THE PRIVATE EQUITY CFO & COO DIGEST 2012

New ways of adding value to the firm, the fund and the portfolio company

Table of contents and sample extract

THE PRIVATE EQUITY CFO & COO DIGEST 2012

Table of contents
The limited partners quest for greater transparency Interview with Erik Hirsch, Hamilton Lane Investor relations in the age of public disclosure By Patrick Curtin, Joe Patellaro and Massimo Zannella, Citi Investor Services and Citi Private Equity Services What the US SEC registration means for fundraising and investor relations Charles Lerner, Fiduciary Compliance Associates LLC interviews Ralph P. Money and Robert E. Phay Jr., Commonfund Capital, Howard J. Beber and Michael R. Suppappola, Proskauer Rose LLP. Preparing for and surviving the US SEC audit By Julia Corelli, Pepper Hamilton Conducting the US SEC annual review By Scott Pomfret, Highfields Capital Management Chief compliance officer roles and responsibilities By David Harpest and Daniel Faigus, PwC Performance measurement: is it all about IRRs? By Alistair Hamilton, Inflexion Private Equity Partners LLP Best practice in financial modelling for private equity CFOs By E. Brooke Whitaker, Serasi Capital Cost and cash management for private equity portfolio companies By Gary Matthews, Morgan Stanley Private Equity and David Hanfland, AT Kearney Private equity accounting the auditors perspective By Nat Harper, KPMG LLP

THE PRIVATE EQUITY CFO & COO DIGEST 2012

THE PRIVATE EQUITY CFO & COO DIGEST 2012

Table of contents
Using technology to manage the compliance function, gather data and report information to investors By David Miller, eFront Information technology: integration and operation effectiveness By James Cashin and Daniel Wheadon, RSM McGaldrey, Inc. Blackstones BXAccess: the next generation of limited partner reporting By Matthew Pedley, The Blackstone Group Comparative data on compensation for CFOs, COOs and private equity employees Plus extensive journalistic coverage by Private Equity Internationals and Private Equity Managers dedicated journalists

THE PRIVATE EQUITY CFO & COO DIGEST 2012

Conducting the US SEC annual review

By Scott Pomfret, Highfields Capital Management

Introduction

Rule 206(4)-7 under the Investment Advisers Act of 1940 (the Advisers Act) requires advisers registered or required to be registered with the Securities and Exchange Commission (SEC) to review, no less frequently than annually, the adequacy of policies and procedures and the effectiveness of their implementation. The purpose of the review is to ensure that the policies and procedures that have been adopted are evergreen (that is, they keep up with the changing regulatory and business environment and changes to the advisers business). In the words of Gene Gohlke, former associate director of examinations at the SECs Office of Compliance Inspections and Examinations (OCIE), the goal of an annual review is to determine if the firms compliance programme continues to reasonably and effectively prevent compliance issues from happening, detect those compliance issues that do happen, and prompt correction of the issues that do occur.1 Although the SEC has not prescribed a specific timeline for newly registered advisers, advisers should generally conduct their first annual review within a year of becoming registered with the SEC.

What form should the annual review take?

The SEC has not prescribed any particular form for the annual review. Instead, the SEC and its staff have repeatedly stated that the investment adviser should tailor its review to its particular business risks. The annual review appropriate to a hedge fund adviser is therefore likely to be different in many respects from that of a private equity adviser. To account for such differences and to ensure that resources of the persons conducting the annual review are appropriately deployed, every annual review should be preceded and governed by an inventory (a risk inventory) of the firms particular compliance risks, as described more fully below. Despite the need for tailoring the approach to particular risks of the advisers business, there are some issues that the SEC will expect every annual review to consider. For example:

What was the nature and frequency of any of the compliance matters that arose during the period covered by the review? Does this data suggest that a change in either is warranted? Examples of compliance matters include violations of the code of ethics or compliance manual, sanctions applied, complaints received, and litigation, regulatory action or investigation commenced. How has the advisers business changed over the year since the last annual review was conducted? Are there new business personnel, risks, products, issues, units or affiliates that require a change to its policies and procedures?
Speech by Gene Gohlke, Examiner oversight of annual reviews conducted by advisers and funds on April 7, 2006, available at http://www.sec.gov/info/cco/ann_review_oversight.htm.

Conducting the US SEC annual review

How does the adviser go about identifying conflicts? What new conflicts has the adviser identified during the period under review? What new measures, if any, are needed to address the conflicts identified? What changes in the laws and regulations applicable to advisers have occurred during the period under review, or are expected to come into effect in the near future?

Who should conduct the annual review?

