May 2016

FUND ADMINISTRATION: Paying for hybrid vehicles

Hybrid carPrivate equity real estate or PERE funds are growing in popularity, but a drive for more transparency could create avoidable costs. Nicholas Pratt reports. The word ‘hybrid’ should normally set alarm bells ringing, particularly if it is prefixed with the word ‘jazz’. Similarly, no one wants to see the word hybrid on a menu, as it is usually a code word for many random leftovers thrown together in a dish based on hope more than taste. The financial world has an equally poor record of pushing out hybrid vehicles – for example, the string of products based on a cocktail of toxic debts that precipitated the financial crisis.  But some of the hybrid funds proving so popular at present have been demanded by investors, and less so pushed out by fund manufacturers.  Of particular interest are real estate private equity funds, an asset class usually referred to as PERE.  Both the component asset classes have obvious benefits of their own. For example, real estate assets can not only generate high returns for investors, but also help finance property portfolios and generate cash for new projects. Additionally, the long-term investment horizon of real estate is attractive to institutional investors looking for more secure returns.  It is a similar story with private equity funds. A recent Goldman Sachs Asset Management survey showed that global insurers will be increasing their allocation to this asset class and they expect private equity to produce the best returns over the next year-and-a-quarter.  NOT ENTIRELY NEW
The trend for combining private equity and real estate funds is not entirely new, says David Bailey, managing partner at specialist administrator Augentius. “It is a model that works for the investors that use it. You are only committing cash when you need to, which is helpful considering the illiquidity of the asset class.” For example, says Bailey, hedge fund structures that have frequent redemption periods (ranging from every month to every three months to every six months) do not work for property assets. This is due to the illiquidity of the underlying investments, unless the fund retains cash to cover any redemptions. Overall, though, there is a comfortable fit between private equity and real estate funds, says Bailey, which makes these funds relatively economic to administer.  “The underlying assets are different but the general accounting and administration principles are the same – the main difference being the interface with the property managers.” However, the administration could become more complex and costly as a result of an ongoing drive for greater transparency, exemplified by the Institutional Limited Partners Association (ILPA) guidelines on fee reporting, launched in January 2016. The guidelines came as a result of disquiet among pension funds and other large US investors about the level of management fees charged by some private equity fund managers and which resulted in a number of investigations by the Securities and Exchange Commission.  TRANSPARENCY COSTS MONEY
While there is a need for many private equity managers to be clearer about how they derive their income, both they and real estate funds are “as transparent as any fund I know”, says Bailey. For example, the underlying assets are clearly visible to investors, certainly more so than other securities-based fund structures, he says.  One implication of the drive for greater transparency is that there will be greater reporting burden and a higher cost. The challenge for the industry, says Bailey, is to ensure that the cost is minimised and the amount of useful and practicable information produced by reporting is maximised. “We want to live in an open world, but transparency costs money. The deeper the data dive, the greater the information that has to be obtained and maintained. It is imperative that the right information is collected at the outset, in the right quantities, and maintained effectively so that costs are properly managed.” Although the ILPA guidelines demand more regular and granular reporting, at least they provide a standard template, something that is welcomed by some administrators.  “Transparency on fees demands simplicity and visibility,” says Alan Flanagan, global head of private equity and real estate fund services at BNY Mellon. “To this extent, industry bodies such as ILPA and their recent publication of a new fee-reporting template that looks to standardise the presentation of fees and expenses goes a long way in the right direction in delivering on these transparency requirements. [That which] benefits investors as a whole will ultimately benefit the broader industry.” There are costs associated with transparency – but also value, depending on how efficiently funds are run, says Miranda Lansdowne, fund services director at Jersey-based fund administrator Crestbridge. Specialist administrators will also have to develop a hybrid model for their servicing – one that combines the uniformity of automation with the flexibility to provide ad-hoc reporting based on individual clients’ demands. This approach is paying dividends in terms of winning clients, some of which are not buying into the notion that more transparency and more reporting are obligatory, says Lansdowne. One of these clients has actually reduced the amount of reporting it produces because it does not feel all of it is necessary.  “I think we will see a shift in PERE funds. Yes, transparency helps you to achieve compliance – but ultimately it should be about what value that information provides to the fund and its investors. I think there is more consideration about whether all of the reporting is appropriate and meets investors’ expectations.” PRIVATE ARRANGEMENTS
Lansdowne adds that, generally, the market trend is for more reporting, but awareness of the distinction between information and intelligence will become more important in the PERE world. “Investors will look more closely at the structures and whether risk is being adequately reported. And it may be that more sophisticated investors will look for more private arrangements with funds, almost like a joint venture that reflects their demands.” It is inevitable that PERE funds will be subject to more transparency as they come up to speed with other asset classes. Overall, most see this as a positive development for the industry, even if it will exacerbate the challenge that comes from administering any hybrid structure where fund firms are trying to marry two different elements in the legal and administration process, says Donnacha O’Connor, partner at Ireland-based law firm Dillon Eustace.  “Transparency is a good thing for the investors, for the sponsors and for the industry in general because it will promote more trust between participants. But it will cost and it will probably be the investor that pays. The trick will be to make sure that the extra transparency provides value for the investors.”
©2016 funds europe

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