| 5/30/2016

Challenges in the Private Capital Markets: Part Two

Last week, we shared the first part of our interview with Kevin Black, EVP of Ipreo Private Capital Markets (PCM). In today’s post, we pick up our conversation with a discussion about the pain points, and how they’re provoking change, within the private capital markets.

Ipreo Blog: When we left off, you suggested that the pain levels were finally spurring the players in the private capital markets to seek out a technological solution.

KB: It’s really a combination of two things: the challenge of new regulations and the demand from investors – both limited partners and general partners – for more transparency into their portfolios.  These dynamics work together and reinforce each other.

Ipreo: Let’s start with the first one.

KB: In 2008, post-financial crisis, rules came down from regulators requiring investment firms to mark all of their private investments to a “fair market value” each quarter. Historically, these investments were just carried on the investors’ books at “cost”, which is what they paid for the investment originally.  This meant that investors would have no indication as to what their investments were actually worth at any point other than when they were bought, and when they were sold.
What the regulators said is that you need to give your investors some idea of what their private investments are “worth” every quarter, rather than just giving them a big surprise when they are sold years later.
When these regulations came out, private capital firms panicked. They had no systems in place to produce fair market values.  The data that would power these valuations was all over the place, and there was no software solution that would allow them to create these valuations systematically and defensibly. Not only that, but these valuations need to pass an audit!

Blog: Hence, the increasing pain level.

KB: Exactly.

Blog: And the second pain point?

KB: Let’s back up first. iLEVEL began as an internal Blackstone system that put a controlled workflow around the collection and reporting of financial data from their portfolio companies. It got all the portfolio company data into a single source of truth so Blackstone could power their investor reporting, valuations, risk management, portfolio monitoring, etc. from data that they knew was correct and consistent. Blackstone eventually decided that such a system had the power to create a level of transparency in the private markets that would transform them in a positive way.  They further believed that this “transformation through transparency” would be vastly more valuable to Blackstone than any proprietary interest they had in the system itself.

Blog: In what way?

KB: The biggest investors in private capital markets are huge institutions like pension funds, sovereign wealth funds and endowments (aka ‘Limited Partners’ or ‘LPs’). They love the returns they get from the private markets, yet they only allocate small portions of their portfolio to them.  The #1 reason why they limit their allocations to private markets is – you guessed it – lack of transparency.
The long game here is that if iLEVEL can significantly improve transparency to LPs, they will ultimately raise their allocations to private capital, and institutions that currently can’t/won’t invest in private markets will start to do so.  A rising tide lifts all boats.

Blog: How would that work?

KB: Today, from the LP perspective, the private markets are a big black box within their overall portfolios. In contrast, the portion of their portfolios that are invested in public securities are completely transparent – they know at all times exactly what they own, what it’s worth, what their exposures are, what the operating results of those investments are, etc.  For their private market investments?  Not so much.
iLEVEL can provide a level of transparency to the LP for their private investments that rivals what they get for their public investments.

Blog: What are they missing, exactly?

KB: Just getting basic data like “how much have I committed to each fund,” “how much capital has been drawn”, “what is the current market value of this fund”, “what is my exposure to telecom investments,” is painful, expensive, and takes several months after the end of each quarter.
But even this data is inadequate.  What LPs really want to understand are things like “how is each company in this fund performing operationally” and “how is this firm creating value?”  “Are they growing their revenue or are they declining” “Are they building market share?” “Are they becoming more profitable or less profitable?” “Are they under pricing pressure, what’s their debt like, are they tripping any debt covenants?” These are all things that good fiduciaries would want to know about the investments.
So LPs have been demanding more information, deeper data, and threatening to withhold future investments if they don’t get it.

Blog: So not only does the government want more transparency, so do the investors.

KB: Exactly. There’s been a big movement over the past couple of years where these LPs are demanding increased disclosures, something more than the typical quarterly PDF they’d be given, something more substantial. And they want it badly enough that now there’s a real financial hammer. “Do this for me or I won’t participate in your next fund.”

Blog: It has an impact on their bottom lines.

KB: All change requires motivation.  Adoption of new processes around data management and technology is painful and expensive, and therefore requires A LOT of motivation.  Historically these firms were making money hand over fist, and saw no reason to change.  Now, however, these dynamics are raising the cost of NOT changing to the point where they motivation is there.

IB: Isn’t this change, though difficult and a long-time coming, ultimately a good thing for everyone?

KB: Absolutely. More efficient markets benefit everyone – pensioners, pension funds, investors and the private companies that need capital.  And of course Ipreo too J.  It’s the closest thing there is to a free lunch.

Blog: That’s a good thing.

KB: Of course. But with that change and growth comes growing pains.
In the final installment of our interview, we’ll discuss those growing pains, and how we’re solving for them.