the beans, but somebody who’s helping the beans grow over time, whether you have private investors or public investors. Obviously a private equity-backed company, depending on the nature of the industry and of its capitalization table, also has the ability to engage with its investor base in a way where it can leverage private equity investors for inside learning capabilities that the firm may have at their disposal, but that the company itself may not have. That’s a key aspect at General Not just a number cruncher: CFOs need to think strategically Atlantic where we have a group of operating resources called the Resources Group that can engage operationally has experience across multiple aspects and functionally with the CFO to help of what a company goes through as Bob Swan joined General him or her address the challenges they it grows and scales the business. For Atlantic in 2015 as an operating find along the way. In our portfolio our CFOs, this means that they have partner, where he works closely companies, that CFO has the ability to a value-added partner that is there to with the firm’s global portfolio lever the capabilities and bench strength support them and be a sounding board companies. Swan previously that General Atlantic brings to the table as they work to create a best-in-class served as chief financial officer at through our Resources Group. finance function with their companies. eBay, Electronic Data Systems, Depending on the company, this could TRW, Inc. and Webvan Group. How can a private equity firm be a mean anything from working with the He began his career at General resource to a CFO? CFO on improved governance and Electric, where he held a number At General Atlantic we are very focused controls, to supporting them as they on working closely with our portfolio evaluate M&A opportunities to support of senior finance roles. General companies on company building inorganic growth, to helping them think Atlantic is a global growth equity efforts to help accelerate growth through steps to prepare for an IPO. At firm that invests in five industry and prepare a business to scale. Our the end of the day, we understand how sectors: internet & technology, portfolio companies are already on a critical the role of the CFO is to our financial services, business strong growth trajectory – our goal is portfolio companies’ success and thus services, healthcare and retail & to enhance it. We’ve built a seasoned aim to form a true partnership with our consumer. team within our Resources Group that CFOs.
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 9 analysis • BREXIT FALLOUT
Preparing for life on the outside The UK’s vote to leave the European Union has plunged the private equity industry into unprecedented uncertainty. What can GPs do to prepare for Brexit, asks Victoria Robson
he outcome of the UK carefully, Korosis cautions. GPs, have to look at costs you can cut and referendum in June in favor LPs and portfolio companies have assume the economy will get worse,” of leaving the European responsibility for managing their own the GP says. TUnion shocked the City of London level of currency risk. “There is a risk UK-based firms will also have to and contradicted widespread support that people will over-react in the short- model for future additional expenses within the private equity industry for term. You don’t want to go into panic incurred operating outside of the EU. the UK to remain a member of the EU. mode.” These range from acquiring British Over the coming years, while Britain passports for EU national staff based negotiates the terms of its exit, UK- Batten down the hatches: in London, to setting up an additional based funds will continue to battle The recession risk is real office in the EU, or relocating entirely. political and economic uncertainty. 2 “Uncertainty is the key risk. There are short-term steps they can The base case is, we are looking at a Living outside AIFMD: take to mitigate the risks of Brexit, recession, how deep or shallow we just Don’t rush industry experts say. don’t know,” says one London-based 3 No one knows yet what shape GP, adding that contagion across a deal with Europe will take, and The plummeting pound: Europe is a possibility. One result is what it means for the UK’s status Don’t over-hedge your bets likely to be a slowdown in exits. within the Alternative Investment 1 While the future remains Fund Managers Directive (AIFMD). unclear - not least as to the date the UK managers do need to prepare for UK government will formally request the future loss of their EU marketing to leave the EU, how long those Uncertainty is passport, but in the immediate term, negotiations will take, and what kind the key risk. The they should not be hasty. of relationship the UK will maintain “For those UK funds that have taken with the rest of Europe afterward - base case is, we the time to get AIFMD authorization, one immediate impact of the vote has are looking at a it is too early for them take a decision been a steep devaluation in sterling. on restructuring themselves,” says In August the pound was still recession, how deep Debevoise & Plimpton partner Sally trading at historic lows at around or shallow we just Gibson. “For fund managers that have $1.30, curtailing sterling-denominated real substance in the UK, it is not a funds’ ability to buy international don’t know five-minute exercise to open up in assets, shrinking the book value of another European jurisdiction. They UK-based portfolios and threatening need to be watching and waiting to see performance. Ideally, funds should have developed what is going on.” One way to address the currency a contingency plan prior to the vote, Beyond assessing the tax risk to track record is to report both the GP says. “Funds needed to have a implications, staffing considerations, hedged and unhedged performance to check-list like they had for the GFC and the logistical expense of setting investors to demonstrate the impact, [global financial crisis].” up in Europe, managers might says Hermes GPE head of strategy and Keeping an eye on costs at both consider converting UK-based funds environmental investing Elias Korosis. fund and portfolio company level is into a European vehicle, domiciled in Any hedging against volatility a significant element of any plan to Luxembourg for instance. This would in the pound needs to be managed weather an economic downturn. “You require investor consent, Gibson notes.
10 private funds management • DELIVERING GROWTH • September 2016 analysis • BREXIT FALLOUT
“The real concern is the intervening period and using the passport. If you are a UK manager and want to go to market at the time [when the passporting rights are rescinded] that is when the problem will arise,” she says.
Political distraction: Regroup and lobby 5 While the new government led by Prime Minister Theresa May grapples with the process of uncoupling the UK from the EU, planned domestic reforms intended to make the UK a more competitive fund jurisdiction are in danger of being pushed onto the back burner. Key among them is proposed changes to legislation governing limited partnerships. However, while GPs and their advisors are now concerned that outside Europe the UK is a much less competitive fund domicile, the negotiations do provide an opportunity to communicate their view on the specifics of any deal with Brussels. A central consideration for the UK-based alternative funds industry is that the UK obtain AIFMD third-country status and retain passporting rights. Divorce concerns: AIFMD status is a key issue Withdrawal from Europe is also an opportunity to push a domestic reform agenda. “The industry should Fundraising worries: how that impacts the fund marketing be as active as possible to improve Timing is everything process,” he says. regulations and the attractiveness of 4 A decision on how and when Others may bring their fundraisings the UK fund market,” Kay says. UK fund managers address their forward to take advantage of their These could include introducing AIFMD status is likely to be dictated current AIFMD accreditation that will the concept of legal personality for by their fundraising timetables, and remain while the UK negotiates its exit funds in English limited partnership these will need to be reviewed. from the EU (expected to take two- law; simplifying value added tax for Some managers may lean toward years once the UK makes its formal fund structures, which is currently conservatism and delay plans while request by triggering Article 50 of the an EU tax; introducing a “corporate they gauge the ramifications of the Lisbon Treaty). This would allow them vehicle” as a new fund structure; Brexit vote, says Travers Smith partner to tap European investors, a number of and streamlining the authorization Sam Kay. “Funds need to work which, such as insurance companies, of foreign fund managers that are through the implications and think can only invest in AIFMD-authorized already accredited elsewhere, Kay about when the new rules come in and funds, notes Gibson. says.
