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The private equity (PE) landscape has changed tremendously within the past decade and the industry’s rapid growth is cultivating a lucrative market that is developing a new set of leaders. New PE fund managers and firm founders are seizing the opportunities and benefits the market has to offer. According to an industry report from alternatives data firm, Prequin, PE’s growth is shown to be promising as the space--along with other alternative investments--is expected to gross $20 trillion by 2025.
A decade ago, this kind of projection would have been considered bleak as the markets were still unraveling through the dense fog of the then financial crisis. Today, the PE industry looks more promising, but there are considerations that new early-stage PE fund managers and founders should keep in mind.
The Fundamental Elements of Early-Stage Private Equity Firms
As leaders of new early-stage PE funds or firms gain their footing, there is a strong chance that they may delve into unfamiliar areas—specifically finance and operations (F&O) functions. Overseeing the F&O functions involves managing finances and resources within an organization. Most new PE fund/firm founders who are entering the space have at least some experience working within large and established PE firms with proportionately sized operations teams. As “investors first” deal professionals, chances are they were not focused on behind-the-scenes F&O processes, such as accounting, fund administration and compliance managed by dedicated operations staff. Managers and founders of early-stage PE funds and firms must build out the F&O functions of their businesses because it is foundational to how the firm will operate. If these functions are not intact, they can create significant risks to the firm’s success.
Finance and Operation Requirements for Early-Stage Firms to Consider
There is a slew of requirements that new PE leaders should keep in mind when building out their F&O functions, however, these requirements take tremendous effort to establish. One common mistake made by PE leaders is underestimating the time and effort needed to commence F&O processes, resulting in a lack of investment in a fundamental piece of their business.
Below are top considerations for new early-stage PE funds or firms when building out their F&O functions:
- Independent Financial Statement Audit and Audit Readiness - Choosing an independent auditor is one of the most important first steps. An audit provider should have the PE experience and accreditation required to provide audit and attestation services to meet annual or interim reporting requirements in compliance with U.S. Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) protocols and provide audit readiness gap assessments focused on the company’s current accounting knowledge, staffing, and reporting frameworks.
- Fund and Partnership Accounting – In addition to consulting with legal counsel, bankers, and other important advisors when establishing a new PE firm, it is also important that early-stage firms engage for accounting advisory services to consult on how they want to set up their fund and partnership accounting, covering critical elements such as general ledger, partner allocations, gain/loss allocations, valuations pricing, and fund controlling.
- Treasury Management - PE firms should develop banking relationships with reputable financial institutions, leveraging the advice of bankers that have experience in the industry. It is particularly important to develop policies on cash management and cybersecurity and ensure firm-wide awareness of the policies. There should also be safeguards against phishing scams and other cybercrimes in place.
- Regulatory Risk and Compliance Function - When it comes to regulatory risk and compliance, new fund managers are faced with another critical decision early on—hire a compliance officer or outsource the role. Some newer firms may merge the role into the CFO's duties. While this may work for a brief period, it is not recommended. Functions certainly need to have a strong working relationship; however, it is recommended to separate finance from compliance.
- Tax Structuring, Compliance and Advisory services - Tax operations for PE firms are likely to become more complex over time. That is why when interviewing tax advisors, PE firms should engage with tax advisers and organizations that have extensive experience with PE funds. Equally important, the organization hired should have a well-tested technology solution that allows services to scale as the firm grows.
Private Equity’s Promising Future Needs the Fundamental Elements for Success
The PE market boom is a promising sign for investors and private organizations, but as new firms emerge, leaders need to adhere to the fundamental guardrail processes to ensure success. Finance and operation functions are critical in the ramp-up phase in early-stage firms. As PE leaders engage with potential partners on the F&O side, they should engage with organizations and professionals with deep PE firm experience. As early-stage firms grow, business needs will shift, and PE leaders should be aware of the different support needed at each phase of the firm's growth.
Jason Menghi is the National Private Equity Leader - Audit & Assurance at Deloitte