This article is sponsored by WithumSmith+Brown and alterDomus, and appears in the December/January issue.
The downfall of The Abraaj Group has encouraged investors to start seeking more information from their fund managers, according to Dalmau Garcia, the New York-based chief financial officer and general counsel at Victoria Capital Partners.
Dubai-based Abraaj is accused of misusing investors’ money in one fund to cover costs relating to other areas of the business. It has become 2018’s poster-child for failed internal controls.
“In part because of what’s happened with Abraaj, LPs seem to be more vigilant to some extent,” says Garcia.
In the past, LPs would have asked just for the budgets from the operating or management company; now, they are requesting financial statements from the management company, Garcia explained at a recent roundtable discussion on fund administration in New York City.
Abraaj’s actions should have raised warning signs when the management company was financing part of their operations with debt, he says.
“That should have been a huge red flag for an investor. If I were to see that, I would ask myself: what were they taking out so much debt for? And why wouldn’t the fee income be sufficient to cover the management company expenses?” The episode feeds into a continuing trend of private equity firms turning to fund administrators for help in ensuring that their operations are up to the standards sought by their investors. Limited partners are asking general partners specific questions, such as: who are the accountants, who is handling treasury, and what is the cash approval matrix, Garcia says.
Prior to the Abraaj case, investors were already requesting more information from GPs. But what had been a three or four-page operational due diligence questionnaire from an institutional LP before has ballooned into 30 or 40 pages.
“All of these things didn’t matter six, seven or eight years ago. And you’re not just getting the sense that it’s just a check-the-box exercise,” Garcia says, adding that GPs should be prepared for follow-up questions from LPs.
Garcia says LPs are also asking for fundraising meetings, and the investor’s CFO now usually has to sign off on operational due diligence. He cites as an example one development finance institution that gave its final approval upon establishing that Victoria Capital had used a reputable fund administrator and that it had summarized a list of tasks and functions being outsourced to the fund administrator.
“They were really comfortable with us, but they also wanted to make sure that we had covered all bases from a fund administration and operational standpoint,” he says. “Definitely it’s a brave new world in terms of operational due diligence.”
Ahmed Badreldin, former head of MENA for Abraaj, writes in an opinion piece for pfm (p. 14) of the importance of outside fund administrators being comfortable with questioning the GP’s instructions “rather than taking blind instructions, lest it become a rubber stamp.” He also suggests having regular third-party oversight of fund administration work.
Since the Bernard Madoff scandal unfolded a decade ago, alternative investments have been under additional scrutiny from institutional investors, and investors are looking for an independent third party to handle the books and records of the fund. This acts as an additional set of eyes on fund operations, says Tom Angell, practice leader of private equity and venture capital at WithumSmith+Brown.
“When we consult with emerging managers, we encourage them to hire a full-time or outsourced CFO,” he says.
“When one of the general partners of the fund decides they will be the acting CFO and be the point of contact for the administrator and the outside auditor, it can create an issue. The GP has limited time to answer questions for the outsourced providers, and they may not have the expertise to handle some of the technical accounting issues. It is not the best use of the GP’s time.”
The GP may be engaged with closing a deal and may not have the time to answer questions from the tax preparer who is pushing to get the fund’s K-1s out to their investors, says Angell, who has more than 30 years of experience specializing in private equity and venture capital – including advising first-time fund managers.
“Outsourcing is helpful, especially to emerging managers, but you really need to decide who is going to be the intermediary between the administrator and the outside auditor in order to have things move smoothly between those two processes,” he says.
Spending time on fundraising
Fund administration as we know it today began as an outsourced solution for the hedge fund industry. When CFOs at private equity firms seek advice on accounting and tax issues, help in negotiating contracts, or need an audit on their operations, they turn to fund administrators. For first-time fund managers, that can be crucial: time spent on fundraising is time spent wisely.
Sanjay Sanghoee, CFO of Delos Capital, says having a fund administrator from the get-go was a strategic decision that allowed the lower mid-market private equity fund to focus on fundraising when it started operating in 2013. It raised more than $250 million for its first fund.
“We hadn’t even staffed up yet, but we wanted to have all the key operational elements of a fund in place as we were fundraising,” Sanghoee says. “When we were fundraising on Fund I, the investors found it very comforting that we had these experts on board with us because we didn’t have the background yet doing these things as a new fund.”
Firms that are starting out don’t have the resources to hire a lot of full-time staff. In Sanghoee’s case, that means taking on additional roles in running Delos’s day-to-day business operations, including overseeing fund administration, legal, tax and accounting.
“Our fund administrator, which services many private equity funds in our size and has a stellar reputation in the industry, provided us with an expert who could lay out all the different elements that were required from an actual operational side, check our internal work, give us guidance and make sure we did it right from the onset,” Sanghoee says. “And we haven’t looked back since.”
Participants in the roundtable addressed the need for a firm to have a CFO, or at the very least have someone operate in that capacity. Angell says Withum can offer recommendations for a CFO who is outsourced or can work on a part-time basis, should a fund be hesitant to bring in a full-time CFO.
“A lot of times when we’re working with emerging managers, a majority of them come out of larger funds,” Angell says. “They were dealmakers in their prior fund, and they didn’t handle any of the aspects of running a fund business. They now have to deal with office space, hiring and providing benefits to themselves and their employees. ‘Should I hire a PEO [professional employer organization] or should I just use a service and bring in a benefits consultant to help select health insurance?’ It’s a number of business decisions they need to make that they haven’t really thought about. Their main focus has been fundraising and deal sourcing. These are just some of the items we discuss with the GPs. We work to make the GP’s life easier so they can focus on the important aspects of their business.”
