featured article globalization market and business … placed to help investment managers find ......

Citi OpenInvestor | May | 2012

14Market and Business OutlookCollateral Convergence — Are You Optimizing Collateral Efficiently?

02Featured ArticleFast Track: Foreign Investor Approval Process Speeds Up in China

06GlobalizationNew Rules Open Indian Market to Broader Investor Audience

What Happens if the Euro Collapses?

18Regulatory SpotlightThe Evolution of Private Equity Investing: Alignment of Interests and the Impact of Regulation

Citi OpenInvestor SM

Insights for institutional, alternative and wealth managers

Citi OpenInvestor | May | 2012 1

Contents Featured ArticleFast Track: Foreign Investor Approval Process Speeds Up in China 02

GlobalizationNew Rules Open Indian Market to Broader Investor Audience 06

What Happens if the Euro Collapses? Willem Buiter, Chief Economist, Citi10

Market and Business OutlookCollateral Convergence — Are You Optimizing Collateral Efficiently? Fergus Pery, Global Head of OpenCollateral, Citi Transaction Services, Citi

14

Regulatory SpotlightThe Evolution of Private Equity Investing: Alignment of Interests and the Impact of Regulation Joe Patellaro, Global Head Private Equity Services, CitiMassimo Zannella, Director, Private Equity Services, Citi

18


The QFII regime, under which foreign institutions are allowed to invest in the Chinese domestic markets, was launched in 2003. Gaining approval is a two-step process:

• The China Securities Regulatory Commission (CSRC) must grant the investor a licence.

• The State Administration of Foreign Exchange (SAFE) must then approve a quota — the amount the firm will be allowed to invest.

In the past couple of years, this two-step process has been taking anywhere from 18 to 24 months. Now that is changing. In December last year, CSRC held briefing meetings with custodian banks, making it plain that it wanted to cut the turnaround time for licence approval to six months, with SAFE then approving quotas in one to three months. That would reduce the whole process to no more than nine months.

Fast Track: Foreign Investor Approval Process Speeds Up in China Good news for would-be investors in China: The licensing and quota approval process has been drastically shortened. This is a new window of opportunity for firms considering applying for qualified foreign institutional investor (QFII) status.

China is already the world’s largest exporter, and is expected to be the world’s largest trading nation by the end of 2014.

(continued)

Citi Transaction Services4

One other change is worth noting. To obtain a QFII licence, investors must submit a document showing how their China investments will fit into their overall strategy. Given the long wait for a licence in the past, this often needed updating as firms got to the head of the queue. To help with that process, CSRC would tell custody banks each quarter which of their clients was coming up for approval. Now that will no longer happen — so firms need to make sure their submissions are kept up-to-date.

The QFII program has been a big hit with investors. In the past eight years:

• 142 applicants have been granted a QFII licence (around 20 are still waiting to get their quota approved).

• Of a total approved quota of $30 billion, some $22.2 billion has so far been allocated to QFII investors.

The Chinese authorities clearly favor long-only investors prepared to invest the majority of their QFII quota in equities and commit for the long term. This may have something to do with the short time frames of local retail investors, who tend to drive the markets.

The speeding up of the QFII process comes at an interesting time. ”The Shanghai index has come back a long way from its high of two years ago, falling from around 6,000 a few years back to 2,400 or so today,“ says Mr. Wong: ”We believe the valuations certainly look attractive, and relative to other markets, China still represents an obvious destination for investor flows given the GDP growth is widely expected to be above 8% in 2012.“

Encouraging moves followed:• In December 2011, CSRC approved a record

14 QFII licence applications from nine different countries, followed by another seven in January 2012

• SAFE reinstated its monthly panel meetings to consider QFII quotas, and approved a total of 14 quotas from November 2011 to January 2012 (11 of which were awarded to new applicants, while the remaining three were awarded as incremental quotas)

What brought about this change of heart? ”We believe the speeding up of approval times may at least partially reflect greater comfort levels in China in light of recent inflation numbers and other key economic metrics being seen as within acceptable levels,“ says Kevin Wong, China Securities Country Manager for Citi Transaction Services. ”For much of 2011, SAFE had been slowing down the quota approval process. CSRC followed suit by slowing its own licensing process. In the last couple of months, both have been clearing up some of the backlog,“ he says.

The Chinese authorities are still expected to proceed at a measured pace, says Mr. Wong. The best guess is that no more than four or five new quotas will be approved by SAFE each month. The authorities want to avoid a sudden surge in market inflows. ”Nevertheless, international investors keen to invest in China should take advantage of the new speeded-up process,“ stresses Mr. Wong.

The Chinese authorities clearly favor long-only investors prepared to invest the majority of their QFII quota in equities and commit for the long term.


