Back to School: Governance, valuation, fund administration loom large for PE firms

As alternative fund managers face challenges from competitors, regulators and investors, the boards of private equity and hedge funds have been addressing governance issues in a variety of ways, according to a benchmarking survey by PwC’s alternatives unit.

The survey of 42 firms was conducted by PwC’s Kristin FranciscoMike Greenstein and Liz Pelan. It found that 88 percent of private equity funds said they’re self-administered, compared to only 9 percent for hedge funds. However, the survey concluded that more private equity funds may use at least one fund administrator instead of handling the job themselves.

“Increasing pressure for private equity firms to deliver greater transparency, better reporting and manage costs may drive many of them to outsource some back office functions,” the study said.

Even when alternative managers use an outside administrator, about half of participants in the study shadow their administrator in the majority of 10 business functions included in the study. An earlier study by PwC showed that 83 percent of managers reported use of an in-house shadow accounting function.

The shadow function helps monitor the operations of administrators as a way to mitigate risk, but it also increases internal costs, the study noted.

On governance, both hedge funds and private equity funds include a balance of affiliated and independent individuals on their boards to avoid conflicts of interest, according to the survey of 42 firms.

On average, half of the board members of private equity and hedge funds are non-executive directors, the survey found. The second largest group of board members (38 percent) is made up of representatives from advisors, followed by consultants/lawyers (4 percent) and “other” (8 percent), according to the study. (The study didn’t break out data for private equity firms on this metric.)

Thirty-six percent of private equity firms deploy a formal procedure to appoint new board members, while nearly 70 percent of hedge funds do so, the survey found.

In terms of valuing their portfolios, private equity firms chose up to eight possible approaches. The market approach ranked as the most popular, with 93 percent, followed by the income approach (79 percent), recent transactions (57 percent) and appraisal value (14 percent), the survey said.

Enterprise value divided by EBITDA ranked as the most common data point used by private equity firms to compute their market approach, with most respondents (92 percent) saying they used that multiple, followed by production multiples (77 percent).

On the income approach for valuation, the most common data point was discount rates, reported by 62 percent of firms, followed by the weighted average cost of capital (WACC), reported by 54 percent.

Overall, the largest percentage of valuation reports issued by both private equity and hedge funds came out quarterly.

By Steve Gelsi