MUFG Investor Services Response to COVID-19

As a firm, we are continuing to monitor the situation about the Novel Coronavirus (COVID-19) and the impact that it is having on global travel, the financial markets and the health of those who have contracted the virus. Internally, we have implemented several precautionary measures to ensure the safety and wellbeing of our staff across all locations. These include travel advisories; specifically, we have banned all international travel as well as non-essential travel within a country until further notice. 

While the impact of COVID-19 varies in different locations, MUFG Investor Services has acted in accordance with local regulatory advisories to ensure the highest levels of care and precaution. We have been monitoring the situation in various parts of the world as the outbreak unfolds, and precautionary measures will be implemented accordingly for our regional offices.

MUFG Investor Services Executive Committee is working with our Business Continuity Planning (BCP) team and with other internal partner groups, to monitor the impact of the virus, as well as provide employees with information on the most effective measures to protect themselves in the workplace and in public.

As part of the BCP process we have procedures in place to handle situations where a large number of employees would need to work remotely. These procedures are vetted regularly through simulations and testing. We have no concerns with the ability of our staff to work remotely should there be a prolonged period of disruption.

Conditions around the COVID-19 virus are likely to shift over the coming weeks and months. Not only are we committed to the safety of our staff but more importantly focused on our commitment to our clients and providing the highest quality service without disruption.

We will provide further updates as we continue to manage through this period.  Please rest assured that we are here to help you in this unprecedented and profound time.

MUFG Investor Services

By Drew Nichol

MUFG has set itself the mission of becoming the preeminent Asian bank in the global securities financing market. It has begun with a series of senior hires and plans for a brand new technology framework to reinforce its global growth plans. Drew Nicol reports

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This year, MUFG Investor Services declared its aim is to focus on building out its securities lending offering. Why now and what are you looking to achieve?

Dan McNamara: MUFG Group has put a huge focus on its investor services franchise in recent years and there’s a genuine commitment to growing this area. We’ve already seen it in our fund administration and fund financing solutions and we see the enhancement of our securities lending proposition as a continuation of that mission. Clients and the industry know that MUFG is committed to this space, we have a longer investment and commitment horizon than many other banks, so a move like this has resonated with the market.

We are the fifth-largest bank in the world by balance sheet, we have a stable brand and we see agency securities lending sitting very well alongside our portfolio of products. You could say we were a little underweight in this area even though we have been here for 20 years, but now it is an area where we can grow dramatically.

We are making this move at a point in time where a lot of regulatory change has been introduced and bedded down; yes changes will continue but we are in a prime position to build a platform for the future that already incorporates many of the post-crisis regulatory requirements in its core DNA. In this sense it’s the perfect time to re-start with our new programme.

What opportunities are you looking to leverage to jump-start your new lending offering?

McNamara: First of all, we’re really excited about the team we have built, including Tim Smollen as the global head of securities lending solutions. This is a team that has a lot of experience with managing clients who have large portfolios and expect a very high-end service in terms of the provision of necessary information, transparency, data and adapting to regulations and clients’ changing needs.

We also believe that buy-side clients are looking for another option in this market and we see a space for another truly global programme, especially one run by an Asian bank. The actors in the industry we’ve spoken to are very interested in what we’ve showcased so far and given the current market environment we see now as the right time to do this.

Tim Smollen: The new regulatory environment also creates opportunities and not every programme out there can take advantage of that. We look to be nimble and responsive to changing market dynamics.

Crucially, we are not going to be a programme that’s struggling with what to do with general collateral. That said, we want to be selective in our marketing and work with clients where we can offer value and something they aren’t getting elsewhere.

Where are you starting on this mission? How will the new global programme be structured and where is your team based?

Smollen: So far we have Jay Schreyer, based in London, who will focus on Europe, the Middle East and Africa, along with Asia Pacific.

Additionally, we now have Anthony Toscano, in New York, who is responsible for building out the business in North America.

Both these gentlemen have experience in working with custodial and non-custodial programmes. They are both traders and risk managers, and client-focused as well, so they have the perfect skill set for our new model.

