Recently, private equity has attracted the attention of institutional and individual investors because of the wide array of opportunities it offers. Within the dynamics of private equity, however, capital deployment decisions greatly impact fund profitability.
This reality makes expense allocation just as important as the real returns of a deal or investment when evaluating these opportunities.
Traditionally, expense allocation for private equity firms is managed with complex spreadsheets and a complicated list of rules that determine how allocations should be made. The manual nature of the work, combined with the fact that most of the required data is sourced from multiple third parties and systems, makes this process quite a challenge.
But it is not one that private equity funds can take lightly, given the Securities and Exchange Commission’s (SEC’s) emphasis on auditing expenses passed through to LPs.
Specifically, the SEC announced that fees, expenses, and conflicts of interest are some of its top concerns for annual examinations, and that private equity firms can face substantial fines and penalties for lack of transparency and overallocation of expenses.
In other words, expense allocation for private equity is a center of regulatory attention. For this reason, private equity firms should consider improving the expense allocation process with a more transparent and well-defined approach. Benefits of this approach include:
- Greater investor confidence: Investor trust is fostered through a transparent and equitable expense allocation process. Investors can be sure they are not unfairly burdened with unnecessary expenses and can better understand exactly how their cash is used.
- Equitable distribution of costs: With a clear and consistent expense allocation process, costs are distributed equally among portfolio firms and investors. This strategy protects any one organization from bearing an excessive financial burden.
- Higher operational efficiency: By allocating expenses effectively, private equity firms can better monitor and manage financial resources. Businesses are better able to allocate resources, create budgets, and manage costs when expenses are clearly identified and categorized.
However, despite these benefits, the main challenges in private equity continue to revolve around managing complex data, regulatory scrutiny, and operational inefficiencies. Let’s take a closer look at what are the challenges of private equity in expense allocation and how automation can address them.
What are the Key Challenges in Private Equity Expense Allocation
1. Deal Allocation
Depending on the stage of investment, deal allocation methodologies may vary. This introduces integration challenges in private equity, as firms often have to connect multiple systems and data sources to track ongoing and closed deals.
An automated expense allocation tool can help manage allocations to ongoing deals and re-allocate them in the future when the deal either closes or ends. It can also generate reports highlighting deal status changes and reallocations, enabling private equity firms to track and report allocations accurately.
2. Complex Deal/Investment Structures
Due to the complicated nature of private deal and investment ownership structures, a wide range of allocation scenarios may need to be used for the same deal. For example, an expense could be allocated to the deal, a specific SPV in the deal, or directly to one of the funds. This complexity contributes to some of the challenges in valuing private equity markets, as allocations and ownership hierarchies influence fair value calculations. An automated expense allocation solution can determine the best scenario with ease, supporting more accurate valuations and consistent reporting.
3. Fund Structure and LPs
Private equity funds operate as limited partnerships, with general partners (GPs) managing the fund and limited partners (LPs) providing capital. Allocation of expenses between LPs and GPs can be complex because GPs must pay certain expenses up front while others are passed on or shared with LPs based on the fund agreement. Similarly, LPs have different expectations for expense allocation. An effective expense allocation tool can manage allocations to specific funds or investment vehicles while conforming to fund-specific terms and conditions.
4. Regulatory Compliance
Private equity firms are obligated to follow regulatory guidelines and comply with the necessary requirements concerning the expense allocation process. In fact, the SEC has expressed concerns about the private equity industry’s overall lack of transparency. According to the SEC, certain LP agreements fail to provide adequate information to investors, preventing them from effectively monitoring their investments and and their advisers’ investments. In October 2021, SEC Chair Gary Gensler reiterated the commission’s commitment to promoting transparency and competition in the private fund sector, adding that the SEC is actively exploring reforms to achieve this objective, including enhanced disclosures related to potential conflicts of interest and fees.
An automated expense allocation solution simplifies compliance and tracking, enabling private equity funds to maintain a detailed audit trail of allocation rules, adjustments, and approvals, as well as store documents highlighting the rationale for allocation decisions. With this technology, private equity firms can ensure regulatory compliance and conduct external audits transparently.
How Expense Allocation System (EAS)™ can Help?
Expense Allocation System (EAS)™ by IntegriDATA, an Indus Valley Partners Company gives private equity firms a streamlined and efficient approach to the expense allocation process that aligns with regulatory requirements.
With the EAS, private equity firms can simplify and enhance the entire expense allocation process while ensuring compliance, improving transparency, and strengthening investor confidence, all of which are critical for overcoming the challenges in private equity today.