Citi provides an end-to-end solution for incoming foreign investors. Our credentials in the QFII market are widely recognized:

• We helped pioneer the QFII system, acting as custodian to the very first QFII in 2003.

• We have a 20% share of the QFII custody market.

• We continue to work closely with the regulators to make QFII a success.

Our role is not restricted to QFII: With our extensive on-the-ground presence, we are also well placed to help investment managers find distribution for their mutual funds in China.

Why Citi?• Leading provider of custody and fund services

to institutional investors of every kind.

• Over 100 years’ experience in China.

• Deep market connections help investment managers to understand the local regulatory nuances.

• Leading distribution support services and market contacts benefit managers looking to expand their business network.

For more information, please contact:Mathew Kathayanatt: +44 (0) 20 7986 7523 e-mail: [email protected]

Jesse Kwon: +1 (212) 816 6097 e-mail: [email protected]

Citi OpenInvestorSM is the investment services solution for today’s diversified investor, combining specialized expertise, comprehensive capabilities and the power of Citi’s global network to help our clients meet their performance objectives across asset classes, strategies and geographies. Citi provides complete investment services for institutional, alternative and wealth managers, delivering middle-office, fund services, custody, and investing and financing solutions that are focused on our clients’ specific challenges and customized to their individual needs. ■

Our role is not restricted to QFII: With our extensive on-the-ground presence, we are also well placed to help investment managers find distribution for their mutual funds in China.


Globalization

New Rules Open Indian Market to Broader Investor AudienceUntil now, foreign access to India’s equity and mutual fund markets has largely been restricted to institutions and funds with a broad base of investors. The new Qualified Foreign Investor (QFI) rules change all that — opening up India’s $1.6 trillion equity market to virtually all categories of investor.

QFI opens the market up to most classes of investor (both institutional and retail), including:

• Private banks, including their clients

• Funds — ranging from hedge funds to pension funds

• Family offices

• Broker-dealer for their proprietary trading desks

• Partnerships

• Corporates

• Individuals

”This is a game-changer,“ says Citi’s Debopama Sen, Securities Country Manager for Securities and Fund Services, India. ”No registration is required, so time to market is a lot shorter. The key requirement is that QFIs must open a securities account with a Qualified Depository Participant (QDP). Citi was one of the first custodians to become an approved QDP,“ she says.

The QDP will be responsible for:

• Routing a QFI’s trade orders to brokers (unlike Foreign Institutional Investors [FIIs], QFIs will not be permitted to place orders directly with brokers).

• Deducting taxes at source before repatriating funds.

• Monitoring individual investment limits: QFIs will be allowed to buy up to 5% of a company’s capital. Collectively all QFIs will be limited to an aggregate 10%.

The new QFI regime is the culmination of two years’ work by officials, regulators and academics brought together in a working group chaired by U. K. Sinha, now chairman of the market regulator, the Securities and Exchange Board of India (SEBI). In August 2011, SEBI had introduced the QFI route for inward investment into Indian mutual funds investing in equities or infrastructure. Now it is to be extended to investment in equities directly. We believe this step has been taken by the regulators to provide direct access to a wider set of investors

”This is a game-changer,“says Citi’s Debopama Sen, Securities Country Manager for Securities and Fund Services, India.

(continued)


and attract more foreign funds, thereby deepening the Indian capital markets. Citi has been actively engaged with the regulators to facilitate a framework for QFI investments, and we continue to closely work with them to operationalize this.

There are some key restrictions:

• Eligibility: At present, only firms or individuals from jurisdictions compliant with Financial Action Task Force (FATF) standards and signatories to International Organization of Securities Commissions' (IOSCO's) memorandum of understanding will be eligible to become QFIs. Indian Regulators are working closely to finalize a list of eligible countries. Jurisdictions such as Cayman or Mauritius look unlikely to qualify.

• Single cash account: Unlike FIIs, QFIs are not allowed to open cash accounts with their QDP so all cash from disposals will be maintained by the QDP in a pool bank account of the QDP, with segregation for each QFI maintained.

• Cash repatriation: Unless funds are invested or reinvested within five days of receipt by the QDP, they must be repatriated.

The table on the right provides a comparison of the QFI and FII rules. In general, the FII rules are more accommodating, but there may be occasions where an FII, such as a fund manager, has subaccounts that are not eligible for FII registration but will now qualify as QFIs.

The announcement of the new rules comes against the backdrop of a surge of inward investment. In January, for instance, FIIs bought around $2 billion of Indian equities and $3 billion of local fixed income stocks. The market has had a good start to the year, although critical state elections are due shortly. A spate of partial privatizations is also expected this year.

Ms. Sen does not expect this to open the floodgates to inward investment overnight.