This is a global business and our clients need and demand continuity when interacting with each of our desks, so the fact that Jay and Tony have worked together before and understand each other is going to be critical.

McNamara: Asia is obviously an important market for us as well and we plan to set up a desk there the future. In the meantime, we will continue to engage with Asian clients, but it’s just a matter of building that physical presence.

We are satisfied with the team we have right now and we’re not planning any further hires for the moment. We have very high expectations for how this business will grow in the coming years and we will take on new hires to support that as needed.

Becoming arguably the first Asian bank to take a leading role in this space would be a major accolade, Tim, is that what drew you and your team’s attention to MUFG?

Smollen: Yes. We love a challenge and we love to build. This business requires long-term commitment and not every bank out there is ready to do that – MUFG is. When I get a client I expect them to be with me for 10 to 20 years, and that’s our goal. There’s also obviously something to be said for working with the fifth-largest bank in the world. We have a strong capital base and a great credit rating and that resonates with clients. I could build the best mousetrap in the world, but, in the end, clients buy the bank, so it’s important to have that rock-solid foundation.

The world’s best mouse trap will require some heavyweight technology to back it up. Can we expect to see some investment in this area for MUFG Investor Services?

McNamara: Technology is at the core of our proposition. Our wider investor services franchise made some acquisitions in 2019. These include Point Nine, a post-trade start-up now re-branded as MUFG Investor Services FinTech, and certain divisions of the fund administration business of Maitland, a global advisory, administration and family office firm.

We’ve done this because we need to own and develop our key technology functions, such as client interface and data management and analytics to continue being a provider of choice.

The acceleration of our agency lending programme will follow a similar strategy. We will take inputs and feeds from market data sources and leverage some other in-house data systems but it will always be in a way that fits within our existing ecosystems. Tim and the team have always been major users of data and data analytics and so our aim now is to take that to the next level. You’ll hear more about all this in the next six to 12 months.

In terms of our in-house builds, we have an opportunity to focus on new market trends such as environmental, social and corporate governance, which we know our clients care about and work with them during the process to know what they needed.

Speaking of clients, where are you going first in search of new lending clients?

Smollen: Primarily, we are hoping to tap into additional supply in Japan by offering a new programme which helps those clients get more comfortable. A number of large clients already lend—and have for years—but most really limit what they do and others have remained on the sideline for years.

Elsewhere, we also fully expect to win business from clients who are already with other lending agents by offering a better option.

We are looking for clients that have large, global portfolios that are diversified across asset types. In turn, we are avoiding clients that only have large general collateral holdings such as corporate bonds or only UK stocks. In terms of clients, generally we are looking to partner with asset gathers. Not surprisingly, that means asset managers and sovereign wealth funds that are chasing yields and own assets that tend to be more attractive in the securities lending markets.

MUFG also has a long history of working with central banks and even though the asset classes they tend to buy are not always the most exciting we can always find value in high-quality liquid assets such as US, German and French government bonds.

Clients who come to us tend to be the ones who want information, who want to be engaged with our traders and our desks on a regular basis.

They are looking for more than a behind-the-scenes programme that generates some alpha and covers costs – they want a proactive management tool where they can find innovation.

And what feedback have you got from the borrowers?

Smollen: It’s actually from the borrowers that we’ve seen the most excitement so far because they have their own challenges and we’re solutions-oriented. We have worked with counterparts on capital and regulatory solutions for many years and we’ve had great feedback when they’ve heard our plans to expand our service for both sides of the trade.

This year’s Pan Asian Securities Lending Association conference is in Tokyo and we’re viewing that as our coming-out party. We know borrowers that will be attending that are especially keen to hear more about what we have planned.

Are you concerned by the fact that the biggest Japanese lender partially pulled out of the market last year?

Smollen: If a client like Japan’s Government Pension Investment Fund was in our programme, I am pretty confident that we would have been able to build a solution to meet their needs and keep them lending. And that’s one of the opportunities we are looking to tap into. Those big, sophisticated investors that need and crave more transparency and information, and a more client-focused service that we can provide. I was disappointed to read about the fund’s decision but I also see it as an opportunity.