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 11 expert commentary • DUE DILIGENCE
Remodeling underway Financial engineering is no longer enough to keep private equity firms ahead of the competition. Now the focus is on operational due diligence, writes Kamal Mistry, strategy & operations principal at Deloitte Consulting
he days of buying undervalued the supply chain can significantly return investors have come to expect. assets, sprucing them with up streamline costs, speed up delivery And yet, many aren’t going nearly a proverbial fresh coat of paint, cycles, and improve margins, but far enough. Deal teams faced with Tand quickly selling them at a profit replacing or upgrading the enterprise constrained time frames and exclusivity are long gone. Generating the above- resource planning (ERP) infrastructure windows for options often stay focused market returns private equity firms that supports the supply chain can be on financial and accounting diligence have historically delivered now requires a long and costly effort. Factories or at the expense of commercial and more than just financial engineering. plants that seem underutilized can be operational diligence. In Deloitte’s Private equity firms are spending more targets for improvement or closure, but experience, skimping on this crucial time in operational diligence, digging running afoul of local labor laws or aspect of deal-making can turn a simple deeper into the operations of potential works councils can bring added costs fixer-upper into a money pit. acquisitions. They’re increasingly and reputational harm. While timing will always be a prepared to make major operational More than any time in the past constraint facing the industry, private changes to realize value. decade, general partners are carefully equity firms can drive rapid operational While this approach can deliver evaluating the implications – both improvements simply by focusing on bigger returns, it also carries bigger positive and negative – of the changes areas that most commonly deliver value risks. For example, changes to they think are needed to generate the or trip up investors.
12 private funds management • DELIVERING GROWTH • September 2016 expert commentary • DUE DILIGENCE
Commercial diligence Operational diligence typically In the past, a rising stock market covers key functional areas of the lifted all boats. It’s true that market target company, including sales, leaders earned greater returns for their marketing, operations, finance, HR, investors, but even laggards could and technology. When conducting generally turn a profit. Now it’s much commercial diligence, you want to harder to spot an attractive target make sure your team is assessing in an increasingly competitive and each of these areas to identify gaps sophisticated market where buyers have in the company’s ability to support funds and are accustomed to financial future growth, as well as the level of leverage. When one is found, it’s investment that might be needed to tempting to jump at the chance and lock maintain or improve performance. up a deal before anyone else. But there This analysis can flag operational are some fundamental questions that or technology issues that have the Mistry: Many firms are not need to be considered first, and that’s potential to become a drag on going far enough when it comes to due diligence where commercial diligence comes into investment or uncover complexities play. Commercial diligence looks at key below the surface that need to be aspects of the target company’s market: addressed. • What’s the size of the market, and One of the most common issues One of the where is it projected to grow? Deloitte sees during operational most common • Who are the key competitors, diligence is with the existing technology suppliers, and customers? infrastructure. As highlighted earlier, issues Deloitte sees • What competitive advantage do we encourage private equity firms to during operational market leaders have, and how does look closely at the ERP systems that are the target company match up? critical to efficient operations. Much diligence is with the • Are there any new entrants to worry like a home’s electrical wiring, an older existing technology about or ones likely to crop up? ERP system may need to be replaced • Are there potential upside or upgraded if it’s not well integrated, infrastructure opportunities that the business requires a lot of manual workarounds, may not be taking advantage of, or or simply no longer supports the needs possible downside risks that could of the business. As these costs can be jeopardize the near term or ongoing significant, they need to be factored in value of the deal? to the due diligence process. Supply chains are another key Understanding answers to these area: they offer great potential to questions can help private equity firms improve margins by consolidating find potential pitfalls – or confirm the suppliers, negotiating better prices, target’s appeal by spotting alternative streamlining delivery and shipping, ways to deliver value. and better managing inventories. But given the complex relationships and Operational diligence logistics that support supply chains, Where commercial due diligence seeks it’s not always as easy to spot the risks, to obtain a comprehensive picture of particularly when the business crosses the company’s market, operational borders and oceans. A thorough review due diligence uncovers the company- of the company’s quality control specific capabilities that help the systems and processes can help spot business compete or the weaknesses red flags, identify opportunities for that are getting in the way. better margins, and find areas where
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 13 expert commentary • DUE DILIGENCE
Three steps to creating value
1. Review portfolio to define fund and hedge fund equity firms have already which customers or pieces counterparts in the use increased the level of their of business generate value of data. This leaves space back-office outsourcing, for the company. The for fast movers in private processes that support private equity manager’s equity to gain a competitive the front office may follow. goal is to extract value from advantage. The accuracy of Firms may want to improve the portfolio company in the data received from the allocation of their expensive the least capital-intensive portfolio companies, and in-house talent and resources manner possible. This means how well it is leveraged for by outsourcing components figuring out how to redeploy strategic decision making, of initial due diligence, or eliminate non-productive are important aspects of operational due diligence, capital, whether fixed assets operational efficiency,and growth strategy or working capital. especially at a time when formation processes for holding periods are the portfolio company. The 2. Use data & analytics to lengthening. broader the range of services document and improve offered by the outsourced performance. At present, 3. Consider what may be provider, the better, as this private equity as a whole outsourced to full-service may help to lower the cost of lags behind its mutual providers. While private operations across the board.
different sourcing approaches could returned expected value, primarily due drive savings. to gaps in execution and integration of deals. These are precisely the kinds of Diligent risk-taking issues that effective commercial and The pressure on PE firms to conduct operational diligence can head off. deeper due diligence isn’t likely to lessen In an uncertain and competitive soon. Merger activity is expected to environment, it’s probably a given stay strong in this sector, as evidenced that private equity firms will find by 87 percent of M&A professionals themselves looking at deals more surveyed in Deloitte’s 2016 M&A on the margin. Even there, the Trends report who expect deal activity challenge will be moving quickly. to meet or beat 2015’s record pace. But Given short time frames, they may survey respondents also see risks ahead, be tempted to focus more on the with global uncertainty cited as the top financial and accounting due diligence concern that could slow down the pace that reaped rewards in the past. of deal-making and depress valuations. But in an environment of increased In the face of this uncertainty, it’s competition and diminished returns, not surprising that the survey also giving more attention to commercial uncovered growing concern about and operational due diligence can 87% deals not delivering on expectations. protect investments, arm firms Share of M&A professionals Fifty-six percent of the private equity with a competitive edge, and generate who expect merger activity firms surveyed said that more than the returns investors have come to to meet or beat 2015 half of completed transactions had not expect.
