What are your peers doing to take the right lessons from the recent fundraising and deal wave and turn them into rational next steps for digital operations?
Chris Gale 00:02
This is the private capital talent series from PFA, episode two. We’ve invited Lionpoint Group’s Jonathan Brock, WireSecure’s Tony Chung, and PFA Solution’s Ryan Burger. As the headline said on LinkedIn, or if you got an email invite, this is on the lessons from digitizing private capital. We’re going to attempt to see what it looks like in the wild and come away with a working definition and lessons on what this group has learned along the way.
For everyone joining, if you have questions, we would love to see them. We’re going to carve some time at the end to share those with the group. Afterward, we would love to have your feedback and any pointers for the next few episodes, as well as guests and topics you’d like to hear us talk about or talk about more. Stay tuned, because we’re looking to have one of these a month.
We’re going to start with Jon and ask him about what workflows we want to focus on as an example of how private capital is digitizing. We’re going to pass that ball to Ryan. Then we’re going to go to Tony and ask him when the money needs to go from one place to the right next place. What would a digitized private capital workflow and solution look like?
Jon, what is digitizing private capital? What is what does that look like in reality?
Jonathan Broch 02:11
I think it would be helpful to take a step back: Why do firms want to digitize? What is in it for them? The business case around that is going to be tied to one or more of three drivers. Either the firm’s looking to create efficiencies, or they’re looking to enable scale, growth, and drive value, or they’re looking to address operational risks. Tony will have a perspective on some of those as we talk later on. Next, it’s really important to understand that each firm is at a different stage in terms of its digital transformation. It’s helpful to think about it as a three-stage journey for that firm overall. Specific departments are going through that first stage, which for most firms looks like using a lot of spreadsheets. That tends to be a common theme within client organizations we work with – spreadsheets are being used for key critical business functions like accounting data, pipeline data, Portfolio companies, financials, carry plans, banking data — all of those types of things. The firm hits an inflection point where they say, “Gosh, we can’t collaborate like this together anymore. We’ve got version control issues with spreadsheets, it feels disconnected, and it’s super hard to report off of the share information.” There’s this realization that they need proper systems in place to manage funds, manage investments, and manage investors.
Stage two for most firms is when they’ve got systems in place. They’ve graduated from spreadsheets into proper systems and are looking to drive greater adoption and use of those systems. They’re looking to derive more value out of the investments that they’ve made in those technologies. The conversations we’re having in stage two are, “How do we streamline processes? How do we integrate these systems better?”
Then we’ve got firms in stage three when there’s a wealth of capability to be enabled as organizations start to change their viewpoint around data and think of it as a competitive advantage. They think of data as an asset, and not something that you have put in a system. There’s this thought: “We’ve seen so many deals over the decades, we’ve been through so many fundraisers, sync cycles — what insights can we start to draw upon that enable us to shorten those fundraising cycles to do more deals, to do deals faster, to engage with companies earlier in the process?” This is a more advanced level for firms. I’d stress that for every firm, again, at stage one, stage two, and stage three, certain departments are at different stages. But the key thing to be thinking about when digitizing private capital is, “What’s the next step for your firm? How can you take that step with confidence?”
Chris Gale 05:36
It sounds a bit like a maturity cycle.
Jonathan Broch 05:47
Absolutely. You’re never really done. It’s very helpful to kind of think of it in terms of a maturation process for an organization.
Chris Gale 05:57
You talked about some of the triggers that lead folks to figure out what the right entry point for digital is, or the entry point to the next stage. What’s going on right now with conversations you’re having with folks in the private capital world?
Jonathan Broch 06:25
Really interesting question. I glanced at the date and saw March 31 — quarter end. That’s one line of thinking. There are a lot of processes in a private equity firm that revolve around the month, quarter, and year-end. I also think about 2022, and themes that are big in our industry right now for growing private capital firms. Everybody’s dealing with the challenge of attracting and retaining great talent. I’d like to do a double-click on both of those.