It’s undeniable that Asia is the future. There are huge opportunities there and we will be ready to take advantage of them.

By Jonathan Watkins

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Acquisitions, high-profile hires and a new securities lending offering have been among the highlights of MUFG’s first year under investor services chief John Sergides

In just over a year as permanent CEO of MUFG’s investor services business, John Sergides has hired, acquired and built from the ground-up, with the latest move coming in the form of a new securities finance team to start 2020.

Sergides’ ascent to the helm started in 2015 with the role of global head of sales and marketing, before he assumed the deputy CEO position and was then subsequently appointed as chief executive in January 2019.

Given his experience in the industry, and within MUFG itself, Sergides wasted no time at the start of his tenure, making moves to hire sales experts with geographical and product expertise in burgeoning sectors such as private equity, real estate and mutual fund administration.

His ability to hit the ground running in the role has also seen it acquire both Maitland’s hedge fund administration business and post-trade firm Point Nine, which gave MUFG an all-important FinTech arm.

The fund administration move increased MUFG’s total assets under administration (AUA) to over $600 billion, and marked the firm’s first acquisition in three years.

With an eye on covering the wide spectrum of securities services from fund admin and trustee services to lending, custody and subscription financing, Sergides said he is thankful to have the support of MUFG’s top brass in realising his vision.

“Investment and autonomy are for me the most important things,” Sergides told Global Custodian, when asked about his first year at the helm. “You need to have the right amount of autonomy but with controls as well.

“A lot of these decisions take a lot of patience and you need a long-term view. A lot of firms are boom and bust, but being able to commit to the space is really one of the strengths of a Japanese firm.”

The appointment of Deutsche Bank’s long-serving head of agency securities lending in New York at the start of 2020 gave MUFG’s clients a clear message that the bank was committing to this space. Tim Smollen was appointed as global head of global securities lending solutions and was joined by eight additional hires who will support the growth and development of its securities finance franchise.

The move is intriguing given the headwinds securities lending faces as a global function, with revenues declining 13% to $8.66 billion in 2019, according to research from DataLend, the market data arm of securities finance specialist EquiLend.

Meanwhile, Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, suspended its securities lending programme over transparency issues at the end of 2019,  and the impending rollout of regulations in Europe could undoubtedly have a global impact on activity.

Sergides however, believes it’s the right time to bolster its offering given the fit within its other services and the appetite of clients.

“We’ve been looking at all the products out there, what’s out there, what’s needed, where is there white space, and some is from a geographical perspective and some is from a product perspective,” he said. “Some of the larger players have de-focused on lending, so it’s become a natural partnership with people to grow this space.

“Japanese institutions who were not involved in the space now have a bank they are familiar with to participate.”

On the fund administration side, MUFG made two major acquisitions in 2015 and 2016, through UBS Global Asset Management’s Alternative Fund Services business and Rydex Fund Services respectively.

The Maitland deal, which was announced in October 2019, added only $20 billion in AUA, but much more on the technology capability front. It also gave hedge fund clients of Maitland access to banking and treasury solutions of Mitsubishi UFJ, MUFG’s Japanese parent bank.

“Given our size, you can see that when you add $20 billion that it’s not an AUA play. Maitland gives us an excellent group of people in a specific location and they are innovative because of their size. We can develop cutting edge technology that the industry is not ready for just yet, and develop these solutions with clients that can later be used for the wider industry.”

On any possibly future deals, Sergides pointed out that with the shrinking number of administrators and demand from the buyers in the market to add complimentary services to their offerings, that opportunities may be sparse.

“There’s not that many acquisition targets left,” he explained. “The multiples have nearly doubled so the cost base has doubled. The bigger trend right now is buying the technology stacks around the business.”

Moving forward, Sergides highlights regional expansion in Australia and the Middle-East as geographies with potential, before adding “there’s more hay to be made” across its range of services.

He also places importance on retaining clients, something MUFG prides itself on, particularly in the fund administration space. This is another reason why any future acquisitions will have to be carefully thought out and truly complimentary. The prioritising of client service and keeping customers happy could certainly stem from Sergides experience as a previous head of sales and markets, turned CEO.