14 private funds management • DELIVERING GROWTH • September 2016 analysis • M&A TRENDS
Beyond Brexit The biggest PE-related M&A deals of 2016 Private equity-led M&A activity Investor Deal size ($bn) and target Exit cooled in the first half of the
year… but only slightly 7.9 Japan Industrial Sharp Corp Solutions (66%) rivate equity-backed deal activity slowed in the first half of the year, as a number of Leonard Green & Partners; Pmacroeconomic factors blew a chill Hellman & Friedman; Hellman & Friedman; Leonard Green & 7.5 Partners Group Holding; wind through the M&A community. Partners MultiPlan Starr Investment Holdings Investment activity – measured by total deal value – dipped dramatically in the first quarter, falling from $74 billion in Q4 2015 to $32 billion in 4.7 Q1 2016, according to data provider Blue Coat Bain Capital Dealogic. It subsequently rebounded Systems in the second quarter to $79 billion. The number of transactions, however, remained relatively consistent, Cerberus Capital 4.6 suggesting the lower end of the market Management GE Money Bank SCA remained unaffected. The number of private equity exits dropped dramatically in the 4.6 first quarter; just 199 deals were Change Blackstone; Healthcare Hellman & Friedman announced, compared with 272 during Holdings the previous quarter and 232 in the equivalent period last year. However, WME IMG Holdings; the value of the deals – and hence the Silver Lake Group; 4 Ultimate amount of capital being returned to KKR; Fighting LPs – has slowed only gradually. MSD Capital Champ. In Europe, Britain’s vote to leave the
EU provides a clear culprit for slowing Energeticky a Prumyslovy dealflow. “If we look at our global Holding as EPH; 3.8 PPF Investments Vattenfall pipeline for processes that are going to launch in Q4, then the UK is definitely under-represented,” says Stewart Apex Technology; Legend Capital; 3.6 Lexmark Licudi, head of European financial PAG Asia Capital Intl. sponsor coverage at William Blair. Manish Shah, a senior managing Boyu Capital Advisory; director in FTI Consulting’s Sequoia Capital China; 3.6 transaction services group, adds: “Some Hillhouse Capital Management Autohome of the deals we have been working on have been put on pause until the
3.6 Vestar Dealogic autumn. But there is no suggestion Sun Capital Partners that they won’t be resurrected after the Products
summer.” Source:
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 15 on the record • TPG CAPITAL
Diligent dealmaking In a sellers’ market, in-house counsel at private equity firms are at the forefront of negotiations as deal terms evolve. Adam Fliss, deputy general counsel at TPG Capital, explains the current M&A pinch points, and how his team is adding value
How are the current market the insurance solution has directly conditions, with high prices impacted our ability to close a deal. favoring sellers, having an impact Does a large asset manager such as on negotiations and deal terms in TPG seek to impose standard deal M&A? terms when entering transactions It is a sellers’ market, and that worldwide? means that as a lawyer on the buy I wouldn’t say that we start from the side you have to be really careful to beginning each time, but it is also stay disciplined. Whether you have important that we realize that we are concerns about a business or about dealing with bespoke transactions. In risk, you may lose out and somebody other words, you can’t anchor to what Fliss: You have to come to else may prevail because the pricing you did before because what if it’s not each transaction with a or the risk allocation has simply got appropriate for this transaction? So fresh perspective to a place where you’re no longer you have to come to each transaction comfortable. You have to constantly with a fresh perspective. challenge your judgment as to what It’s more about giving honest terms really matter. advice to our clients, employing Representations and warranties judgment and making collaborative insurance is a real push point at decisions as a firm about risk. the moment when it comes to negotiations. That insurance has How is the TPG legal function been prevalent in Europe and structured so as to maximize emerging markets for some time, support to the deal teams? but it’s increasingly becoming a We have aligned our legal team standard topic of discussion in with TPG's business units, so there M&A transactions with private are lawyers who are dedicated equity sponsors on the sell side. The transactional lawyers for each of sponsors are increasingly offering our platforms. That model has two no post-closing cover on reps and principal advantages over relying warranties, and instead they are solely on outside counsel: the internal saying to buyers, “If you want that lawyers are both more familiar with cover, go buy it from an insurance their clients' business and more company.” available, because they are sitting That’s an area where our legal team within the walls of the firm. has taken the lead and developed, Our lawyers are an embedded directly with large insurers, the part of the transaction team, so they technology and learning to help work closely with TPG's investment our teams utilize the product where committees, deal teams, and other appropriate to get deals done. I can areas of TPG, to become very well think of at least two situations where integrated into the business.