Quarter-end processes for the finance department form a key intersection point for a lot of the mission-critical processes of the firm. Think about things like portfolio companies, financials, valuations, exit planning, forecasts, waterfall calculations, financial reporting, and GP carry plans. For many firms, these are very disconnected processes run on spreadsheets. Right now firms are feeling the pain of having to maintain and update a lot of spreadsheets, copy and paste, and have multiple sources of the truth. It translates into long days, inefficient processes, risk of errors, and staff spending more time on processing and managing data and less on driving insights and value out of that data. That’s where my head goes.
The beautiful thing is it can be a much more connected experience. Take a deal and how it’s being valued. Think about exit projections, how that flows through the waterfall, and what that means to an employee in terms of your carry. When we’re working with a private capital organization, a lot of it is stepping back and helping you understand how all these things connect, so you can get out of siloed systems or spreadsheets and start to systematize and connect the organization in a really beautiful way. The second point, Chris, is on that trend around attracting and retaining talent. Everybody wants to understand their compensation. Everybody wants to understand if a deal exists at this value at this date in the future, and what it means for them as an employee. Traditionally, private capital firms haven’t done a great job of being able to communicate that. It’s the most important thing for an employee in many cases — understanding their total compensation and how carry ties into that, and the value of carry. The other aspect is just from an employee’s work experience: employees want to be working with the latest and greatest technology. They want to be spending more time using tools and technologies that allow them to derive more insights and do higher-value analysis, and a lot less time just managing data and trying to make sure that different spreadsheets all line up. The question is, “Do I want to work in an organization that’s using cutting-edge tech, and is allowing me to use my skills to add the most value, or am I going to be with an organization where I’m just managing data in these disconnected spreadsheets?” It’s a much more attractive experience for an employee to be using technology.”
Chris Gale 10:12
Focusing on waterfall, can you tell us more about the pain point there?
Jonathan Broch 10:57
We’re working with organizations, helping them understand what processes are the most time-consuming and tedious. Waterfall absolutely fits within those characteristics. You’ve got to do it every quarter and it’s a pretty painful analysis you’ve got to absolutely get right. So it’s a great candidate for being able to systematize. We’ll work with organizations on, first of all, making sure that the source data that feeds into their waterfall models is clean and tagged properly. For most organizations, that means having a proper fund accounting system in place and they are thinking through how the source data is managed so it can flow seamlessly into that model. Then, whether it’s a European style model, deal by deal, or hypothetical, these are all models that can be systematized. We’ve had great success doing that with organizations. The real carrot, though, is how you connect that into the broader firm and connect that into carry models. Don’t just stop with the waterfall and say, “This is how it impacts the distribution,” or “This is how it impacts financial statements.” Continue to ask, “What other processes does this hook into?” Firms can derive the most benefit when they think holistically about waterfall.
Chris Gale 12:24
I like this idea of how the different pieces connect, which then allows us to connect to Ryan. After what Jon has described there with waterfall, where would PFA Solutions pick that up? Where does carry enter the picture?
Ryan Burger 12:43
Totally agree with Jonathan on all the points we’re seeing across our client bases. What we do at PFA is a platform that manages all employees’ and partners’ allocations to that profit share that’s calculated as a result of the waterfall calculation, so both realized and unrealized. If the fund accountants generate or the fund administrator runs the waterfall, and there’s distributable or realized carry, they sell investments, or have other proceeds — say a million dollars — our clients will process that million dollars into firm view. It automatically allocates down to all the individual employees and partners who have a predefined percentage share of the proceeds of any distributions or carried interest received by the fund. Our clients are then able to apply escrow, holdbacks, tax withholdings, loan repayments, and other adjustments, and then generate the statements out to employees and partners. Finally, they will process the money to all the employees and partners’ bank accounts. That’s the first part of how we connect to the waterfall.
The second part of how we connect to the waterfall is on unrealized carry. As Jonathan mentioned, on a quarter-by-quarter basis, a calculation’s run. It can be complicated. If the firm is successful, and in a position where there are performance or incentive fees as a result of that waterfall calculation, our clients are able to put that into our system. Then partners and employees can see that transparency: how much their carry percentage is worth at any given point in time. An example here is if the results of the waterfall are $2 million unrealized — the investments have done well — a client will enter that $2 million into firm view. It’s automatically allocated down to all the individuals and through their statements on the platform. Individuals can see their portion and how much is invested. It ties back to that point Jonathan made earlier, where employees are able to see how the funds are doing, and what this means from a personal economics perspective.
