Are private equity managers being asked to play poker with their cards facing up?

Private Equity 13 Dec 2009

cards facing upApparently it’s not just hedge funds that are now being held to a much higher standard when it comes to demands for transparency by institutional investors.

According to a recent survey published by SEI (downloadable with free registration here), financial advisors and other investors, private equity (PE) shops are also under increasing pressure to provide higher quality reporting and more “look-through” ability to their existing and potential investors.

The survey, which was completed by senior investment professionals at 51 organizations ranging in size from less than $500 million to more than $20 billion in assets, revealed that more than 90% of institutions polled planned to either increase or maintain their allocations to private equity in the coming year.

Still, in the report accompanying its findings, SEI noted that PE managers who standardize and institutionalize transparency practices will likely be the only ones who “retain and capture assets because they will create efficiencies while delivering a more consistent and enhanced client experience.”

Indeed, as SEI’s illustration below (taken from its survey) shows, the primary concern among PE investors is liquidity risk — being able to turn that investment into cash if and when the alarm bells sound again.

SEI Chart 1Like hedge funds, however, meeting these new standards of transparency and liquidity can be, to say the least, challenging, particularly for long-term and hard-to-value assets that have long been part of the PE world.

Beyond physically seeing the hard assets supporting an underlying interest-bearing bond or surveying the inventories or resources of a company that is part of a long term investment, it’s not easy tipping the hand on a private equity investment – not to mention that providing such details is in many cases akin to playing poker with the cards facing up.

“Investors are seeking transparency of holdings, valuation methodology, and investment processes, as well as more comprehensive, timely, and independent reporting,” Phil Masterson, Managing Director for SEI’s Investment Manager Services division, noted in an accompanying press release.  He continues:

“While managers may not need to provide the same level of transparency to all clients, they will need to instill best practices across their business in order to attract and retain institutional assets.”

As noted above, liquidity risk was cited as a primary concern by the majority of investors polled (62%) followed by poor performance, both absolute and relative (58%). When rating the criteria most important in selecting a PE manager, the top three responses were: quality of management team, clarity of investment philosophy, and sector expertise.

The next three most important selection criteria were compliance infrastructure, portfolio transparency, and quality of reporting and communications — demonstrating the increased emphasis institutions are placing on transparency.

Despite these requirements, there’s still a healthy institutional interest private equity according to the survey. As the graphs below show, the majority of institutional investors surveyed are looking to increase their PE allocations next year from current levels.

SEI Chart 2
The hitch is that the allocations will only come if the managers can vault over the newer, higher hurdles being set.

The longer-term question, though, is how long it will take for an institution that is really, really keen on throwing some cash at a PE fund to loosen their purse strings.  And will they really demand to see mangers’ hands before those managers play the cards they’ve been dealt?

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  1. Lurker
    December 14, 2009 at 12:14 am

    Since private equity is basically Stock Beta + Illiquidity Premium, aren’t they just cutting their own throats by demanding a reduction of liquidity risk from their PE investments?

  2. cgoldman
    December 14, 2009 at 12:54 pm

    I think you’re right, though I also think it depends on the type of investment and level of risk. For more traditional types of PE, real estate, infrastructure, etc., sure; for more “nuanced” PE deals (capitalization, securitization, etc.) perhaps not, depending on the level of risk versus the level of transparency.

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