16 private funds management • DELIVERING GROWTH • September 2016 on the record • TPG CAPITAL
Where are the biggest opportunities for be required. You can no longer make a We are in a very high-price the legal team to add value on M&A decision in a vacuum, and then think environment in the US right now and transactions? about filing in China and then what to a lot of people are trying to sell assets, We are far better positioned to tailor due do in the EU. Those decisions have to at a time when there is also good diligence and terms than outside counsel be made very early on and considered availability of debt financing. So the alone, to achieve a competitive advantage together now, not one at a time, and can prevalence and volume of buyouts, in M&A. We scope the due diligence on add significant uncertainty to the deal. minority investments, SPACs, PIPEs every single deal, and integrating our law I spend a lot of time monitoring (private investments in public equity) firm partners stategically, tailor the work enforcement trends, and how exposed and carve-outs is being influenced by plan to the particular business. We spend we are to those trends. I’m looking high equity markets and availability a lot of time making sure we have very at businesses for us to invest in in of debt. When the business cycle bespoke diligence for each transaction, the US that have significant overseas turns over and asset prices come and that’s a competitive advantage down, you might see more PIPEs and because it allows us to spend the majority more minority investments, to reflect of our time on the issues that are most I spend a lot companies’ needs for capital. relevant to the deal, allowing us to be of time monitoring Nasdaq has been considering some more efficient with our time and more reform of the rules around PIPEs, so we efficient for the target company. For enforcement trends, will see if the exchanges start adopting example, we want to use our potentially and how exposed we a more flexible view for private investors limited time with management to ask in public companies, though I don’t the highest impact questions we can ask are to those trends expect a great deal of movement. based on our investment team's goals and objectives as oppoosed to merely going operations, and I’m looking very early Finally, how do the legal issues that through a law firm's standard "legal due on at the merger control risk. You can’t you encounter on M&A transactions diligence checklist." underestimate the US aspect – the US vary across the many jurisdictions in I like to think we are "thought partners" antitrust environment right now is very which TPG is doing deals? in developing effective governance, where hard to predict, as both the Federal Going back to due diligence, if you we are partnering on a transaction with Trade Commission and the Department are looking at investing in a business a management team or entrepreneur, of Justice have been blocking a number that has significant operations or touch or where we are putting two businesses of deals and taking an assertive points in high-risk countries from together. On the legal side there’s a lot stance. That has a tremendous impact either a sanctions or an anti-bribery we can do in that situation to deliver on our business, and as we evaluate perspective, then you have to be really innovative technology. For example, we strategic combinations, our investment careful to do a thorough due diligence worked on a transaction where we were committee is very focused on antitrust exercise. partnering with a non-profit, which was risk. Certainly if we are on the sell side, You need to document everything very complicated on the governance side. selling to strategics, that is one of the very you do in terms of due diligence, and We have since been able to leverage that first things we think about. then your follow-up, because if you technology on other deals to get to better own that company you have to show agreements with our partners. What are you witnessing in terms of that you are monitoring anything trends on deal structures? that you think should be remediated How is globalized merger control having Special purpose acquisition companies or improved. You have to watch the an impact on costs and considerations (SPACs) have been around for a while but company, check in, and talk to the in cross-border M&A? they seem to be taking on momentum, management team to show that you Global antitrust regulators are and coming up more and more. They understand what is happening. increasingly co-ordinated and the provide investors with liquidity for certain While these are best practices in any enforcement dynamic is very active, types of transactions where private equity investments, if you’re in a high-risk which leads us to think much earlier has traditionally lacked liquidity, so I can jurisdiction, you absolutely have to about where in the world approvals might see the appeal for investors. focus on it.
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 17 expert commentary • TECHNOLOGY
of automation priorities: deal and portfolio management, finance operations, investor relationship management, and supporting functions. Capabilities in green tend to be key investment focus areas for smaller firms but are often already automated in larger, more mature firms. As a private equity firm grows in maturity and complexity, we see a shift in focus to more of the priority one and priority two capabilities, namely in finance, reporting, and enterprise solutions. Over the next one to two years, we expect to see these trends emerge: • Smaller firms are likely to invest in automating foundational capabilities, including fund and partnership accounting, portfolio group Life beyond spreadsheets management, and investment (deal) In today’s pressure-filled market, private equity firms need to management; • Mid-size firms will be prioritizing invest in more advanced technology solutions. Luckily, IT is their technology efforts to automating becoming more affordable and easier to implement than ever, capabilities within their operations, writes Deloitte principal Roland Waz investor relations, fundraising, and relationship management. • Large firms may be eyeing next- lowing growth, heightened technology applications, five key trends generation digital solutions that help regulatory pressures, increased are putting pressure on private equity enable business transformation. Among competition, and greater investor firms to invest in advanced technologies targeted capabilities are regulatory, Sdemands are putting pressure on private (see table on p. 20). The key question investor, and management reporting, equity firms to transform. In the past, is: How do firms strategize, prioritize, enterprise-level business intelligence general partners’ limited investments and select the key areas to focus their (BI), content and document in information technology solutions technology investments? management, workflow, and robust didn’t seem to put a drag on their ability In our work with private equity firms, finance management. to deliver above-market returns. But we typically advise clients to evaluate in today’s environment, private equity three areas before making IT investments: In general, while each firm’s technology firms can’t skate by on offline, outdated, 1. Current technology infrastructure investment strategy will vary depending or siloed point solutions. They need maturity; on its business priorities and existing to start thinking about technology as 2. Business model complexity – firm technology infrastructure, Deloitte has a competitive advantage and tool for size, number of funds, geographic been seeing private equity firms focus enabling growth, not just as a cost center. footprint – and executives’ strategic their investments on: Firms that continue to under-invest in vision for the firm; • Modernizing core applications to technology will be challenged to grow 3. Unique regulatory and investor support opportunity and deal tracking, and sustain returns, meet investor and pressures. portfolio company data collection and regulatory expectations, and manage analysis; operational risk. While many firms (with Firm size and complexity also influences • Cloud HR and finance solutions, the exception of the mega firms) thrived technology investment strategy. The chart including reporting improvements; for years with minimal investments in opposite outlines the four broad categories • Investor portals, including support