“For me the greatest achievement is that we have not lost a client on the fund admin side for a number of years,” he said. “Ultimately, the loss rate shows you listen to your clients.”

By Joe Parsons

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In the final part of our ‘what to look out for in 2020’, we ask industry experts’ in for their input on what changes they see within the client world and market infrastructures in the New Year.

Expect M&A between post-trade financial market infrastructures

James Arnett, partner, Capco

An increase in M&A activity within the post-trade financial market infrastructure (FMI) community seems inevitable, particularly in Europe, as FMIs look to consolidate to achieve scale, enhance service capabilities, expand asset class and market coverage, or position themselves in other areas of the transaction value chain. They will also look to protect themselves against the threat of new competitors, as emerging technologies give rise to disintermediation opportunities for post-trade intermediaries and their end-clients.

This M&A activity may also see a change in the FMI ownership landscape during 2020. Central securities depositories (CSDs) in particular have attracted investment interest from sovereign wealth funds and private equity groups, and 2020 could see this interest leading to firm acquisitions by these types of investor.

In addition, enhanced middle-office services, such as automated risk reporting and AI-enabled collateral management, have already begun to leverage APIs and compatibility layers already deployed in the retail banking space, making near-time monitoring across the asset servicing lifecycle of institutional investments via your smartphone a reality.

A changing M&A landscape, while asset managers set to transition to open source

John Sergides, CEO, MUFG Investor Services

We see a year ahead of a changing dynamic on the M&A front in financial services. The number of potential targets has shrunk, while the price has significantly risen. For the acquiring firms who have obvious synergies this may still be an acceptable pain but for new participants this may no longer be the case. We will start to see listings of firms such as fund administrators as an exit route, and greater investment in niche technology firms to enhance value, rather than pure asset gathering acquisitions.

The asset management industry and surrounding services is still behind the curve with regards to using the elastic nature of cloud storage and processing as an infrastructure foundation. We expect this to be a big theme in 2020 with not only large scale shifts but also moving more to open source technology to codify infrastructure and finally be able to use and and monetise the vast data that has been collected.

The buy-side will turn its attention to innovation

Anders Kirkeby, head of open innovation, SimCorp

Fee compression, regulation and data challenges may continue to be the status quo in 2020 but it will also be a year where we will see early movers on the buy-side realise that these long-standing trends impacting asset management will demand concerted effort and collaboration. We’ve already seen some effort to achieve standardisation and automation of investment processes. In 2020, I believe we will see the buy-side open up further in the way of co-creation and collective action, to innovate and respond to shared workflows. It’s certainly a movement we are excited to be a part of and facilitate.

Three words: Engagement, solutions and integration

Michaela Ludbrook, global head of securities services, Deutsche Bank

The post-trade industry focus for 2020 will centre around the following key words: 

engagement, solutions and integration. A promising future is one where we are integrated with our clients and partners. This fosters closer collaboration where we create solutions together with our clients, engaging them in true innovative thinking and developments. Integration will offer implementation of transparency and speed of service with the appropriate controls and segregation.

And to add to this excitement, developing/emerging markets are at different stages of evolution. When a market is on the verge of something great, it’s about being the first to spearhead clients’ entry into those markets. Value-added services will continue to feature strongly as a differentiator. To increase real-time transparency, manual input will continue to be eliminated. Service models will change into industry brainstorming and development, turning our roles into more value add in the future. Successful custodians are those who will be at the forefront of engaging with clients, solutions and integration.

Mutualisation of post-trade services

Yousaf Hafeez, head of business development for financial solutions, BT

The concept of mutualising costs in non-differentiating post-trade functions has been a point of discussion amongst market participants for at least a few years. While the benefits of this approach have always been evident, the uptake of mutualised services has been relatively slow due to an insufficient strategic alignment between industry participants, as well as other issues such as the lack of standardised processes in the post-trade space. Nevertheless, existing regulations such as MiFID II as well as upcoming regulatory mandates such as SFTR are driving post-trade mutualisation higher up the agenda. While the practical implications pertaining to service integration and interoperability will need to be addressed, next year we will likely see a greater appetite for this approach.

