Fund administrators, the independent service providers that verify the assets and valuation of investment funds, are not currently as big a presence with private equity and real estate funds as they are with hedge funds. But private equity and real estate funds should take note, because fund administrators are becoming increasingly critical to how they go to market.
Fund administrator penetration of the hedge fund market is above 80 percent, and having a fund administrator has become a requirement for hedge funds of any size.
Private equity assets have risen from $30 billion in 1995 to $4 trillion in 2015. All indications are that growth will continue to be steep, as 64 percent of limited partners (LPs) plan to increase their allocation to private equity funds, which increased from 26 percent just five years ago.
Despite this dynamic in hedge funds, fund administrators have not penetrated private equity and real estate funds in the same way. Estimates are that penetration by fund administrators of private equity and real estate fund assets under management (AUM) is only 30 percent today, and projected to increase to 45 percent by 2018.
I think this growth projection is understated, however, because many of the reasons that compelled hedge funds to begin using fund administrators also apply to private equity and real estate funds.
Here are three key reasons why hedge funds had to begin working with fund administrators and why these also apply to private equity and real estate funds:
Investor Demands for Greater Transparency
I think that this is going to be the biggest driver that will force private equity and real estate funds to use fund administrators. Investors are increasingly demanding third-party validation of AUM and Net Asset Values, as well as greater transparency in reporting.
Also, operational due diligence of a fund is occurring earlier in the request for proposal process, particularly when institutional investors are factored in. Institutional investors want to have confidence in the middle and back office capabilities of the fund, which generally means a strong accounting and reporting practice.
If these investors don’t have confidence in the management company, then they will increasingly pass on the opportunity. One recent private equity study shows that 65 percent of limited partners are increasing the level of operational due diligence that they are performing on general partners.
Increasing Regulatory and Compliance Pressures
This started to materialize in the aftermath of the Bernie Madoff scandal, with acronyms like KYC/AML, FATCA and others fast becoming part of the lexicon. Conventional wisdom holds that regulatory and compliance pressures aren’t the same for private equity and real estate funds because the level of activity is less frequent. I find this argument to be short-sighted because some of these regulations already apply to fund types beyond just hedge funds.
Technology as a Requirement
Technology is already a means of differentiation among progressive private equity and real estate fund managers. My feeling is that technology should be a requirement for all of these fund managers.
Technology can provide an effective means to address the first two points, but how to best employ technology can be tricky. When it comes to technology, there are two typical approaches. The first is often for the management company to try handling it on its own, including attempting to build out the required technology itself. The second approach (often after having been unsuccessful in the first step) is for the management company to retain an external technology vendor to handle it. Either way, the experience often ends up with the same result: Managing technology on their own takes more time, personnel, and money than the fund expects.
Private equity and real estate fund managers should instead look to fund administrators to implement and manage technology that they need. Fund administrators are better suited to adopt and manage technology given that it is required by all of their fund manager clients. This is also a more cost effective solution for fund managers, because fund administrators are better suited to spread the cost of technology across their clients.
Private equity and real estate fund managers that still think they can go it alone without the help of fund administrators are going to quickly fall behind, and lose out on opportunities.