The international accounting firm RSM recently published a white paper/client alert regarding outsourcing private equity fund administration. This article raises very interesting points. As firms that focus on the private securities markets look to scale their operations, in part expecting growth in the private markets as high-net worth individuals look to private markets to diversify their own portfolios and wealth management professionals look for more options in their offerings to clients, there are increased demands on the firms themselves. CFOs and other operations professionals within these firms are increasingly looking to third-party service providers (such as fund administrators for accounting and reporting matters, third-party HR managers, third-party compliance professionals, outsourced IT departments, etc.) to alleviate these administrative demands on investment professionals' time.
There are, of course, a lot of benefits to having a third-party expert provider manage some of these functions. For example, a fund administrator may have a deep bench of accounting professionals to manage treasury services, bookkeeping, revenue services, etc., in accordance with GAAP investment company reporting standards. It is likely not economical for a private equity or other investment firm to retain, train, and supervise a large accounting team, and a smaller team may have gaps in critical skills or knowledge.
But, there are risks to outsourcing.
These risks come from two directions. The first and most obvious is regulatory oversight by the SEC. The second, which this article does a great job explaining, is investor scrutiny.
Many investment firms are registered investment advisers (RIA) under the Investment Advisers Act of 1940. RIAs owe an unwaivable fiduciary duty under the Investment Advisers Act of 1940. Even those firms that are not RIAs (such as real estate managers and certain private lending managers) will typically owe fiduciary duties to their funds and investors under their own fund documents. In 2022, the SEC issued a notice of proposed rulemaking that (A) affirmed that an RIA's fiduciary duty included the duty to use reasonable care in selecting and overseeing an outsourced third-party service provider and (B) would have imposed prescriptive rules governing the RIA's diligence and oversight function. Commenters generally panned the rule because of its prescriptive nature, and with the coming change in the SEC chair, the future of this outsourcing rule is very unclear. However, commenters did generally agree with the SEC's premise that an RIA's fiduciary duty included the duty to use reasonable care and conduct appropriate diligence when selecting and overseeing a third-party service provider for core functions. And, in recent speeches and conversations, SEC commissioners and SEC staff members (whose views, of course, do not represent the position of the commission or the staff) have indicated that they do consider, consistent with traditional concepts of fiduciary duties, that when utilizing third-party service providers, RIAs do have a heightened duty of care when selecting and overseeing third-party service providers.
However, investors are also increasingly scrutinizing the use of third-party service providers, as indicated by the RSM white paper. This is understandable given the economic structure of private funds. Generally, when services are performed in-house by the investment firm, the cost of those services must be borne by the investment firm through the asset management fee charged in the notional “2 and 20” fee structure. However, when services are performed by third-party service providers, the fees charged by those service providers will often be an “Operational Expense” borne by the fund (and indirectly, its investors), which effectively increases the investment firm's operating profit by reducing expenses. Sophisticated investors want to make sure that, if the expenses they must bear are increasing, the service provider is reputable and delivers increased value to the fund. Increased investor scrutiny of outsourcing may also lead to increased downward pressure on management fees from investors, which is already under immense pressure from sophisticated limited partners.
We continue to monitor this area and other market trends in investment management to ensure that our clients continue to provide best-in-class services to their own investors, stay ahead of regulatory developments affecting their business, and maintain investor relationships.