”The onus is on the QDPs to ensure investor compliance with the local know your customer (KYC) and anti–money laundering rules and there are tax issues to be sorted out,“ she says. ”We will move in a phased manner.“ The KYC, cash account rules and taxation aspects are also still being discussed with the regulators.

There is other work to be done, too, she says: ”The Central Depository will be responsible for monitoring the aggregate limits of QFI investments in individual stocks. Meanwhile, some QDPs will need to build systems for taking in orders and routing them on to brokers.“ Citi shall leverage its proprietary Order and Trade Management Systems in place to facilitate the new order-routing process.

For all that, the new rules look set to attract a multitude of new investors into India. ”We think the QFI route will be interesting for a couple of groups,“ says Ms. Sen. ”One is the broker-dealer community, whose proprietary trading desks do not qualify as FIIs but do as QFIs. Another is private banks, whose clients have never before been able to directly access the Indian market and other institutional players.“

Why Citi?• Qualified Depository Participant.

• Leading provider of custody, fund and cash management services to institutional investors of every kind.

• Deep market connections help investment managers to understand the local regulatory nuances.

• Leading distribution support services and market contacts benefit managers looking to expand their business network.

For more information please contact:Mathew Kathayanat: +44 (0) 20 7986 7523 e-mail: [email protected]

Jesse Kwon: +1 (212) 816 6097 e-mail: [email protected]

For all that, the new rules look set to attract a multitude of new investors into India. .


Eligibility • Open to all categories of investors — Retail and Institutional

• No track record required

• Only investors from jurisdictions that are FATF compliant and signatory to MMOU of IOSCO

• Popular jurisdictions like Mauritius/Cayman not eligible

• Entities with Opaque structure(s) may not be allowed

• Route open to specified categories of institutional and retail investors, meeting the predefined conditions

• One-year track record prior to seeking registration as FII

• FII from jurisdictions whose local Securities regulator is an Ordinary/Associate member of IOSCO

• Subaccounts can be from any jurisdiction

Registration • No SEBI registration required

• No market access regulatory fees

• Obtain registration with SEBI under defined categories

• Registration fees of USD 5,000 (for FII) and USD 1,000 (for subaccount), additionally payable every three years

Permitted Investments

• Equity and mutual fund schemes • Equity, debt, listed derivatives, MFs, Interest Rate Futures, etc.

Account Structure • A single securities account

• No cash account permitted

• Permitted to open a single securities account

• Permitted to open both local and foreign currency accounts

Clearing & Settlement

• Client to place trade orders to brokers through the QDP

• Clearing & Settlement of trades: DVP between QDP and broker

• Client to place trade orders directly with the stockbroker

• Clearing and settlement of trades done by the local Custodian

Investment Limits/ Restrictions

• Up to 5% of the paid-up capital of the company

• Aggregate QFI investment limit of 10%

• QFIs cannot issue ODIs

• Up to 10% (5% for foreign individual & corporate) of the paid-up capital of a company

• Aggregate FII investment limit of 24% (extendable)

• FIIs can issue ODIs

Tax • QDP/Mutual Fund to deduct applicable income taxes prior to repatriation/redemption

• Computation of income tax by FII appointed CPA

Foreign Exchange • To & Fro movement of fund from the QFI’s designated overseas bank account to the QDP’s account

• Funds to be invested/re-invested within five days of receipt by the QDP

• No specified investment/Repatriation period for funds

• FX hedging of portfolio through Forwards permitted

Citi OpenInvestor is the investment services solution for today’s diversified investor, combining specialized expertise, comprehensive capabilities and the power of Citi’s global network to help our clients meet their performance objectives across asset classes, strategies and geographies. Citi provides complete investment services for institutional, alternative and wealth managers, delivering middle-office, fund services, custody, and investing and financing solutions that are focused on our clients’ specific challenges and customized to their individual needs. ■


A breakup of the Euro Area would be rather like the version of a divorce in the movie The War of the Roses: disruptive, destructive and without any winners. Even a partial breakup involving the exit of one or more fiscally and competitively weak countries would be chaotic. A comprehensive breakup, with the Euro Area splintering into a Greater DM zone and around ten national currencies, would create financial and economic pandemonium. It would not be an orderly unwinding of existing political, economic and legal commitments and obligations.

What Happens if the Euro Collapses?The following article is an excerpt from the latest edition of Citi Global Perspectives & Solutions (GPS). Citi GPS is designed to help our clients navigate the global economy’s most demanding challenges, identify future themes and trends, and help our clients profit in a fast-changing and interconnected world.

Willem Buiter Chief Economist,

Citi


It took seven years of careful preparation and planning to launch the then 11-nation Euro Area in 1999. Exchange rates of the 11-candidate national currencies converged smoothly to the irrevocable euro conversion rates agreed among the member states well in advance. Even the fiscally weak and uncompetitive Euro Area candidates had, under pressure to meet the Maastricht criteria for Euro Area membership, engaged in years of fiscal austerity, inflation convergence and domestic cost control prior to entry.