Chris Gale 15:17
If we look at allocations, like in a conversation a member of the firm has with the CFO, is there a before and after that digitizing input represents?
Ryan Burger 15:44
How this correlates to the CFO is that there’s the annual comp process, then there are conversations throughout the year, depending on the employee and their situation, from an annual comp timeframe. That’s obviously an important time for employees to see how much they’re going to receive in their bonuses and other incentives. For the CFO it’s a very busy time of year — or for the controller, or whoever’s responsible for gathering all that information for that comp conversation. We’re seeing a lot of firms focus on reporting so that they can provide aggregated analytics to employees, including carried interest details, co-investment information, and base bonus benefits all in one view or statement. A tremendous amount of work goes into that. Another component we’re seeing is that CFOs or other individuals responsible for producing these statements are adding in forecasting. Just this week we had a client generate statements across all of their clients that included full compensation across the board. Their feedback to us after they had all of the comp conversations with the individuals was that forecasted carry was the most important part of the statement. They knew how much their salary was, they had a sense of what their bonus would be, and they knew how much they had personally contributed to the fund. But they did not know what that future carry potential could be. The feedback from the CFO of this firm was to add that in. So we’re just seeing this maturity and digitization in that overall data aggregation and dissemination to the employees right now.
Chris Gale 17:38
Focusing on carry, Jon was laying out the three different stages a firm might be in. What is PFA Solutions seeing in terms of firms coming up with a strategy for digital transformation in place, or with a specific pain point? Should you have a master plan in place and then methodically move through it? Or is there a case for starting with a particular place, then looking at how that informs the master plan?
Ryan Burger 18:24
We love strategic plans. We love to see where carry and compensation fits in across the overall prioritization roadmap our clients have laid out, or folks like Jonathan have laid out for them. Within the carry and compensation area, we are seeing that roadmap — or helping our clients find that roadmap — because there’s so much that’s manual or done in Excel right now. We always figure out the priority to start with. Sometimes it’s statements.
In the last example, where our clients generated all their comp letters out of the system, they signed on with our platform in January. Their number one goal was, “By the end of March, let’s generate all-in compensation reports out of the system and disseminate those to employees.” This firm hasn’t enabled the employee portal we offer or other bells and whistles. That was the number one priority. Yesterday, we were on a call with a client whose number one priority was getting their bonus and deferred bonus plan on the system. Others want to focus on getting distributions in the system tested and working because they know they’re going to start processing distributions soon. We do try to figure out the roadmap, the quick plans, and the priorities because there is a laundry list of things they want when they come to us. There’s always more once we start implementing, start adding data, and start adding reports there, and when people see the system new ideas come about to add to that list of initiatives.
Chris Gale 20:07
Tony, I don’t know if it’s overly broad to say you’re on the security side of it, but how do you approach digital and both the benefits and some of the scarier parts?
Tony Chung 20:54
Thanks, Chris. A lot of firms want to automate waterfalls and carry plans and the complications that go along with doing that. Imagine that the money went to the wrong place. Just to give you some perspective, according to the FBI — and this report came out last month — in the US alone in 2021 we experienced an unprecedented increase in cyber-attacks and malicious cyber activity, to the tune of almost $7 billion. Impersonator fraud is a category within cyber — malicious cyber activity — and alone accounted for almost $2.5 billion. That’s what was reported. We know a lot of these things don’t get reported for reputational risk reasons and otherwise.
Another statistic from the FBI, for better or worse, is if you have a loss under million dollars, they’re just not going to look at it, because there’s so much cybercrime going on and they’re somewhat short-staffed. An average capital call loss is about $800,000. There are some issues here. While it’s essential to keep the bad actors out, which a lot of security solutions do, it’s equally important to ensure that the good actors are who they say they are, and that they haven’t been compromised.
Chris Gale 22:35
On that point of good actors, we have cybersecurity concerns. Right now, there are things going on in Europe. Does that relate to what we’re talking about here?