Louis Crasto, managing director and head of private equity in North America at alterDomus, a Luxembourg-headquartered fund administration and corporate services company, says that depending on the complexity of the firm, the CFO role should be filled by someone preferably with a private equity background. If it’s a relatively new firm which doesn’t have an overly complex structure, the role is sometimes filled by an experienced controller who’s ready to take the next step, he says.
For larger and more complex firms, an experienced CFO may be more suitable. In all cases, the firm should have someone focused on the function who can speak to the finance and accounting operation, offering the firm’s view on issues such as how to interpret the fund’s LPAs, and the preferred amount of reporting for their LPs. For start-up firms, to control costs, for a limited time at the onset GP members will sometimes try to wear multiple hats and fulfill the CFO role initially, but this often pulls them away from the critical functions of fundraising and sourcing investments.
“For new fund managers launching their first fund, there’s just so much for them to do to have a state-of-the-art back and middle office. They can go right to an administrator now and get a comprehensive fund admin solution instead of having to get up to speed on so many different things. For the more established firms that haven’t outsourced yet, there is also a compelling case to be made for outsourcing. Maybe they’ve grown their internal accounting infrastructure to a certain level and they want to control or reduce costs. Or maybe they feel like they need current technology, but they don’t want to spend the time and resources implementing it. Outsourcing to a fund administrator can assist on both of these fronts as they provide industry-based technology and also alleviate the need to make additional accounting hires when new funds are launched,” Crasto says.
For some CFOs, a fund administrator is a business partner who has been with the firm since the first fundraising. That means developing a relationship that spans years in helping the CFO with his or her duties, including calculating fund expenses, preparing the financial statement, filing regulatory reports, controlling fund bank accounts and liaising with auditors.
Joshua Cherry-Seto, chief financial officer at Blue Wolf Capital Partners, turns to fund administrators for help in compliance with certain regulations, such as the Foreign Account Tax Compliance Act, which is designed to detect tax evasion and anti-money laundering.
“And the other part of it is investors, right?” he says. “Investors were mostly focused just on returns about a decade ago. Now they’re interested in leverage and they want to take a look at your portfolio for risks.”
The community between fund administrators and private equity firms is so small that building long-term relationships is important, and it takes time for fund administrators to learn how to be partners with a firm like Blue Wolf, he adds.
“Frankly it’s really hard to switch even when things go wrong,” Cherry-Seto says. “You spend years building a partnership with your administrator, so there is a lot of rope when conditions change and the fit is no longer a good one. Generally, the cause is a change in people on either the administrator or GP side, which isn’t surprising as private equity is a people business. It is also important for the GP that the break-up is as amicable as possible, as there is reputational risk in being viewed as a difficult client for vendors.”
Sanghoee says that Delos’s fund administrator, FLSV, which is owned by the Sanne Group, has “effectively become an extension” of the firm. “We work with them or loop them in on everything, including investor requests or concerns, in order to maintain robust operations,” he says. “We work for our investors and always need to ask: what do our investors need and how best can we provide it?
“The other real value-add with our fund administrator is that they watch our back and advise us on the best way to structure deals so that we can optimize returns while staying true to the highest standard of operations. The deal guys’ job is to find and execute on great deals – my job is to make sure we structure them in a way that is fair to all our investors, meets all regulatory requirements and to maintain careful accounting to meet our auditor’s requirements. Our fund administrator is invaluable in that process.”
AROUND THE TABLE
(From left to right)
Dalmau Garcia is partner, general counsel and chief financial officer at Victoria Capital Partners, which focuses on private equity investments in South America – mainly in Brazil, Argentina, Colombia, Peru and Chile. Since its founding in 2007, the firm has raised more than $1.7 billion in capital commitments. Garcia joined in April 2012 and oversees all of the legal, compliance, finance, tax, operations and administrative aspects of the firm, including the oversight of all of its principal service providers, which includes auditors, fund administrators, lawyers, tax advisors, banks and insurers.
Louis Crasto is a managing director and head of Private Equity in North America at alterDomus. He previously worked at CARTA Fund Services, which was acquired by alterDomus in 2017. Prior to CARTA, Crasto spent more than six years at Centre Lane Partners, where he was CFO and chief compliance officer. He also served as CFO at other companies and worked in a variety of financial reporting positions at Solomon Smith Barney and Dean Witter, Discover. He started his career at Ernst & Young in the audit division.
Tom Angell is the practice leader of the financial services group at WithumSmith+Brown. He has more than 30 years of experience specializing in private equity and venture capital funds, including helping first-time fund managers. Angell is a certified public accountant and a member of the New York and New Jersey Societies of Certified Public Accountants, as well as the American Institute of Certified Public Accountants.
Joshua Cherry-Seto is chief financial officer and chief compliance officer at New York-based mid-market firm Blue Wolf Capital Partners, which has more than $1.2 billion in assets under management. Its portfolio of companies includes healthcare, forest and building products, energy services and industrial and engineering services. Prior to joining Blue Wolf in 2013, Cherry-Seto worked for five years as a portfolio and finance manager at Grove International Partners. He also held various positions within Citigroup.
Sanjay Sanghoee is chief financial officer and chief operating officer at Delos Capital, a New York-based lower mid-market private equity firm that raised more than $250 million for its first fund. He is responsible for managing the day-to-day business, strategic direction, fundraising and all aspects of Delos’s operations, including fund administration, tax and accounting, legal and human resources. Prior to Delos, Sanghoee worked at Ramius Capital, a multi-strategy hedge fund, and in the mergers and acquisitions groups at Lazard Freres and Dresdner Kleinwort Wasserstein.