In contrast, exit, partial or full, would likely be precipitated by disorderly sovereign defaults in the fiscally weak and uncompetitive member states, whose currencies would weaken dramatically and whose banks would fail. If Spain and Italy were to exit, there would be a collapse of systemically important financial institutions throughout the European Union and North America and years of global depression.

Consequences of Exit or BreakupThree kinds of consequences of exit or breakup can be distinguished: first, balance sheet or portfolio revaluation effects; second, international competitiveness effects; and third, procedural, redenomination or legal effects.

Consider the exit of a fiscally and competitively weak country, say Greece — an event to which I assign a probability of around 20% or 25%. Following exit, most contracts, including bank deposits, sovereign debt, pensions and wages, would be redenominated in New Drachma and a sharp devaluation, say 65% if we take the collapse of Argentina’s currency board in 2001 as a guide, of the new currency would follow. Consequently, as soon as an exit is anticipated, depositors will flee Greek banks and all new lending and funding governed by Greek law will cease. Following the exit, contracts and financial instruments written under foreign law will likely remain euro-denominated. Balance sheets that were thought to be balanced in the absence of redenomination risk will become severely unbalanced and widespread default, insolvency and bankruptcy will result. Greek domestic demand and output will collapse.

(continued)


and price inflation, driven by the collapse of the currency itself and by the monetization of the likely remaining government budget deficit, would quickly restore the uncompetitive status quo.

If Greece storms out of the EA, something that has become more likely following the growing political unrest and economic uncertainty and distress in the country, there might be little fear other countries would follow suit. However, if Greece is de facto pushed out of the EA, say because other member states refuse to fund the Greek sovereign and the ECB refuses to fund Greek banks, the markets could beam in on the next most likely country to go. This self-fulfilling fear might force the actual departure of the afflicted country. This exit contagion might sweep right through the rest of the EA periphery — Portugal, Ireland, Spain and Italy — and then begin to infect the EA “soft core”: Belgium, Austria and France.

A disorderly sovereign default and EA exit by Greece alone is manageable. Greece accounts for only 2.2% of EA GDP and 4% of EA public debt. However, a disorderly sovereign default and EA exit by Italy would bring down much of the European banking sector. Disorderly sovereign defaults and EA exits by all five periphery states — an event to which I attach a probability of no more than 5% — would drag down not just the European banking system, but the North Atlantic financial system and the internationally exposed parts of the rest of the global banking system as well. The resulting global financial crisis would trigger a global depression that would last for years, with GDP falling by more than 10% and unemployment in the West reaching 20% or more. Emerging markets would be dragged down, too.

An exiting country, facing massive disruptions in its international capital account transactions, would need to impose strict capital and foreign exchange controls following exit if some semblance of financial order is to be maintained. However, Article 63 of the Consolidated Version of the Treaty on the Functioning of the European Union does seem to rule out the imposition of capital controls and payments controls not only between 27 members of the EU, but also between members of the EU and countries outside the EU, so-called third parties.

Fortunately, for every Article in the TEU and the TFEU asserting that something is either required or not allowed, there is another Article or Protocol asserting the opposite or creating a loophole. TFEU Articles 346, 347, 348 and 352 invoke the threat of war, serious internal disturbances and other unforeseen contingencies as grounds for overriding Treaty clauses and other legislation, and provide mechanisms for implementing such overrides.

Good Will Is EssentialIn the EU, as in life, love normally finds a way around mere Treaty-based and legal obstacles to common sense. But good will is essential. If a country were to exit in a haze of confrontation and hostility, it is unlikely it would be shown the kind of forbearance that is in principle possible in a consensual exit.

The sharp decline in the New Drachma’s external value following exit would temporarily give Greece a competitive advantage. But Greece (like Portugal, Spain and Italy) does not have the persistent nominal rigidities found in more Keynesian economies like the U.S., the UK and perhaps even Ireland, that would turn a depreciation of the nominal exchange rate into a lasting competitive advantage. Soaring wage

A breakup of the Euro Area would be rather like the version of a divorce in the movie The War of the Roses: disruptive, destructive and without any winners.


Exit by Germany and the other fiscally and competitively strong countries would be possibly even more disruptive. I consider this highly unlikely, with a probability of less than 3%. Following the exit, Germany and the other core EA member states (perhaps excluding France) would introduce the new DM. The sovereigns in the periphery would default. The new DM would appreciate sharply. Financial institutions in the new DM area would have to be bailed out because of losses from exposure to the old periphery and the soft core. As nothing holds the remaining EA countries together, the rump-EA splits into perhaps 11 national currencies. The legal meaning and validity of all euro-denominated contracts and instruments is up for grabs.