Tony Chung 22:52
Cybercrime and cybercriminals, in general, are getting more sophisticated. I recently heard a story from a cybersecurity consultant, where a private equity firm had a security breach. In this instance, the cyber criminals accessed the firm system where they keep all the investor data. If the cybercriminals actually knew what they had their hands on, and what they had access to, they could have easily changed all the wire instructions for the investors and redirected funds to fraudulent accounts. By the time the GP found out, it would be too late. What we’re also hearing more about are simple email account takeovers. This is a highly targeted market, the private capital markets. Cybercriminals are watching email dialogues between the GP and the LP, they know when the calls and distributions are coming. They understand the timing, and the nuances of the communication, and they understand the details of those transactions, and they’re just waiting for the perfect moment to strike.
Chris Gale 24:13
That brings me back to an earlier point about culture and behavior change, and impersonator fraud as opposed to email fraud. What are the cultural changes or the behavior changes you need, along with technology? How do those two work together and trigger conversations with you and prospects?
Tony Chung 24:50
Not to sound like the scary guy who’s ruining the party, but I use the term “person at front” specifically because everybody knows about business. Email can be compromised, where somebody’s changed something in an email address, or it’s a Nigerian prince asking for money. Those are easily detected because you have email filters that do that. But when the email address is good, it actually passes through those security features and they’re already in the fortress. The differences are the nuances. Go to the FBI website and look all this stuff up: In February they sent out a warning where participants or cyber criminals were joining Zoom calls, Teams calls, but they just don’t have their faces showing. But again, they’re hacking into these things, understanding what’s going on in each of these firms or communications between LPs and GPs. It’s beyond email compromised, this is in-person. They’re just finding other vehicles to put themselves in the middle of a transaction.
To your point about culture, Chris, not to oversimplify this, but sometimes it’s just like vitamins and aspirin. You know vitamins are good for you and you should probably take them. However, when you have a migraine, you’re going to do anything you can to go find that aspirin. In our world, if a client had first-hand experience or one of their peers was a victim of impersonator fraud and lost money, they will address the problem because they can’t afford to have it happen again. The other element here is that unfortunately, many cyber insurance policies do not provide enough coverage against this type of loss when it does happen. As there’s more of an acceleration to digitize, businesses and clients are open to change. Now more than ever, what we’re seeing is that providing a frictionless experience is really paramount to driving change in adoption.
Chris Gale 27:12
Let’s come back to that question that Jon was nice enough to field at the very beginning. Jon, would you be willing to revisit defining digitizing private capital and what that involves, and the lessons we should take out of this?
Jonathan Broch 27:47
We guide and counsel our clients to be very balanced and pragmatic when they’re thinking about technology, transformation, digitization, and things along those lines. It’s important to have an overarching strategy to understand how these parts connect within an organization, absolutely. But you want to balance that as well with being able to take action and deliver results. When you talk about things like managing carry plans and compensation, about things like impersonator fraud, if those are gaps in your organization, by all means, shore those up and get those addressed. I also think about the broader strategy and just making sure you have confidence that as you’re making individual technology decisions, it’s fitting within the broader picture. You’re able to approach those decisions with confidence and know that you’re marching towards a broader technology ecosystem, and it’s all going to fit and play nicely together.
Chris Gale 28:53
Tony, same question.
Tony Chung 28:56
Three points come to mind. First, digitizing private capital is about driving growth, to echo what Jon was saying earlier. Then you have to be intentional about providing the best client or investor experience. Third — and that’s resonated here — this is an exciting time for digital solutions in private markets. However, it always comes down to the people, the commitment, and leveraging their talent and experience to shape that digital transformation journey.
Chris Gale 29:25
Ryan, can you bring us home? How would you cap that off?
Ryan Burger 29:33
I totally agree with Tony and Jonathan. The other item I would add is to expect the unexpected. With even our simplest clients, there are always nuances — things that come up, changes we have to adapt to. It’s really embracing change, moving from spreadsheets to systems, but knowing there will be some hiccups and things that come up along the way that you have to address.
Chris Gale 30:01
One question from the audience: Do you see more demand coming from GPs or LPs? Who’s driving the digitization conversation? Tony, maybe I can start with you.