18 private funds management • DELIVERING GROWTH • September 2016 expert commentary • TECHNOLOGY
Automation priorities for PE firm
Investment (deal) management Portfolio group management Research/ Controls/risk Financial Financial Exit Performance Deal Pipeline Staffing Due Deals and portfolio sourcing management diligence analysis management reporting restructuring strategy attribution
management Modeling/ Loan Deal Deal Deal Operations Talent Returns Portfolio valuation structuring structuring closing monitoring consulting acquisition analysis analytics
Fund and partnership accounting
Contributions/ Investor Feel/carry Gain/loss Pricing/ Cash/wire distributions allocations processing Ledger allocations valuation management
Management company finance Finance Tax Payroll Cash General ledger Financial stmt. Budgeting/ Strategic operations management preparation forecasting planning
Reporting Regulatory Performance Management LP reporting reporting Analytics/Report Tax reporting reporting
Relationship management
Interaction Contact LP requests & Co-investment Communication Marketing & Investor LP portal management management servicing mangement management business dev relationship management Fundraising Consultant Investor relationships LP management onboarding
Enterprise solutions Supporting Legal/ Business Collaboration Content Document Workflow HR functions compliance intelligence management managemen
Typically automated Typically manual - continues to stay manual Priority 1 Priority 2 Target for automation / improvement
for data integration and reporting enable seamless data integration and business user-friendly, requiring smaller capabilities; connectivity to provide consistent views of IT teams for maintenance. • Big data analytics platforms to support information, superior service and modern The key to getting the most value out all aspects of the business, including digital experiences for investors, and of technology investments is to make research, deal valuation and portfolio advanced analytics to support strategic sure they are aligned with business company operational optimization. business needs. strategy. To drive alignment, firms should The good news is that the cost of develop a technology roadmap that lists To scale operations to meet growth or ownership for these technologies has required investments; factors in evolving expansion objectives and to manage dropped significantly in recent years due regulatory requirements and industry increasing regulatory and investor to technology advances such as cloud trends; considers the firm’s appetite for demands for information, firms should Software as a Service (SaaS). The cloud change; and includes a proactive approach consider investing in technology solutions has become a true technology disruptor, for addressing risks. such as cloud-based HR and finance especially for the private equity industry. The first step when developing platforms, performance management Cloud solutions’ licensed subscription the roadmap is to clearly establish solutions, and modeling and analytics model offers a lower-cost and shorter- the technology program’s vision and solutions. time-to-market alternative to traditional objectives. This will help the program Private equity firms seeking to quickly on-premises solutions. Another factor team prioritize the functional areas that scale up their IT infrastructure should driving down cost is that many of today’s require technology investments. For consider technology solutions that solutions are highly configurable and example, firms aiming for operational
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 19 expert commentary • TECHNOLOGY
efficiency and cost reduction should A firm’s appetite for change may change management efforts into the focus on building a solid foundation of impact the sequencing and speed of roadmap is important. core capabilities such as partnership technology initiatives. Mid-sized or The roadmap also should consider the accounting, investor portals (document smaller firms may hesitate to take on evolving industry environment. The firm distribution), and pipeline/deal tracking. large technology programs owing to may have to prioritize initiatives to meet Once the foundation is in place, firms limited resources. Another consideration regulatory requirements and/or protect should evaluate and prioritize more is new technology’s impact on business against potential risks over those that may sophisticated solutions that can deliver a processes and the firm’s ability to help provide better return on their technology competitive advantage. users manage the change. Embedding investments. As firms undertake these large technology programs, they should give special consideration to addressing cyber risks. For example, the roadmap What’s driving tech investments? should include implementing robust information security procedures and technologies to counter cyber threats and 1. Increased competition for deals manage confidential data or competitive Implications Technology response intelligence. • Need to compete for deals globally • Data integration to provide unified Last but not least, the roadmap should views across due diligence teams • Need for differentiated due diligence processes clearly outline the benefits or value • Advanced analytics to unlock deal Need for next-generation analytics for complex • value (market sentiment analysis, achieved from each initiative. deals advanced modeling)
2. Renewed focus on generating operational value What’s next for PE firms? Over the new few years, the PE industry Implications Technology response will see more firms move away from • Ability to analyze large amounts of data to • Advanced analytics (data- and identify operational improvement levers information-driven optimization manual, offline solutions and invest in and value-generation) • Ability to analyze data across multiple portfolio robust, modern technology, especially as companies in the same sector investors and regulators demand improved transparency and responsiveness, 3. Growth and global expansion deals become more competitive, and Implications Technology response growth continues to slow. Combined • Need to scale operations to support global • Cloud platforms and applications with the rise of digital and cloud-based footprint and varied investment strategies platforms that offer lower costs and easier • Need for increased transparency across business units/locations implementation, the opportunity cost of not investing in IT technology solutions 4. Investor demands for information and transparency may be significantly higher than the Implications Technology response actual cost of implementation. Already, • Manual reporting processes are no longer • Next-generation investor first movers are capitalizing on increased sustainable reporting solutions (mobile, self- service) efficiencies, reduced costs, and enhanced • Data consistency and accuracy becoming paramount for daily/weekly reporting (as • Data integration and reporting competitiveness. It’s time for their peers opposed to monthly/quarterly reporting) providing more frequent, to get with the (technology) program. consistent reporting
5. Regulatory pressures
Implications Technology response Roland Waz is a principal in • Process automation and controls (reduced • Cloud platforms and applications reliance on Excel) Deloitte Consulting's financial • Cyber security • Improved reporting capabilities services and technology strategy • Investment in operational risk management practices
20 private funds management • DELIVERING GROWTH • September 2016 Want total coverage of the private equity markets?