Even if the breakup of the EA does not destroy the EU completely and does not represent a prelude to a return to the intra-European national and regional hostilities, the case for keeping the Euro Area show on the road would seem to be a strong one — financially, economically and politically, including geopolitically.

Willem Buiter joined Citi in January 2010 as Chief Economist.

One of the world’s most distinguished macroeconomists, Willem previously was Professor of Political Economy at the London School of Economics and is a widely published author on economic affairs in books, professional journals and the press. Between 2005 and 2010 he was an advisor to Goldman Sachs advising clients on a global basis. He has been a consultant to the IMF, the World Bank, the Inter-American Development Bank, the Asian Development Bank, the European Commission and an advisor to many central banks and finance ministries. Willem has also held a number of leading academic positions, including Cassel Professor of Money & Banking at the LSE between 1982 and 1984, Professorships in Economics at Yale University between 1985 and 1994 and Professor of International Macroeconomics at Cambridge University between 1994 and 2000. Willem has a BA in Economics from Cambridge University and a PhD in Economics from Yale University. He has been a member of the British Academy since 1998 and was awarded the CBE in 2000 for services to economics. ■

The resulting global financial crisis would trigger a global depression that would last for years.


Fergus PeryGlobal Head of OpenCollateral

Citi Transaction Services, Citi


Since September 2008, however, there has been a substantial shift in the landscape of the marketplace: a significant decrease in the availability of collateral, largely driven by market-wide deleveraging in the wake of the global credit crisis. In a working paper published last year (WP 11/25), the IMF estimated that source-side collateral has declined by as much as $5 trillion.

Alongside the reduction in source collateral has been a corresponding increase in the required amount of collateral. This is due to a number of factors, but principally:

Market and Business Outlook

Collateral Convergence Are You Optimizing Collateral Efficiently?

Banks and broker-dealers on the sell-side use and reuse (“rehypothecate”) collateral to cover their margin requirements with their counterparties. Margin requirements are typically driven by stock borrowing, repos, OTC derivatives, clearing margining and structured products. Collateral to meet these margin requirements is sourced either from the firm’s own inventory or from trading activity with buy-side institutions such as hedge funds, pension funds, insurers, corporate or other institutional investors.

Fergus PeryGlobal Head of OpenCollateral

Citi Transaction Services, Citi

(continued)


There has been a marked movement toward higher-quality collateral and stricter testing of collateral, e.g., testing for liquidity.

• Stricter collateral eligibility. There has been a marked movement toward higher-quality collateral and stricter testing of collateral, e.g., testing for liquidity.

• Collateralizing previously uncollateralized obligations. For example, counterparties that had a high credit rating must now post collateral against obligations that previously didn’t require them to post collateral. Because of credit downgrades or a greater focus on risk, trades such as uncollateralized OTC derivatives and intraday credit lines are now often collateralized.

• Regulatory drivers. As a result of growing capital requirements and/or mandatory collater-alization, new regulations in jurisdictions around the world are focusing on risk mitigation via collateralization. The clearing of OTC derivatives as mandated by EMIR and Dodd-Frank will result in a major increase in the amount of collateral that is required from market participants. And from a capital requirements standpoint, there will also be major impact on collateral demand from BASEL III, Solvency II and CRD IV.

Optimizing Collateral EfficiencyAs with all instances of decreasing supply and rising demand, the net result is an increase in the cost of collateral and a drive toward its efficient use. At Citi, we believe that efficiency in a collateral program may be achieved by:

• Developing an optimization strategy (e.g., using the lowest grades of collateral possible), with the technology and operational capability to support it.

• Overcoming internal organizational silos and a culture of segregation between trading desks (e.g., fixed income vs. equity), therefore allowing:

— Centralizing and pooling of collateral and processes by creating a virtual pool of collateral across a firm’s entire holdings;

— Collateralizing centrally across all trade/obligation types by netting obligations where possible and ensuring that the pool of available inventory is allocated as efficiently as possible across a holistic portfolio of obligations.

• Reducing unnecessary buffers, i.e., where collateral is held in reserve to mitigate late calls, risk of settlement failure or missing market cutoffs.

• Transforming ineligible collateral for eligible, e.g., via collateral upgrade or financing trades to “upgrade” to higher-grade collateral or cash.

• Rehypothecating received collateral where permitted by the underlying agreement and ensuring that effective and automated recall management is implemented.


In 2012 and BeyondAgainst this backdrop, market participants are facing a hugely increased demand for collateral against a dwindling source. In our view, the market will need to converge toward a model that is:

• Asset-neutral — by leveraging a firm’s entire inventory of assets across all asset classes, including collateral that is available for reuse.