By Alice Murray

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“It would have been great if the legislation was put on the books 12 months ago, which would have been timely in the context of Brexit” John Aherne William Fry

Post-AIFMD and since the Brexit vote, Ireland’s funds industry has been all too aware of the potential it holds as a private equity fund domicile. But only if it can reform its Investment Limited Partnership (ILP) structure.

Ireland’s current limited partnership law was last updated in 1994 and is essentially deemed not fit for purpose for private equity funds. According to a note from law firm Walkers, “Investment limited partnerships under the 1994 Act were not as successful a fund structure as had been initially anticipated by its advocates.” Indeed, there are only a handful of ILPs registered.

Thankfully, reform is underway and the proposed amendments address the specific private equity deterrents and seek to align the structure with international standards.

Hungry like the wolf

A huge driver behind the reforms is demand. According to Irish Funds, €2.4trn of alternative assets are administered in Ireland. However, the most popular structure is the Irish Collective Asset management Vehicle (ICAV). But the ICAV structure doesn’t quite work for private equity, which largely seeks a partnership model, and one that offers a passport under AIFMD.

Despite the lack of suitable structure, Ireland is often considered by private equity funds as a desirable domicile when considering their options. A key attraction for UK managers is post-Brexit, Ireland will be the only English speaking EU member. The cultural alignment enjoyed through shared language, time zones, and let’s face it – drinking habits – further contribute to the industry’s thirst to domicile on the Emerald Isle.

Harder factors include Ireland’s service provider community. With so many funds flocking to Luxembourg following the Brexit vote, the Grand Duchy’s fund administrators and law firms have struggled with recruitment and retention. Ireland, on the other hand employs 1,600 people throughout the country and enjoys decent levels of retention.

Boy who cried wolf

Unfortunately, the ILP reform is an old story, having been discussed for three and a half years. This is partly a symptom of Ireland’s legislative process where Bills must pass through 10 stages before being signed in. “It has taken longer than many would have liked,” says John Aherne, partner at William Fry and member of the ILP reform working group. “It would have been great if the legislation was put on the books 12 months ago, which would have been timely in the context of Brexit.”

Ironically, the delay has been caused by Brexit, which has major implications for Ireland. However, the country’s politicians are aware of the hold-up and keen for the process to speed up. During the debate of the reform Bill in Parliament in September, Minister of State at the Department of Finance, Deputy Michael D’Arcy said: “The legislation has been ongoing for three and a half years. Our systems and structures are not sufficient to put in place financial services legislation.”

The Bill is currently in Committee Stage, which is the third stage of five stages in Dáil Éireann. If it passes, it will still need to pass two further stages in the Dáil and five further stages in the Seanad (Senate) before being signed into law by the President of Ireland. The exact timing of this process is still unclear yet most commentators are confident it will come into law at the start of 2020.

“The environment is welcome to this,” says Audrey Nangle, head of private equity in Dublin for MUFG. “The cause of the delay has been Brexit, which is having a huge impact on Ireland. A lot of the political strength that was pushing for the reform has been refocused. As soon as the situation has stabilised then the attention will return to this.”

Dances with wolves

But Brexit isn’t the only threat to the reform. Alongside the lengthy legislative process, the Central Bank of Ireland is reviewing the AIF rulebook and encoding it into law. Says Aherne, “While we have the legislation that deals with the legal features, we also have the AIF rulebook, which applies to qualifying funds, that the ILP falls within. This hasn’t moved totally in parallel with the reform.”

However, Aherne doesn’t see “anything major in that regard. Sponsors will be able to quickly deploy the ILP once the legislation is there and the existing AIF Rulebook has the necessary flexibility to accommodate the classic range of private fund terms.”

In terms of the proposals themselves (see box out), the majority look set to pass. “We see 90% if not all of these changes going through in the final Bill, but we will have to wait and see what actually comes through,” says Nangle.

One open point is around the GP entity of the ILP. “It looks as though it’ll have to be quasi-regulated, which isn’t optimal,” says Aherne. “They’re looking at the GP being the AIFM, which isn’t typically the case, or a special creature called an AIFM Manager.”