Tony Chung 30:31
From a security perspective, we’re seeing both GPs and LPs. On the LP side, imagine you’re making 50 to 100 commitments across many funds and GPs, you’re getting bombarded with emails, capital calls, access, portals, and so forth. There’s hesitancy to click on these emails because you don’t know if the person is who they say they are. In those cases, LPs would love a solution whereby they can verify that the party on the other end is who they say they are. The same thing goes when a GP is sending money, whether it’s a distribution or paying expenses. The example I gave before where someone’s CRM system got hacked and they could have changed all the information — why take a chance? This is a 30-second process to just ensure the person is who they are before the money goes out the door.
Chris Gale 31:26
I’ll move to the next two questions. What degrees of sophistication are you seeing regarding how carry gets allocated to employees? Are employees getting a share of all carry generated, or is it based on deal performance? Ryan?
Ryan Burger 31:48
We see varying degrees of complexity. Some firms allocate fund-level carry, some do deal by deal, some have a hybrid approach where there’s a vintage share concept, and some even allocate, carry down to the individual funding round of deals based on the employees there at the time of those new investments. Every firm does things slightly differently. We can talk about the varying degrees of that, and about whether or not all employees get allocations. We do see some clients where every single employee across the entire firm gets into carry allocation. A lot of them have a cap, like VP and above, who get carry. It depends on the organization and their overall comp program. For example, a firm that may not provide carry to all employees might have a different bonus structure in place. We are seeing complexity, we are seeing deal-by-deal clients, and we are seeing simple, fund-level carry allocations. From a complexity perspective, a third of the firms we talk to — and our clients have very complex models — are in-between, where there are some nuances, and a third are fairly straightforward carry models.
Chris Gale 33:23
This one’s for you, Tony. Then, Jon, coming back to you. Are you seeing private capital firms embrace anti-phishing, training, and tools as critical pieces of their cybersecurity framework? Or not?
Tony Chung 33:44
Embrace is an interesting word. We all go to take those tests to make sure we adhere to the best practices, and we get our test results and so forth. It’s just more standard operating procedure. What’s interesting, though, is that a Harvard Business Review article recently said that for 65 percent of employees who go through these sorts of training, when something is time critical and they’re under duress, they bypass all that training because they’ve got to get something done. It’s at that moment when there’s urgency, there’s a lot of cybercrime and wire fraud risk that happens. I think people just do it because they have to. But even after going through training, problems can still occur.
Chris Gale 34:44
Jon, I wanted to close with you and come back to that question about where demand is coming from — the LP or the GP side? When I say demand, do you see a particular side pulling it?
Jonathan Broch 35:15
It’s a really interesting question and has a few different angles to it. An LP or a GP, they’re each on their own journey. It’s a little bit different, with a lot of overlapping parts. There’s certainly a lot of digital transformation taking place for both. The other interesting angle to it is LPs and the diligence that they do on GPs when they’re looking to invest. If the question is more, “Do LPs care that GPs are shoring up their technology stacks, addressing operational risk, and having good systems in place?” The answer is absolutely yes. Because they invest during that fundraising period, and they’re thinking about whether or not to place a commitment with the manager. They invest in doing diligence assessments and making sure that the technology is in place. We see those assessments becoming more and more rigorous and more pointed as LPs are more aware of where the risk areas are within the GP. They want to make sure they’re entering into a relationship with a GP that has a strong tech stack and controls in place for how it’s performing its operations.
Ryan Burger 36:25
Just to piggyback on that, some of our clients — the CEOs and CTOs — are spending a lot more time with LPs or the consultants doing the operation. They’ll do diligence on them. There certainly is an uptick in that rigor, especially on the cyber side. There are consultants specialized in doing operational due diligence on GPs on behalf of LPs and they’re just getting smarter and smarter on what the risks are, and there are those providing that service to the LPs to do that due diligence on the GPs.
Chris Gale 37:05Thank you very much to everyone who’s stayed with us. Thank you, panelists, for joining us. It’s been fantastic. I can’t wait till next month’s webcast. More on that soon. Thank you, everybody.