• Obligation-neutral — by looking at a firm’s overall collateral requirements as a whole, rather than by trade/underlying type.

• Custody-neutral — by ensuring that the asset inventory held at multiple custodians can be leveraged without the need for unnecessary market movements or the maintenance of inefficient “buffers.”

Besides a change in culture to move toward a centralized model, a significant investment in technology and operational expertise is essential to support an overall collateral optimization strategy.

At Citi, we’ve developed our OpenCollateralSM

service to meet the increasingly complex requirements of your collateral program and to help you succeed in an ever-changing marketplace. ■

For additional information:Americas: Daniel Ulrich [email protected]

Europe, Middle East and Africa: Fergus Pery [email protected]

Asia Pacific: Pierre Mengal [email protected]

Besides a change in culture to move toward a centralized model, a significant investment in technology and operational expertise is essential to support an overall collateral optimization strategy.


Change is often driven by crisis, government intervention or a combination of both. This is certainly the case in the private equity arena where the current dynamic between fund managers and investors is being reshaped with investors desiring and needing increasingly granular information and a significantly evolving regulatory environment.

Joe PatellaroGlobal Head

Private Equity Services, Citi

Massimo ZannellaDirector

Private Equity Services, Citi

Regulatory Spotlight

The Evolution of Private Equity Investing: Alignment of Interests and the Impact of Regulation


Citi has partnered with more than 60 ECAs and MFIs, lending its global reach to support companies in many challenging regions of the world.

The gap between what the limited partner (LP) wants and what the general partner (GP) is able or willing to provide is not a new phenomenon but current market conditions are shining a brighter light on this disconnect and solutions are now required. The perceived balance of power has swung toward investors. This article discusses the main factors driving this trend including the fallout from the recent financial crisis, the Institutional Limited Partners Association (ILPA) efforts to encourage increased transparency, consistency and disclosure, and a number of key regulatory developments.

Private equity is an inherently complex industry and there are notable differences in the approaches being taken to provide even some of the most basic industry information to private equity investors. This is further complicated by the obvious conclusion that whatever the series of outcomes in addressing these evolving needs, there can be no one-size-fits-all model to address the vast degree of differences across the managers that will need to implement these changes and the investors who will ultimately invest capital in them.

While the exact future of private equity investing and the relationship between managers and investors has yet to be written, the evolution of a long journey ahead is most certainly under way.

Drivers for increased reporting and disclosureThe financial crisisBefore the financial crisis, investors in the private equity asset class were more accepting of a lesser degree of transparency from their managers. This was due in large part to the high rates of return that the best managers were able to generate for investors. Furthermore, given the demand for access to the elite managers, LPs typically did not “rock the boat” by being overly demanding of managers or making onerous requests for information. This changed considerably in 2008.

As capital markets dried up, private equity investments were impacted on multiple levels. The dearth of transactions led initially to fewer distributions, greater uncertainty regarding future cash flows and eventually reduced returns for investors. Continuing capital calls for expenses, new and add-on investments exacerbated the liquidity crisis that investors were feeling across their entire portfolios. For recent entrants to private equity investing, the lack of clarity around cash flows was even more challenging. Investors attempting to gauge their exposures to markets or various economic factors found it difficult to assess risk at the portfolio level if they could not understand the credit, counterparty, sector and market risk of their investments.

(continued)


The financial crisis has, therefore, led investors to scrutinize private equity performance metrics more critically. As a result, increased disclosure is no longer a nice-to-have option that fund managers may or may not provide to their investors, but rather a basic requirement to get past the due diligence of most investors. Furthermore, a willingness to disclose information and data can be a factor that GPs use to differentiate themselves from competitors.

Industry changes and investors as agents of change The growing complexity of the industry coupled with the fact that investors are more sophisticated and accustomed to private equity investing is facilitating the need for closer alignment and dialogue with fund managers. It also means that investors are less reticent about asking for data and information from GPs or about expressing a wish to exert more control over what they do and how they invest money.

Sophisticated investors, for example, are seeking products that provide more liquidity, shorter duration and more control in various bespoke solutions. Separately managed accounts and direct coinvestment vehicles are increasingly popular among investors that do not wish to be commingled with LPs that have different objectives or that want to have an enhanced degree of control over how their capital is allocated as well as increased visibility into those investments.

The largest institutional investors are putting additional options on the table. With $44 billion of its $110 billion total allocated to private investments, Texas Teachers has struck strategic partnerships with large private equity managers that “affords us greater flexibility and more control…[and] the opportunity to closely inspect the practices of these firms and get a grasp for how they consistently outperform the public-equity markets.”1

Alternative investment asset managers themselves are creating additional complexity in reporting and transparency with the increasingly blurred lines between private equity structures and investments and more actively traded instruments.

