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The Controversy Surrounding Private Equity Funds’ Performance Disclosure

 


The relatively low level of transparency in private equity, regarded by many as a compelling feature of the asset class and one that has done much to attract sophisticated investors, may be on its way out. The question is whether this is a good or a bad thing? That depends on who you ask.

To Disclose or Not to Disclose

Most self-respecting general partners are not exactly thrilled by the idea of revealing the inner workings of their funds only to see sensitive portfolio information blasted over the web. They argue that, at least in the world of private equity, less disclosure may be more, and more disclosure may be less. 

For starters, take the controversy surrounding public disclosure of private equity firm portfolio valuations. While the talking cure option may not be surprising in this period of poor financial returns and heightened sensitivity to corporate governance, this outcome misses the real point that interim reporting of private equity portfolio valuations usually provides a misleading picture of the ultimate returns of private equity investments.

This is an argument that many institutional investors heartily agree with. After all the opportunity to capitalize on the inefficiencies of a private market with sparse information is all part of the fun. One of the reasons investors are attracted to private equity, is the lower degree of transparency in the asset class.

It would not be fair to conclude, however, that these are irrefutable arguments in favor of non-disclosure. Rather, they reflect more a recognition that disclosing interim internal rate of return data is a little like declaring the marathon winner at the halfway point. 

This is particularly true in the new world order of private equity where it is no longer fashionable or even possible for sponsors to generate superior returns by simply supplying money to purchase already well-run companies. 

The rich returns from increased leverage that were readily available in the past are long gone. Increasingly, buyout firms are focusing efforts on messy transactions that demand a high level of intervention, let alone time, to transform.

Positioning Management Know-How

As most practitioners in the market agree, the name of the game today is operationally oriented transactions that require the ability to deal with substantial strategic and operating challenges. While there are no microwaveable solutions in creating better businesses, the patient investor can reap outsized returns from successful business transformations.   

In taking an operations-oriented approach, sponsors benefit by driving returns through both increased profitability and a leveraged capital structure - true enough - but the process of making the sausage may not always be a pretty sight. 

Nevertheless, it is nearly axiomatic that portfolio companies under the stewardship of a buyout manager committed to adding substantial value to the business can look like a disaster at any given moment during the transformation process. 

Transformations are always disruptive. They require often massive and prolonged doses of change: change in management leadership; change in strategy; change in
production practices; and many others. 

If that is the reality that an activist private asset manager confronts, then static valuation snapshots wont provide much insight. What investors in private equity need is more light shed on the plans private equity firms are pursuing to enhance the business performance of their portfolio companies and the progress they are making in executing those plans.

At a certain level, the push for increased transparency may prove to be a positive development for the private equity industry. Potentially it offers the opportunity for sponsor firms to elevate their reputations, differentiate their capabilities from the pack and increase LP confidence, particularly at a time when business failure and corruption have captured the imagination of the public.

Building LP confidence 

There is ample evidence that LPs as fiduciaries are re-examining their commitment to private equity as an asset class, and not just because of depressed returns, reduced allocations or irritation over GP compensation. With the traditional notions of risk shattered by world events alongside colossal accounting and corporate governance failures, forcing LPs to rethink risk assumptions on a more fundamental level. 

Private equity firms that take affirmative steps to provide better information in the current challenging environment will boost the confidence of investors and arguably gain a competitive advantage when seeking to raise additional funds. To engender institutional credibility, three essential imperatives should guide communication policies: projecting a clear and compelling vision; clearly defining distinctive added value; and emphasizing investment process quality. 

First, to project a clear and compelling vision, a private equity firm needs to articulate its philosophy, which boils down to responding to the question, What does the firm stand for? While the obvious answer may run something along the lines of making as much money as possible for investors, firms should always bear in mind that investors will be more likely to invest money with people they trust and who have a reputation for integrity.

Investors are not alone in wanting to be associated with people of integrity by the way. Lenders, customers, suppliers, management and employees all share the same interest in collaborating with people that are trying to do the right thing, not what is expedient. A firms vision should always include a statement of values by which the firms partners conduct themselves. And part of the value system should include a commitment to providing reliable information on a timely basis in understandable language to LPs. 

Second is the question of what distinctive value a particular firm brings to the table. Whether you are talking about toothpaste or private equity, the market demands and values differentiated capabilities. To stand out, a private equity firm needs to define clearly the manner in which it delivers added value.

The task is a triple one beginning with highlighting previous investments where the firm spearheaded successful efforts to usher in new strategic and operational plans. Next, people always make the difference and so the experience of the firms human capital, as well as the specialized capabilities of firm affiliates and advisors should be emphasized. 

Finally, each transaction that a firm undertakes, whether an investment or realization, should provide a powerful platform to reiterate the manner in which it delivers added value.

Third, private equity firms need to effectively communicate the quality and focus of their investment process. Investors who have been burned by investment strategy drift now place as much emphasis on how returns are generated as on actual performance. They want to see that a risk-controlled process exists, that it is consistent, and that there is a reasonable likelihood it can be repeated. 

One of the delicate communications challenges for operationally-oriented private equity firms today will be to substantiate their business improvement claims with convincing metrics.
 

Complicating this effort is the fact that investors increasingly expect to see a larger portion of private equity returns generated by operating enhancements at precisely a time when achieving those enhancements has become far more difficult to deliver.

Candor is King

Each of these communications imperatives is necessary to establish an institutional franchise at a time when investors and other stakeholders are demanding a much higher level of transparency. The most effective response to the sometimes shrill calls that private equity firms cut the size of their funds and slash fees is to shine light on the strategies, capabilities, and metrics for adding value to
corporate operations.


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