By Dwight Cass
Private equity-owned companies increasingly have to meet demands for more accurate, granular and timely information.
The treasurers of public companies often ignore happenings in the leveraged buyout world. Yes, there’s always the danger that a buyout bubble could prompt timid management to boost leverage, or even undertake a leveraged recapitalization, and there’s a buyout boom’s effect on debt capital markets and shareholder return expectations. But treasurers of public companies can usually stick to their knitting.
Treasurers of companies that fall into buyout bosses’ clutches face some different challenges. The job can start to involve finding ways to slice increasingly volatile cash flows finely enough to satisfy all the new creditors that are created by the deal and the crippling dividends and management fees sucked out by private equity firms.
The magnitude of this challenge was highlighted in a Moody’s report in early February warning that some of the credit boom’s biggest LBOs, like Clear Channel Communications, Texas Competitive Electric Holdings and Caesars Entertainment, could struggle with their debt loads.
But the job is changing further. Private equity firms are finding that pressure from investors and regulators is forcing them to be more transparent, to provide more granular and timely performance data, and to satisfy a host of other information demands. Those that fail to do so will find it difficult to raise funds, and could spend a lot of time with inspection teams from the Securities and Exchange Commission.
This means that private equity firms—many of whom were still running their businesses using “QuickBooks” up until a few years ago—are beefing up their operations and technology, outsourcing more non-core tasks to fund administrators and other service providers and generally trying to put in place the infrastructure they need to satisfy investor and regulatory demands.
Trust But Verify
In the US, investors have banded together under the auspices of International Limited Partners Association (ILPA). ILPA was formed to develop reporting and management standards, and to provide reporting templates and other materials, for limited partners of private equity firms.
With the profusion of private equity firms’ and investors’ losses during the financial crisis, private equity firms are finding it harder to raise capital. According to the SEI Private Equity 2013 Update, the average time it takes to close a fund has doubled over the past five years, from approximately 10 to 20 months.
LPs need transparent and reasonable valuations in order to make asset allocation decisions. A lack of credible valuation data about portfolio companies and funds overall during the financial crisis put LPs in a bind, as the decline in the value of liquid, traded assets left many of them overweight private equity and other alternatives. Another consequence of the financial crisis was the realization that different financial institutions put very different valuations on the same level three assets. Investors determined that they needed to have independent valuations or to do it themselves, driving the demand for more information from portfolio companies.
So the main goal of ILPA is more transparency. As limited partners have increased their portfolio management sophistication since 2007 they have come to need more information to feed their models. Some of this comes from the private equity fund level—that is, portfolio metrics such as correlation and volatility, and analytics such as risk and return attribution. And some of the information comes from the portfolio company level, and must be generated by the treasury and related groups at those companies.
For example, the following is the data that ILPA members require regarding risk management, from the organization’s January 2011 Private Equity Principals, Version 2.0:
“GP annual reports should include portfolio company and fund information on material risks and how they are managed. These should include:
- Concentration risk at the fund level.
- FX risk at fund and portfolio company levels.
- Leverage risk at fund and portfolio company levels.
- Realization risk (i.e., exit environment change) at fund, portfolio firm levels.
- Strategy risk (i.e. change in, or divergence from, investment strategy) at portfolio company level.
- Reputation risk at portfolio firm level.
- Extra-financial risks, including environmental, social and corporate governance risks, at fund and portfolio company level.
- More immediate reporting may be required for material events.”
Since January 2011, ILPA members have sought more granular and frequent reporting, with an emphasis on portfolio company valuations, cash-flow forecasting and leverage.
More important, to land a large investor, PE firms often will undertake to provide bespoke reports. Examples of the content of these include FX exposure and hedging approach, stress tests of cash forecasting models and the like. This type of “active” limited partner could seek regular updates, first from the deal team that closes the transaction and subsequently from the portfolio management team.
Compliance Blues
Private equity downplayed or underestimated LPs’ concerns for a long time. For example, in the SEI’s 2011 report, after ILPA’s standards made headlines in industry news outlets, more than 85 percent of private equity managers believed their stakeholders received all the information they need but only 43 percent of investors felt the information received was adequate. Regulators, however, are harder to ignore. The Dodd-Frank requirement that private equity firms become Registered Investment Advisors (RIAs), subject to Securities and Exchange Commission oversight, has given ILPA’s initiative significant impetus.
Dodd-Frank requires RIAs to put in place stringent compliance protocols and supporting technology. It requires private equity to file significantly more complex disclosure documents—including Form ADV and Form PF. These will require detailed risk and financial data from portfolio companies to complete—data that treasury can best generate.
Private equity will also be subject to exams by the SEC’s Office of Compliance Inspections and Examinations (OCIE) based on OCIE’s evaluation of their perceived risk. If the SEC believes that a full exam is warranted, it will establish an on-site presence at the fund manager in order to collect as much information as it needs.
Moving Targets
The fluidity of the regulatory situation, and the slow process of forging an LP consensus on these matters, means there will be significant uncertainty for some time regarding the demands made on treasury in gone-private companies. If respondents to a recent survey by PE Hub are right, there won’t be a new rash of Mega LBOs to worry about. But with debt plentiful, even the overblown valuations in today’s market may not be enough to keep the barons behind their walls.