Family offices that manage the affairs of very wealthy families have long had interest in private equity investing. Many have made their fortunes through entrepreneurial activities, often as the founders of privately held companies. They are long-term in nature and understand the value of patient investing. Given the talent available as Wall Street firms grapple with profitability pressures and the terms of the pending Volcker Rule, many family offices have built teams to manage private equity internally.

Importantly, diverging approaches to improving transparency differ not only across vehicle and client type, but also across investor segments. Old-school private equity investors have a long-term, historical view of the asset class and may not as quickly question the need for deep transparency in this asset class. Newer investors, by contrast, may have more experience with listed equities and more traditional markets and have been immediately horrified by the lack of transparency in their private equity portfolios.

Ultimately, LPs of any ilk are looking for some level of industry standardization in order to be able to maximize their ability to analyze performance, risk and other metrics across their entire portfolio. However, this can be more challenging in an industry that has different requirements and, therefore, does not necessarily speak with one consistent voice.

The role of ILPA Investors are also driving change through ILPA, which is playing a significant role around improving transparency and is helping to direct the industry toward an increasing level of standardization. With over 250 members collectively managing over $1 trillion in private assets globally, ILPA2 has established operating guidelines to drive consistency in the manner in which GPs are reporting certain information to their investors. Its Private Equity Principles center around an alignment of interests, improved governance and increased transparency.

The principles include the suggestions that:

• fee and carried interest calculations be transparent and subject to LP and independent auditor review and certification;

Perhaps the most significant question to be answered is whether this changing landscape will cause the long-term returns for the asset class to suffer.

1The Wall Street Journal, (February 16, 2012), “Private Equity Keeps Public Pensions Sound.”2Institutional Limited Partners Association website: http://ilpa.org.


• detailed valuation and financial information related to portfolio companies should be made available as requested on a quarterly basis; and

• GPs should reinforce their duty of care beyond the minimum standard for indemnification.

ILPA took a further step toward facilitating reporting consistency in October 2011 when it issued the Quarterly Reporting Standards and Capital Call and Distribution Notice Templates, but while the templates are highly instructive, they are not meant to be definitive.

ILPA is a trade group, however, not a regulator, and therefore its recommendations are nonbinding. This has led skeptics to question the extent to which managers would voluntarily embrace such standards, given their pedigree and their ability to attract new investors that might not insist on implementing ILPA’s guidelines. However, large managers seem to be leading the way in terms of responsiveness. Although these managers have strong reputations, some are trying to use their willingness to improve their disclosure as a source of differentiation from competitors in order to attract new capital. Perhaps some GPs are responding directly to their current investors’ demands for compliance with the ILPA guidelines. CalPERS, for example, has formally announced that starting March 1, 2012, GPs will have to comply with its new ILPA-style terms on capital calls and distributions.3 It may also be the case that the largest managers have the resources (people and technology) available to change their communications — not just the actual reporting, but the approach to collecting data and ensuring its quality.

While there are clear signs of evolution in the dialogue between GPs and LPs, the clear and consistent consensus is that one solution will not fit all of the needs of the industry’s constituents. Even ILPA itself recognizes that “a single set of terms cannot provide for the broad flexibility of market circumstance.”4

The impact of regulation In the United States and Europe, regulators have taken significant steps to improve transparency

through a series of new regulations. The Dodd-Frank Act in the U.S. and the Alternative Investment Managers Directive (AIFMD) in the EU are particularly salient. A critical component of these reforms (see “Summary of key regulations in the U.S. and EU” on page 23) is that unlike any concessions advocated by industry groups such as ILPA, these regulations are mandatory, absolute, standardized and treat all investors alike.

While many of the provisions of AIFMD and the Dodd-Frank Act are aimed specifically at reducing systemic risk in the wake of the financial crisis, they are likely to reinforce the drive toward increased transparency and the control being sought by many private equity investors. As a general rule, regulatory oversight leads to more investor confidence: Investors may take comfort in the fact that someone is watching over their managers.

Although these regulatory changes and additional disclosure should improve transparency for private equity investors, other issues still remain. The lack of clear standards for valuation, risk management, performance measurement and benchmarking of private equity investments compared to traditional and even hedge fund investments still exists.

The challenge will be managing these changes into and throughout the industry in a systemic and efficient manner, coupled with the potential unintended consequences of the impact of certain evolving regulations on private equity managers and investors alike.

Perhaps the most significant question to be answered is whether this changing landscape will cause the long-term returns for the asset class to suffer, since part of the theoretical appeal of private market investing is that information advantage leads to superior returns. With complete transparency and therefore less information advantage (regardless of cost of implementation), will returns suffer and begin to more closely mirror public market returns, making private equity investing a less attractive asset class?

