PE firms eye more assets but margin concerns remain

Players in the Private Equity (PE) space have shown optimism in acquiring more assets this year however, high operational expenses that are eroding their margins, remains a very big constraint, according to key findings from a survey by Ernst&Young.

The survey which is the sixth annual survey of the London-based management consulting firm captured the views of Chief Financial Officers (CFOs) from 103 PE firms, who showed great strides in launching new products and investments in new technological solutions, but expressed concerns on continuous growth in expenses growing as fast as the growth in their assets.

Nearly 40 percent of CFOs reported that margins have worsened over the past two years, and are doing everything possible to reduce expenses from cutting of staffs, to exploring technology and outsourcing to mitigate the pressure

On the other hand, about 28 percent of the respondent said they saw their margins improve in this period of asset growth.

“CFOs face different paths for altering their operational infrastructure and achieving sustainable growth,” says Denise Davidson, Associate Partner, Wealth and Asset Management, EY. “Determining the right balance of technology, talent and outsourcing is not a one-size-fits-all approach. While CFOs are divided on which path is the best fit for their aspirational goals, one thing is certain: they must act quickly to achieve a competitive edge”

Attentiveness in PE looks bright, with 76 per cent of CFOs saying that asset growth is the top priority for their firm. What is shocking is the level of competition that the PE industry poses to hedge funds.

Currently, 18 per cent of the typical investor’s alternatives portfolio is made up of traditional PE investments, and nearly 40 per cent of investors expect to allocate more capital to PE firms.

Taking advantage of this momentum and displaying optimism, over half of CFOs noted that they expect to raise a new fund in 2019 and 65 per cent expect that the new fund will be larger than their last.

The survey also found that while CFOs begin to prioritise the cost-effective and competitive advantage of outsourcing to boost their bottom lines, they are acutely aware of the talent necessary to grow their firms.

Forty-six percent said they are renegotiating fees with vendors, 39 percent are implementing technology solutions, and 37 percent have increased outsourcing of certain functions.

A little over a quarter of firms have reduced headcount, and just under quarter has added junior people rather than making senior hires.

“The pressures facing private equity managers are well-known — fee pressure and growing expenses, to name a few,” EY said in the survey. “This environment is straining the economics of almost every manager,” they continued.

Last year, private equity firms raised about $681 billion in assets – and falling margins aren’t keeping them from further fundraising.

According to EY, it’s also the third year in a row that the majority of firms planning to raise a fund expect that fund to be larger than its predecessor.

At the same time, firms are facing fierce competition for investors, even as most of them are increasing their private equity allocations. To appeal to a broad range of clients, firms are offering more customized services, the report the report said. In particular, smaller firms, without well-known name brands, are offering separately managed accounts and single-investor funds to stand out from the competition.

In addition, private equity firms, which have long escaped investors’ ire when it comes to high costs, are also facing pressure on fees, according to the survey of 103 CFOs.

To attract new clients, 59 percent of CFOs said they have either adopted or are considering adopting a non-traditional fee structure, including expense caps and a giving investors the choice between paying a higher management fee and lower carry or vice versa.

Of those firms that have non-traditional fees, 64 percent said they offer a performance-fee only option. Fifty-six percent reported offering fee breaks based on investor commitments, while 23 percent and 18 percent offered tiered management fees and tiered carry rates, respectively.

Some private equity firms are also competing for clients by giving them fee breaks on separate accounts and single-investor funds. Sixty-four percent reported that they are providing some kind of fee cut, with 16 percent offering discounts of more than 100 basis points.

Despite historical underinvestment in technology, most PE CFOs note that their firms have recently made or are planning to make investments in technology across a wide array of functions.

 Over the past two to three years, PE managers have made technology investments in the areas of fund accounting (66 per cent), investor relations (62 per cent), accounts payable/time and expenses (57 per cent), and compliance and regulatory reporting (56 per cent).

 Unfortunately, most report that the payoff has yet to be seen. The tax and accounts payable finance functions have received the biggest benefit thus far, with 33 per cent and 40 per cent of CFOs reporting net decreases in operating expenses in these areas, respectively. The hurdles include the need to enter clean data, integrate systems and fully enable the workforce.

As the workforce is evolving, approximately half of CFOs have changed the profile of the candidates that they evaluate, interview and ultimately hire relative to 5 to 10 years ago. Now, more than ever, they recognise the role diversity plays in fostering different perspectives that can positively impact investment decisions. Because of this, 79 per cent of CFOs seek to improve gender diversity and 63 per cent seek to increase cultural diversity.

 Even as technology plays an increasingly critical role in a fund’s operations, there is no substitute for quality people. Investors expects talent programs to develop future leaders, increase diversity of skill sets and maintain employee satisfaction to minimise disruption caused by turnover are commonplace.

In fact, 78 per cent of investors request information about a firm’s talent management program during the due diligence process, and, of those that request information, 68 per cent say that is it critically important to them. Managers need to heed these requests, as more than half (54 per cent) of PE CFOs surveyed do not yet have a formal talent management program in place.