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Subscribe today at privateequityinternational.com on the record • THE CARLYLE GROUP
Maintaining tax neutrality is becoming harder Shannon Stafford is managing director and head of tax for The Carlyle Group. She talks to pfm about tax risk, BEPS and the most dramatically changing tax landscape in a generation
Do you feel the private funds however, challenges to an endeavour industry has become less aggressive, like this. BEPS was designed to more conservative in its approach to prevent multinational companies tax risk? creating structures to exploit different We are managers investing on behalf countries’ rules. of our investors. For this reason tax A lot of multinational businesses neutrality is a very important concept: – and BEPS was created with one by which we have to live. Our multinationals in mind – have taken approach is that if our investors – advantage of different structures and many of which qualify for various tax rules. But while the OECD’s cause is exemptions – could have made similar noble, the challenge here is that each Stafford: Every time the law investments directly without incurring country may well implement these changes, it causes you to any tax, then we need to ask how we rules differently. Thus an exercise look at how you structure your activities can accomplish this in our structures. that was intended to ensure rules Our investors should philosophically are consistent could well result in a pay only the tax that they would have situation that is not vastly different owed if they invested directly; part to the one we started with, in terms What we of our job is to ensure that this is the of allowing egregious, aggressive tax currently see is case. That’s how we think of it. structuring. The concern for us has always probably the So has maintaining this tax-neutral been that we are investing as a fund most dramatically position become more difficult? with the goal of tax neutrality. It has. And it will become more difficult BEPS, meanwhile, is written for changing tax as time goes by, given initiatives such multinational corporations… things landscape I have as BEPS [the OECD’s global initiative like treaty provisions, country-by- to prevent base erosion and profits country reporting… these have left a seen in my entire shifting], which is currently being lot of people in our industry scratching tax career implemented at a local territory level. their heads. Elements like the ‘principal purpose test’ and ‘limitations on benefits’ rules What is your assessment of the effect as part of application to benefits under of new rules relating to interest a double tax treaty are giving us plenty deductibility – stemming from BEPS to think about. action four – on Carlyle’s business? We have worked with our teams to BEPS is such a wide-reaching analyze the various effect of debt- initiative. Should it be welcomed by equity and interest deductibility the private funds industry? rules on our portfolio companies in Philosophically, I would say ‘yes’. the relevant territories. Additional Ensuring that companies are doing guidance was recently issued on the the right thing and not avoiding tax ‘group-wide’ rules, which is another is a noble, worthy cause. There are, example of where BEPS actions are
22 private funds management • DELIVERING GROWTH • September 2016 on the record • THE CARLYLE GROUP
difficult to fit to the private equity fund model. What exactly constitutes Advisor view the ‘group’ for the purposes of the debt-equity ratio? Is the portfolio “If you look back a few years, BEPS and the related country- corporation deemed to be a portion of by-country reporting started largely because certain the group related to the fund? global corporations were perceived to be avoiding tax through basing subsidiary companies in various tax So what was your assessment? Do efficient locations,” says Doug Puckett, deputy national interest deductibility rules have tax leader for private equity at Deloitte. “They typically a significant impact on portfolio have a lot of subsidiary companies but they are all ultimately controlled companies? from the top: one board controlling the entire group. It’s early stages, and there is an awful “With respect to certain of the BEPS-related reporting requirements, lot of detail still to be ironed out and a concern is that private equity may be treated by various countries’ considered, but there will certainly tax authorities in much the same way – as one consolidated group. be some effect. Will it be material? I At its heart though, private equity is investing rather than operating don’t think so overall, but may be for and its portfolio of investments at any particular time is generally an a particular portfolio or jurisdiction. unrelated mix of companies. Thus, you cannot gather information from these investee companies and get them to report in the same way that Tell me about your role at Carlyle. a corporate group can get its subsidiaries to report.” I am the managing director of global tax and my team’s responsibilities cover everything related to our investors, funds and transactions. And what were you doing before Tell us about the changing tax We have a team of roughly 30 people joining Carlyle? landscape: any changes that looking at issues around the world I spent about 30 years at PwC and particularly stand out? relating in some way to tax. My public accounting, before joining At the moment every country is focus at any one time depends on Carlyle about two years ago. changing its tax laws. The UK, the underlying businesses at that for example, is among the most point and which of the businesses are Tax is an emotive and highly dramatic: carry tax, non doms… not most active and whether any specific politicised subject. For example, to mention Brexit. The UK has been tax issues are coming to light. Much carried interest is a frequent target keeping me and our teams very busy. of my time is spent advising on the for politicians on the campaign trail FATCA and CRS… the list goes on structuring between the funds and the and offshore structures are often and on. portfolio, as well as monitoring the villainised. As head of tax, do you changing legislative landscape globally have to get involved in lobbying So finally: what about Brexit? As – identifying structures that, for efforts for Carlyle to ensure a global firm with a presence in example, may no longer be workable. lawmakers and the general public London, have there been discussions Every time the law changes, it causes understand the firm’s position? about relocating the London you to look at how you structure your We certainly have a regulatory affairs personnel to a different European activities. For example if you look at the team here and my team works closely hub? recent changes in Asia (India, Korea, to provide any support they need.. Of course we have thought about Australia, etc) and Europe (Anti Tax What we currently see is probably it… not just from a tax perspective, Avoidance Directive, Luxembourg, the most dramatically changing tax but for regulatory reasons. Nothing UK, etc), these are examples of landscape I have seen in my entire is imminent in terms of changes, things that would potentially cause tax career. I am not a lobbyist by and it would be difficult really to us to explore different structures trade, but I try to provide some say where our European when making investments in those relevant input into the discussions headquarters really is… we are in a jurisdictions. via our team. lot of places.
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 23 analysis • STRATEGIC PLANNING
Growing pains (and how to avoid them) Rapid growth brings a whole set of new challenges for GPs. David Turner asks experts for their tips on how to scale up successfully
any a private equity placement agent MVision. There tend do? What do partners do and what do firm has foundered after to be three points at which a firm you do to qualify to be a partner? They suffering fatal growing changes and the business model and also need procedures. Everything that Mpains: the problems that come with governance must be reconsidered: happens has to be documented, and rapid growth or sudden success. Pfm when it reaches about 35 people, 75 the firm has to know the answers to has gathered some top tips from people and 150 people. Institutional questions such as: what if somebody experts on how to ensure that scaling innovation is required. On a broad makes a very big mistake on a deal? up a private equity business doesn’t level, management needs to have sacrifice its core strengths. The key is to a very clear understanding of the Create a focused vision keep the good habits of smaller firms, composition, responsibility and We look for private equity while developing the sophisticated development of the team. Everyone 2 funds that have a focused structures and processes of the bigger needs to know what the firm stands vision and defined strategy – one players. It can be a complex task. for and what its business model is. On that the general partner keeps to a procedural level, bigger firms need even as its fund sizes grow, says Prepare for growth a huge infrastructure: HR, internal Vicky Williams, senior investment The business model andlegal and internal compliance, for director at Cambridge Associates, an 1 governance must be ahead of example. They also need a clearly investment advisory firm. Too often, growth, not behind it, says Mounir defined hierarchy: what does an we see fund managers that have Guen, chief executive of fund analyst do? What does a vice president developed an impressive track record
24 private funds management • DELIVERING GROWTH • September 2016 analysis • STRATEGIC PLANNING