Most private fund advisers carry out the required annual review under the direction of the firms chief compliance officer. Based on a risk inventory, the chief compliance officer creates the game plan for the review and oversees the performance of particular tests, reviews, inquiries, interviews and other tools necessary to carry out the review. In a larger firm, the chief compliance officer and his or her staff may have sufficient resources to carry out the annual review without assistance from employees in the business units. However, in a firm of any size, the better practice is for the chief compliance officer to set a plan and tone with the business unit employees carrying out much of the testing under the direction of compliance staff who then review the results. This approach leverages compliance resources to allow a more comprehensive review and emphasises that compliance is the responsibility of everyone, not just designated compliance professionals. However, compliance must always ensure that the business unit employee carrying out the review is independent (that is, business unit employees should not review their own work). Some investment advisers hire third parties (primarily compliance consultants and law firms) to conduct annual reviews on their behalf. The third-party reviewer may not only have the advantage of experience with a wide variety of advisers and approaches, but also are often former SEC examiners. For an adviser with no or a small staff, an outside review provides a fresh look at the compliance programme. Typically, based on a risk inventory, the third-party reviewer works with the chief compliance officer to establish an agreed-on scope for the annual review. The reviewers findings are incorporated into a report to management. From time to time, such reviews may consist of a full mock SEC examination, in which the third party provides a document request and simulates the experience of a visit by SEC examiners. While this approach may be very comprehensive, it is also expensive. Therefore, other more limited or targeted reviews may be appropriate. For example, an adviser may conduct a mock review every four to five years, but have a more targeted review in each of the other years.

When does the annual review take place?

The SEC has not prescribed any particular time for the annual review. Gohlkes speech on the goal of an annual review describes a range of timing from as compliance issues arose to rolling routine review by functional area to work concentrated toward end of annual period. Notwithstanding its name, the annual review can be a culmination of ongoing compliance activity throughout the year, perhaps supplemented by additional year-end
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Conducting the US SEC annual review

testing. Under this practice, the chief compliance officers game plan largely consists of a 12-month compliance calendar that prompts particular tests, inquiries and other assessment tools, on a frequency prompted by risk level. The results of these assessments are then documented to enable easy summary at the end of the period. Such an approach spreads out the burden of the annual review (other than a final summary of results) over the year, instead of creating spikes in demands on the compliance department or others involved in the annual review. Where other business units are mobilised to undertake part of the review, the chief compliance officer should take care to coordinate with the units busy periods (such as audit season).

What assessment tools inform a robust annual review?

No matter when the annual review takes place, the SEC expects reviewers (whether inhouse personnel or third parties) to use a range of assessment tools. These include:

interviews of employees in key risk areas; observation of key processes; re-performance of key tasks or calculations; exception reports; transactional testing (focused on processes repeated on a daily or regular basis); forensic testing (testing over time focused on trends and patterns not obvious from pure transactional testing); surveillance; and third-party inquiry (for example, service providers).

What steps should advisers take to conduct the annual review?

The person coordinating the annual review (for brevitys sake, this chapter assumes a chief compliance officer) should consider the following steps:

Step 1. Assess any compliance and regulatory developments that became effective during the review period. Step 2. Conduct or update a risk inventory. Step 3. Review the results of the prior years annual review (if any) and any compliance matters that have arisen since. Step 4. Review any prior deficiency letter and the state of implementation of any corrective action taken in response. Step 5. Create a game plan for the review, including deciding the areas of focus, the specific assessment tools for each such area to be reviewed, the sample sizes and frequency of each test, the approximate timeline, and an estimate and identification of the resources needed. Step 6. Oversee the review and adjust the game plan as needed. Step 7. Address any compliance issues identified. Step 8. Assess adequacy of current policies and procedures in light of review results and develop recommendations. Step 9. Share findings and recommendations with senior management. Step 10. Implement necessary changes as approved by management.

Performance measurement: is it all about IRRs?

By Alistair Hamilton, Inflexion Private Equity Partners LLP

This chapter discusses:

How the performance of individual private equity funds are measured How the performance of a fund manager is measured How the performance of individual investee companies of a private equity fund is measured

Although all private equity professionals would agree that the internal rate of return (IRR) is a very important performance-measurement tool, it would be wrong to consider IRRs as all-encompassing when measuring performance. This chapter is structured into three distinct sections: firstly, it describes how the performance of an individual private equity fund is typically measured; secondly, how a fund manager is appraised; and finally it explains the basics of investee-company performance measurement. I will argue that there is no single, all-powerful tool for measuring performance in private equity. A range of approaches and metrics is required, as is a strong understanding of the basis of preparation. As a private equity professional with a mid-market fund manager, I have drawn a number of examples from this industry subsector. While all firms will measure performance in their own way, there are strong parallels between firms in different parts of the industry. No doubt performance-measurement tools will continue to develop as the industry matures, but the fundamental performance metrics, being the level of absolute return on capital invested, and the speed that this return is realised, will remain of central importance.