Aherne doesn’t see this as a major hurdle either. “In practice we have a fairly healthy host management company offering to all the classic PE providers who will fill that space.”

There is understandably fatigue concerning the reforms; it has been in the making for almost four years and is still yet to materialise. But there is cause for optimism and excitement. We’re potentially looking at a hugely compelling modern private equity partnership that exists in a highly flexible framework: it would seem whatever passes from the Bill there are sufficient workarounds to suit most needs.

The ILP is set to be a modern structure, one that is onshore and can satisfy even the most scrupulous tax professional’s concerns around consistency and transparency. The ILP satisfies BEPS considerations, LP demands around regulation and reputation, as well as AIFMD rules.

The cultural factor may seem innocuous but on a day-to-day basis, working in the same timezone and in the same language is a considerable factor. Furthermore, while there have been few studies, many believe the cost of running through Ireland will be attractive. The service provider landscape in Ireland is one to be envied.

The proposals

Audrey Nangle of MUFG discusses each proposal and their meaning for PE firms.

Safe harbour

Developing the list of LP activities without affecting liability. “Many institutional investors want to sit on advisory committees, or appoint a representative so they can have a say in how the fund is being run. Under the current rules they’re unable to sit on committees without prejudicing their liability, so this is a really big win for the industry.”

Majority consensus

Moving from unanimous consensus to majority. “Under the current rules, unanimous consent from LPs is needed to make changes to the LPA. There have been various discussions around this but it looks as though it will move to majority consensus or notification on smaller decisions. This is a big win from an administrative perspective as it will be more time and cost efficient to make changes.”

Transfer of assets and liabilities

“It’s very rare to change the GP, but under the current rules it is very difficult to do this. Under the proposals, amendments will allow for statutory transfer of assets and liabilities if there is a need to change the GP.”

Alignment with AIFMD

Amendments to certain terminology and requirements to align the Act with EU norms and standards under the AIFMD such as the depositary function.


An ability to establish an ILP as an umbrella fund. “In other jurisdictions it’s very common to have a main fund and several feeders. The Bill proposed the ILP have the same ability, with one fund structure and allowing several sub-funds, all of which are ring-fenced separately and do not require full consolidation across the structure.”

Alternative foreign name

Ability to register an alternative foreign name in a non-English speaking jurisdiction. “At MUFG we have lots of ties to the Asia Pacific market, so this is really important to us, that ILPs can have their English name as well as an official name in countries such as Japan or China,” says Audrey.

By Joseph Mariathasan

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Questions are being raised about the understanding and analysing of private equity returns data. How can one determine in which general partners (GPs) to invest? As Peter Wilson, managing director at HarbourVest Partners, says: “Many GPs claim to be top quartile on some metric.” Comparisons between private equity GPs is not the only concern. There are many difficulties that make comparisons with public market returns hard. Yet these need to be tackled for institutions to make well informed asset allocations decisions between private and public markets. 

The Yale Endowment has been seen as the leader in alternative asset investment based on an aggressive stance in private equity. It had a 30.4% reported annual return from its launch in 1973 to 2011. But, as Ludovic Phalippou, a professor at the University of Oxford’s Saïd Business School, pointed out in a 2011 paper, earning 30.4% a year for 38 years would mean a return over that time of 24,000 times. Such performance would imply $1m in 1973 would have grown to $24bn by 2011. But the latter figure was more than the size of the whole Yale endowment at the time. Understanding why that has not been the case is essential for any analysis of private equity performance as well as comparisons with other asset classes.

Mathematic flaws

The problem that Phalippou highlighted is that the internal rate of return (IRR) calculation used to describe returns has numerous flaws that makes it a poor metric for describing actual returns.

An IRR figure can be described as the discount rate which makes the net present value of investment and return cashflows sum to zero. It assumes that all cashflows during the period are reinvested at the same rate given by the IRR.