3The Wall Street Journal, (February 27, 2012), “CalPERS standardizing general partners’ reporting form.”4ILPA Best Practices, ILPA website: http://ilpa.org.


The evolution has only just begunAll evidence indicates that alignment between fund managers and investors is moving in the right direction. Managers are building processes and capabilities commensurate with the increasing needs of their investors. It remains to be seen whether the increasing impact of a regulatory overhang stunts or fuels that progression.

CFOs and COOs are on the front line of this information revolution. They are required to set up the back-office functions, the processes and the infrastructure essential to meet the increasing reporting and information needs of investors. They are also responsible for weaving this into an organizational structure of risk management, compliance and oversight to address the new and evolving regulatory environment that is taking place across the globe and achieve this manner that also aligns with their investors’ compliance requirements.

There are many players who will have a role in this evolution beyond the GPs and LPs themselves. Technology must play an increasing role in capturing, managing and reporting the hoards of data captured for both internal and external reporting purposes. Firms continue to invest heavily in technology to meet these increasing needs and, as a result, technology providers are increasing their presence in the private equity space.

In order to improve risk management and control, the historical focus on core accounting and reporting has necessarily expanded to include portfolio transparency, benchmarking, enhanced investor reporting tools, data feeds and aggregation of portfolio information with other asset classes.

Other industry constituents will also play increasingly important roles in areas such as assisting with regulatory compliance in the new landscape, advising and consulting on operating platforms and procedures and creating a more consistent outsourcing model for the administration of funds in accordance with evolving industry standards.

There is ample evidence to suggest that investors remain committed to the asset class. Moreover, given low expected returns for most of the developed world for some time, investors are unlikely to add to their traditional investments at the expense of their private equity allocations. Despite the pressures from investors and regulators alike, the future of private equity has yet to be fully written. While there are demands for a certain level of standardization, there is not a one-size-fits-all solution. Some investors will rely on the regulators to set these standards, others will negotiate directly with fund managers and others still will rely on new investment structures to meet their goals. Although the precise vision of the future remains cloudy, it is clear that there is no going back.

All evidence indicates that alignment between fund

managers and investors is moving in the right direction.


Summary of key regulations in the U.S. and the EU U.S. overview

The Dodd-Frank Act is the most significant recent regulatory development in the U.S. Under this Act, private equity firms with more than $150 million in assets under management are required to register as investment advisors with the Securities and Exchange Commission by March 30, 2012. In addition, they must comply with the Advisors Act and will be required to implement a compliance program, designate a chief compliance officer (CCO) and create a written compliance manual setting out the firm’s procedures for portfolio management, maintenance of books and records, employee conduct guidelines and regulatory reporting protocols.

Another requirement under Dodd-Frank is that SEC-registered firms are required to periodically file a reporting form called Form PF, which may require a firm to include some or all of the following information:

• details of valuation policies and practices;

• extent of leverage incurred by their portfolio companies;

• size and scope of any investments in financial institutions;

• types of investors in the funds; and

• information related to the funds’ service providers.

EU overview

The two key regulations are: the Alternative Investment Fund Managers Directive (AIFMD) and Solvency II.

AIFMD

The directive applies to private equity and hedge fund managers operating in the European Union and requires them to do the following:*

• designate a depositary for the safekeeping of fund assets and take on a fiduciary duty in their approach to safekeeping;

• disclose use of leverage to investors and comply with forthcoming limits to be defined by regulators;

• disclose any preferential treatment offered to specific investors (without revealing their identities), particularly with regard to liquidity management and gating;

• appoint either an independent entity or a functionally separate unit of the AIFMD to value the fund’s assets; and

• establish risk management systems, which will be functionally separate from portfolio management and subject to annual review.

Firms with total assets under management of less than €100 million (leveraged) or €500 million (unleveraged) escape the full registration and reporting regime under the AIFMD. Full implementation of the directive will not take place until 2013 at the earliest.

Solvency II

The proposed Solvency II framework is designed to reduce systemic risk. The three main pillars are:

• Pillar 1 includes quantitative requirements (Solvency Capital Requirements, estimates of the liabilities and risk margin and a minimum capital requirement).

• Pillar 2 sets out requirements for the governance and risk management of insurers as well as for the effective supervision of insurers.

• Pillar 3 focuses on disclosure and transparency requirements.

At a macro level, there is a concern that these stress tests on private equity assets may drive insurers to de-risk and move out of private equity toward assets that are perceived as safer. The European Commission has also argued for applying Solvency II standards to pension funds, given the size and duration of their liability profiles. This could prove to be a blow to private equity managers, given pension funds’ historical private equity capital base. ■

*See Articles 12 to 17 and Article 19 of the AIFMD.

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