in the small or mid-size bracket Balance speed with good move into larger deals as they raise governance We are wary ever increasing pools of capital, and 4 Private equity is much of fund managers then struggle to replicate their earlier less cumbersome than some large success. This might be because of institutions, but growing firms still that grow assets increased competition, or because face the challenge of how to maintain under management they have to pay higher entry prices the speed of decision-making and in a more intermediated, efficient execution, while ensuring the too quickly market. A larger fund size is not investment committee is as well- necessarily a bad thing – our research informed as when there were just shows that funds with more than a few directors, says Jonny Myers, Travers, director of alternative $1.5bn have lower capital loss ratios global head of private equity at law investment funds at SEI Investment than sub-$500m funds. But we look firm Clifford Chance. Manager Services. These systems for managers that can deploy capital The investment committee needs cannot cope with the increased at a sensible pace and typically with to retain its investment rigour but volume of investment strategies, the same operational improvement accept that more of its working week investor demands and regulatory strategy. This is a playbook for is tied up with investment decisions, requirements. transformation that works for all because more things will be presented To retain competitive advantage, kinds of companies, big and small. to it – often at short notice. It also private equity firms need to adopt has to ensure that it gets to see the and integrate new technology for the Learn to say no potential investments at a number of next stage of growth in areas such as There is great pressure to stages, so that it has the opportunity investor relations, data management, 3 extend fundraises to new to examine them properly. portfolio-company monitoring and investors, with significant interest in regulatory reporting. Private equity private investments from investors Keep up the conversation firms that can use these to build in the Middle East and Asia. But we Growth poses a a scalable and flexible operating are wary of fund managers that grow 5 communications challenge, platform will be better placed to deal assets under management too quickly, says Myers. Expanding into new with the evolving fund-raising and says Williams. For example, if a fund regions, opening new offices or investment landscape. manager were to double its fund size increasing the product range means in the space of one funding cycle – you have to work harder to maintain Look at what you can three to four years – alarm bells would staff communication. To do this, outsource start to ring. Such dramatic growth you must ensure that you encourage 7 As private equity firms look to raises questions about asset gathering an ethos of individual contribution expand, they should consider whether and fee structures (is it motivated by to team discussions. And the debate to invest in the technology and management fees rather than carried needs to be wide and open, especially staffing resources to handle the greater interest?), team stability (does the within the deal teams, to avoid simply compliance requirements and greater manager have the right number with following one individual on the team reporting demands from investors, or the right capabilities going forward?), like sheep. to outsource to a third party service legacy portfolio workload (because provider in order to reduce operating the team is heavily occupied with a Embrace technological costs. Outsourcing can also offer large new fund while trying to deal innovation value-added opportunities including with old commitments as well) and 6 Growing private equity firms independence, access to the expertise strategy drift. When a fund manager tend to find that their myriad front, of external staff and improved cannot adequately answer these middle and back-office systems and technology, says Alan Flanagan, questions, it is better to say “No” to service providers are no longer capable global head of private equity and new investors—however tempting it of meeting client service, investment real estate fund services at BNY is to say “Yes”. and operational needs, says Giles Mellon.
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 25 on the record • KKR
Responding to the regulatory environment The SEC’s increased focus on private equity is forcing GPs to embrace a whole new level of compliance, says Bruce Karpati, KKR’s global chief compliance officer
How has the role of chief compliance on these issues as it relates to investment officer at private equity firms evolved advisors, especially since the financial in recent years? What are some of the crisis. The new development is the challenges that CCOs are facing? increased focus on private equity The role of CCO at private equity firms as the industry evolves from small has evolved significantly, as compliance partnerships to larger financial services has become more institutionalized, firms. That evolution has created a real bringing a new level of transparency need for processes to mitigate risk and and process to the industry. The enhance alignment with investors. At financial crisis and the subsequent the same time, the SEC has developed SEC prioritization of private funds has specialized expertise and enforcement Karpati: Ensure you cover placed growing pressure on firms over to scope out emerging issues, especially your bases ahead of an the last five years to institute stronger over conflicts of interest. SEC exam compliance. Private equity managers The SEC has the mandate to regulate have placed a priority on ensuring they investment managers of all stripes are complying with their regulatory – whether mutual funds, registered obligations. investment companies, hedge funds, Today, there is an expectation in or private equity firms. To ensure these private equity that CCOs have a seat at managers are complying with their the table and that they are effective in fiduciary duty and acting in the best their job. CCOs should be involved in interest of investors, the SEC looks at all the governance of their organizations types of potential conflicts of interest. and part of a firm’s decision-making In private funds, key ones to consider process, including its core committees. include fees and expenses, affiliated The challenges CCOs face are service providers and allocations. impacted by regulatory obligations. This is a natural evolution of how Firms are under a lot of regulatory the SEC examines investment advisors, requirements and need to cover a especially given the criticism of the PE lot of ground. To do so, CCOs need industry for lack of transparency and adequate resources, but first they need its approach to investors. At KKR, the backdrop of a strong compliance we have made every effort to make culture at the firm, offering the sure we’re aligned with investors. necessary support so they can run their One recent example is the adoption programs effectively in every business of the Institutional Limited Partners and region. Association’s (ILPA) reporting template which provides for detailed Why has the SEC focused so much fee and expense reporting. attention on conflicts of interest and on fee and expense allocation and What are some of the best practices documentation in its reviews? when it comes to conflicts of interest? The SEC has always focused attention Firms must have a mechanism in place
26 private funds management • DELIVERING GROWTH • September 2016 on the record • KKR
for identifying conflicts of interest and Establishing the right relationship is there must be adequate disclosures of extremely important so make sure you There are an those conflicts, including fees and have the right people interacting with astounding number expenses, in documentation with the exam staff. You need to appear investors — for example, within a credible, and the exam staff need to of regulatory private placement memorandum, understand their points of contact and Form ADV, or in discussions with know that your team is responsive to obligations – any of LPACs. Firms must also ensure their concerns. which the SEC can they’ve developed sufficient policies And cover all your bases. There are and procedures, and that they are an astounding number of regulatory come in on carrying these out once a potential obligations – any of which the conflict has been identified. SEC can come in on, including Looking ahead, I believe compliance co-investments, fees and expenses, functions and increasingly compliance in the private equity industry is cyber security and anti-corruption officers are playing a role in due heading towards more technology and efforts. You need to make sure you diligence sessions. LPs want to make automation which can demonstrate have the right policies and procedures sure there is a culture of compliance appropriate documentation and audit for each of these, and be able to from senior management down to the trails. We are in an environment demonstrate these processes. most junior level. There is an emphasis where PE firms are transitioning from on transparency, as demonstrated by purely reacting to areas of concern to How can GPs best learn from recent the growing acceptance of detailed being proactive in identifying – and SEC enforcement actions? How has fee and expense reporting such as the preventing – issues from arising. the PE industry responded to these ILPA template. actions? LPs also want to be sure that GPs What are some of the SEC’s main SEC enforcement actions are case have sufficient resources to handle concerns regarding co-investments? studies on what can go wrong and, the complexity of compliance needs, These are similar to its concerns over therefore, how to act. These are great as well as the proper procedures in conflicts of interest. They want to opportunities to understand the place to address them. Finally, LPs make sure investment managers have current regulatory issues, and how to are interested in seeing that firms are a policy and process on how they respond to these issues. evolving their compliance programs handle co-investments, one which The private equity industry has been for future market or regulatory risk. has been communicated clearly to very active in responding to these Compliance is increasingly a very investors and has been executed on. issues through enhancing compliance, important consideration in an LP’s Of course, there are different types putting policies in place, and ensuring decision on whether or not to invest of co-investments to consider, but the message of alignment with in a fund. If there are vulnerabilities, ultimately the SEC wants to see investors emanates throughout the LPs will question whether or not to that managers are carrying out their industry. As the role of compliance invest. responsibility as a fiduciary. continues to evolve, part of the agenda must involve how you address issues As the CCO of a private equity firm, What are your top three pieces of of regulatory concern and ensuring what are you most focused on? advice for GPs going through an you can effectively deal with new I am most focused on making sure our SEC exam or preparing for an exam? regulatory issues. stakeholders are appropriately satisfied Preparation, preparation, preparation! with how we’re handling their issues. How prepared is your firm and the What compliance issues are LPs On a daily basis, we need to make sure specific individuals who are going typically interested in when doing due we are acting in the best interest of our to participate in an exam? I strongly diligence on funds? How important LPs, meeting the expectations of our recommend mock exams and making is compliance in their decision? outside stakeholders, and addressing sure your people understand how the There is clearly a high-level of interest any concerns our regulators might exam process is going to work. by due diligence firms on compliance have.