In practice, if a fund spins out an investment quickly at a multiple of the initial investment the IRR could be 40% or more. However, investors cannot be assumed to be able to reinvest the proceeds at that figure. That is why the money multiple, which is merely the multiple of the initial investment obtained on sale is often used alongside IRR calculations. This can be defined as the ratio of distributions to paid in capital (DPI).

Alex Scott, a partner at Pantheon, explains that what matters when it compares private equity funds is a combination of IRR and money multiples. In general terms as regards a private equity fund, a net money multiple after all carried interest and fees in excess of two times would typically be seen as an attractive return. A respectable IRR would be anything above 12% in a fund with a lifetime of 15 years at maximum with underlying investments typically held for between three and six years.

Subscriptions blur figures

What can improve or distort IRR figures, is the increasing use of subscription line financing by GPs. This is a credit line taken out by GPs secured on the committed capital from limited partners (LPs). This ostensibly is to reduce administration burdens on LPs by having just one capital call per year with other short-term capital requirements catered for through the credit line. What it means though, is that the timing for an LP’s capital to be called up is delayed, increasing IRR figures. However, the investments are not any better, and if the funds are not being deployed elsewhere the LPs will not benefit.

As a result, Andrew Brown, head of private equity manager research at Willis Towers Watson, goes so far as to see IRR calculations as being of less relevance. A judicious use of subscription lines can alleviate the ‘j-curve’ characteristics of private equity and improve IRR figures. But, as he points out, taken to extreme, GPs could finance new investments through realising old investments financed by subscription lines pushing IRR figures to infinity for investors. Moreover, there is a danger for investors in the overuse of subscription lines. If a GP uses them to finance investments which then fall in value, an LP may be being asked to pay 100 for an investment only worth 50. Is it fulfilling its fiduciary duties by doing so?

“Some investors will say no and that becomes a huge risk for the fund. Subscription line financing has not been tested in a downturn,” says Brown. He adds that the managers seen with top quartile performance are often those who have been the most aggressive users of this technique.

Yet, says Scott, Pantheon’s clients are not averse to GPs using subscription lines, albeit with limits on how much and for how long. “We believe that the best practice for LPs is to have IRRs reported pre- and post-subscription lines and, generally speaking, that tends to be what the most sophisticated GPs provide,” he says.

Hidden costs exposed

The biggest challenges may not even be ensuring fair comparisons between private equity firms. Instead, says David Sarfas, global head of private equity at MUFG Investor Services, there could be transparency and hidden costs. In 2015, for example, the Securities and Exchange Commission, the US securities regulator, fined KKR. As Andrew J Ceresney, director of the SEC enforcement division, says: “Although KKR raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses incurred to explore potential investment opportunities that were pursued but ultimately not completed.”

Hidden costs can also be a problem with the capitalisation of expenses such as set-up fees. A decade ago, any fees could have been capitalised, but today it has become difficult to do so.

“There is clearly an industry push for fees to be recognised immediately and flushed through the P&L and that creates a lower cashflow immediately, adversely impacting IRR figures,” says Sarfas. As fees can total between 1% and 5% of total deal value, the impact on cashflows in early years can skew IRR calculations. “Transparency, subscription lines and hidden costs are the three big areas which can skew IRR figures”.

Comparisons hard

For institutional investors, finding appropriate metrics to compare private equity firms is just one issue. Of perhaps equal or higher importance is how best to compare private equity returns with those seen in public markets. Private equity is just unlisted equity and any claims of lower volatility are a reflection of illiquidity rather than of different economic characteristics. The most appropriate measure appears to be the public market equivalent (PME). Here, private equity market cashflows are compared with an equivalent investment in a public market benchmark. It is assumed that capital calls and distributions generated by the private equity fund are invested or divested from a portfolio invested in the benchmark at identical times. Variations of this idea can be used to calculate performance relative to public market benchmarks on a like-for-like basis.

Given the contraction in public markets with a dearth of new issues, it is not surprising that investors are turning to private equity in the search for growth. But private equity investments do incur higher management costs and can have complex cashflows that skew return measures. Understanding what makes a good private equity investment relative to others and relative to public market investments has for long proved to be controversial. But to pour money into private equity without fully understanding the issues seems folly.