Performance measurement of individual funds

The performance measurement of individual private equity funds is a very important building block in the overall performance appraisal of fund managers, which makes starting the analysis at the fund level a logical introduction to the wider debate. The principal metrics used in performance assessment could be viewed as a mysterioussounding set of acronyms IRR, PIC, DPI, RVPI and TVPI without suitable definitions and explanation. None of these metrics are individually complicated, but the basis on which they are calculated needs to be properly understood to benchmark fairly.
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Performance measurement: is it all about IRRs?

Internal rate of return (IRR)

The IRR is the discount rate that makes the net present value of cash flow from a particular source equal to zero. Presenting a simple example using a single investment rather than a whole fund, if the investment was acquired for 100 and sold two years later for 121 then those cash flows have an IRR of 10 percent, being 100 multiplied by 110 percent, and then multiplied by 110 percent again. If the investment was sold for the same 121 after only six months the IRR would be 47 percent, and if it were sold after, say, ten years then the IRR would be 2 percent. As you can no doubt imagine, this is a very important tool to use in benchmarking one fund against another, as all the fund cash inflows and outflows can be analysed and summarised in one individual and easy-to-understand statistic. What makes it even more appealing is that the calculation can be done in basic spreadsheet applications using one of the pre-programmed functions (the XIRR function is best to use in Microsoft Excel). It is not necessarily the case that the fund with the highest IRR is the best; it depends on many factors and also the basis of preparation. IRRs can be presented in a range of different ways and funds can be operated in different manners, which can lead to materially different IRR results. The European Private Equity and Venture Capital Association (EVCA) Reporting Guidelines recommend a standard method for calculation, but there are many variations on this best practice, examples of which are cited below. Fund borrowing facilities, also known as capital-call Some, but by no means all funds operate a capital-call facility. These are facilities set up with a bank that lends money to the fund so that investments can be purchased without drawing down cash from investors. Typically a bank will lend money to a fund for up to a year and at this point the loan from the bank is repaid via a capital call to investors. As you can imagine, the fact that the investors might be putting their money into the fund a year later than the investment is made leads to a higher IRR result despite the money multiple, being the total returned cash divided by total cost, remaining the same. The IRR of the investment of 100 that I mentioned previously from an investors perspective is 10 percent if it invested its money for two years, but it is 21 percent if the use of the borrowing facility results in the investor only investing its money for the second of the two years. There is of course a cost to setting up and operating a capital-call facility (that is, the bank arrangement fees and interest) and so in reality the actual IRR would be marginally lower than the 21 percent quoted above. An important point is that when appraising the performance of a fund it is important to make sure the appraiser understands whether a fund has been operated with or without a capital-call facility. Clearly the manager of the fund with a capital-call facility that returned an IRR of 21 percent is not more than twice as good as the manager that did not deploy a capital-call facility and that returned a 10 percent IRR.
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Performance measurement: is it all about IRRs?

Basis of preparation of the IRR calculations IRRs can be presented in a number of different ways that give different results. The main difference in presentation is whether the cash flows are presented before or after a deduction for operating expenses and carried interest. A return quoted on the cash flows between the fund and the investee company before these deductions, which is defined by EVCAs Reporting Guidelines as the gross return on all investments, just considers the pre-tax investment-specific cash flows, and can give a materially higher result than on a post-deductions basis. The main expenses that net down the result are the priority profit share (PPS) and carried interest, which is typically 20 percent of profits. By way of an example, assuming a 2 percent per annum PPS (paid every six months in advance) and a 20 percent carried interest on profits, the gross IRR (that is, pre-deductions) of the investment bought for 100 and sold for 121 after two years is simply the 10 percent described earlier. However, as shown below, the post-deductions return is 6 percent. An illustration of the timing and quantum of cash flows is shown in Table 1. Also, it is important to understand whether the IRR being quoted is that of the cash flows between the fund and the investors, or the cash flows between the fund and the investee companies. You might think that there would be very little difference between the two alternatives, however sometimes there can be a material difference between them. As an example, a capital call could be made on January 1 for the 100 investment but, if there were unforeseen delays in the due diligence process then the investment might not be made for another three months. The IRR of the cash flows between the investors and the fund, (ignoring PPS, carry and similar items), would be 10 percent if the investment was sold and the proceeds distributed to investors after a total of two years after the drawdown. However, due to the threemonth delay between the drawdown from investors and the actual investment date there is a shorter time period between the actual acquisition of the investee and the realisation. Therefore, the IRR between the fund and the investee would be higher
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Table 1: Gross vs. net IRR illustration

Gross Jan 1, 2010 Jan 1, 2010 June 30, 2010 Jan 1, 2011 June 30, 2011 Dec 31, 2011 Dec 31, 2011 IRR -100 121 10% Net -100 -1 -1 -1 -1 -4.2 121 6%

Table 2: IRR between the investors and the fund versus fund and the investee
Investors and the fund Jan 1, 2010 Mar 31, 2010 Dec 31, 2011 IRR -100 121 10.0% Fund and the investee -100 121 11.5%