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 27 news round-up • REGULATIONS
The world of UK Disclosing investor information compliance Britain signed agreements with Crown Dependencies and Overseas Territories (CDOT) From the US to Australia, under the UK version of the Foreign Account Tax Compliance Act. Funds domiciled in crown a wave of new regulation is dependencies such as Gibraltar, Isle of Man, Jersey and being felt across the private Guernsey are required to disclose information on UK investors for the calendar year 2015. The agreements mean equity industry that UK-domiciled funds must also report on investors from CDOT countries.
CALIFORNIA Increased transparency rules California proposed a bill that would require public pensions to collect detailed information on fees paid to the private equity funds in which they invest. These include fees charged directly to limited partners, such as state pension funds, and those charged to the fund’s portfolio companies. The proposal would apply to fund agreements set to begin in 2017 and would require that the collected data be publicly disclosed at least once per year at an open meeting.
NEW YORK Closing the carry ‘loophole’ The state of New York proposed a bill that would raise taxes on state residents who benefit from the so- called carried interest ‘loophole’, which allows fund managers to pay a significantly reduced federal tax rate on much of their income. The bill has been introduced following a campaign by a coalition to close the loophole and will offset the tax savings received at the federal level.
LUXEMBOURG Easing AIFMD fund rules The Luxembourg THE NETHERLANDS Parliament approved the introduction of the Private equity reforms Reserved Alternative Investment Fund (RAIF). RAIFs The Dutch Labour Party proposed differ from Luxembourg’s specialised a green paper outlining a 12-point investment funds in that they can be reform plan in an attempt to launched without the approval of the state increase scrutiny on the private regulator, the CSSF. Instead, supervision equity industry. The proposals put will be placed on the management firm, forward to the Dutch parliament which is still subject to the Alternative include limiting the tax deductibility of Investment Fund Managers Directive. interest payments, evaluating rules around The RAIF law will come into force three fund manager responsibility and expanding the days after publication in Luxembourg’s rights of works councils. Official Gazette Mémorial.
28 private funds management • DELIVERING GROWTH • September 2016 news round-up • REGULATIONS
ITALY & GERMANY SOUTH KOREA Relaxed lending rules Welcoming retail investors Both Italy and Germany introduced rules to allow international debt managers to make direct After South Korean lawmakers loans. In Italy, European alternative investment made it easier for managers to funds will be entitled to originate and make loans to raise funds in the region last year, Italian companies and for real estate deals. Germany’s the Financial Services Commission new rules allow both domestic and international private funds now plans to allow the public to authorized under the Alternative Investment Fund Managers invest in funds of funds that will make Directive (AIFMD) to make loans in Germany without a banking investments in private equity funds. The proposal will license. The rule only applies if fund managers based outside of the allow individuals to invest a minimum of 5 million won European Union are AIFMD compliant. ($4,200; €3,700) in a private equity fund, which could account for up to 20 percent of the private equity fund’s total value.
CHINA Impact of the five-year plan All eyes were on Beijing’s plans for the economy this year and what the country’s 13th five-year plan, finalized in March, would mean for local businesses and foreign investment. The plan included suggestions for the gradual liberalization of foreign investment, including the eventual implementation of national treatment for domestic and foreign investors prior to entering the market, known as “pre- establishment.” It also called for a unified foreign and domestic investment system and highlighted the need to formulate “basic laws” for foreign investment. Other proposals included expanding market access for foreign companies engaged in banking, insurance, securities, and pensions.
AUSTRALIA Tax incentives for early stage investors The Australian government has introduced tax incentives for startup investors which will provide concessional tax treatment for investments in new companies with high growth potential. The tax incentives aim to help offset some of the high costs faced by potential investors SOUTH AFRICA and startups. This in turn will increase the level of equity investment in new firms. Reducing regulatory burdens The South African government announced plans to reduce the regulatory burden for investors. INDIA Pravin Gordhan, the finance Easing compliance burdens minister, left, said the government’s intention was to address institutional The country’s tax department said the amount and regulatory barriers to business received on buyback of shares between 1 April 2000 investment and growth, and the need to put more and 31 May 2013 will be taxed as capital gains and not effort into sectors and industries that have competitive dividends in the hands of the recipient. This decision advantages. The reduction is expected to help attract is part of a wider initiative to reduce litigation and ease foreign and local private equity investment into the the burden of compliance. The Central Board of Direct economy, according to the South African Venture Taxes has made a number of recent decisions to clarify the Capital and Private Equity Association. applicability of various provisions of the Income Tax Act.
September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 29 profilexxxxxxxx • DELOITTE • XXXXXXXXXXX
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September 2016 • DELIVERING GROWTH • privatefundsmanagement.net 31 profile • DELOITTE
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32 private funds management • DELIVERING GROWTH • September 2016 13297 Private Market Fundraising Advert_Layout 1 11/10/2013 16:42 Page 1
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