The fund management landscape has undergone significant change in the past two decades, leading to a re-evaluation of operational strategies within the industry. The traditional operational model of maintaining in-house a full-service middle and back-office faces considerable challenges. Factors such as increased structural complexity, increased regulation, difficulties in hiring and retaining experienced staff, rising technology expenses, and a challenging investment environment have prompted many private equity fund managers to reconsider their operational model.
The historical alternative to the in-house model — fully outsourcing — is itself a daunting proposition considering the time-consuming transfer of data and knowledge that will be required, as well as the high risk of losing talent and institutional memory during the transition period. Additionally, the manager also depends on the outsourced provider to maintain a level of service and continuity consistent with the manager’s prior experience, an expectation that can be challenging to overcome with a new servicing relationship.
A new approach has emerged that addresses these challenges — the lift-out. The lift-out is becoming an increasingly attractive option for established private equity fund managers with multiple funds, sizable internal middle and back-office teams, and intricate technology systems and processes integrated across the organization because it offers the manager an excellent opportunity to preserve the quality of the operational experience it has previously enjoyed while shifting the complexity and cost of maintaining that service level to a qualified third-party administrator.
This article explores the reasons behind this transformational shift, highlighting the characteristics that make lift-outs an appealing option for private equity fund managers as well as key considerations in executing a successful lift-out.
The cost of maintaining full middle- and back-office teams internally has increased significantly over the past two decades, making the choice to maintain these functions in-house challenging.
One of the main drivers of this trend is the growing complexity of fund managers’ investment operations. The rise in popularity of segregated accounts, co-investments, continuation vehicles, and financing structures such as preferred and NAV facilities has introduced a level of complexity in accounting and reporting that requires significant resources. Complicating matters further, regulators and investors often demand more frequent and detailed reporting, increased oversight over valuations, and greater transparency. Fund managers are experiencing these demands across various facets of their middle and back-office operations, including financial reporting, expense allocation, and waterfall calculations, as well as ESG (Environmental, Social, and Governance) and compliance.
Adding to this complexity is the accelerated pace of technological innovation. Investors, having experienced the benefits of newer technology in one fund, now expect a similar experience across all funds. The adoption of digital documentation, streamlined onboarding processes, and robust data security measures have become essential for fund managers to stay competitive. Bringing on new technology and integrating it with existing systems is expensive and time-consuming.
Cost inflation also arises from the fact that attrition rates can be low at many fund managers. The competitive pay and benefits packages offered by many fund managers, especially in larger markets, may make employees less likely to move on even in the face of limited opportunities for promotion and advancement.
Fund managers face not only cost pressures but also management challenges with a large operations function, particularly in maintaining a motivated workforce. Middle and back-office functions such as fund accounting, loan administration and monitoring, investor reporting, GP and management company accounting, and the like can be mundane and stressful and often provide limited career advancement opportunities compared to the fund manager’s investment team counterparts. Even within larger asset management firms, employees in these crucial functions may feel growth opportunities are limited, and productivity and employee satisfaction may suffer.
As fund managers grapple with these challenges, they have traditionally had three paths to follow: invest further in the in-house function and its supporting technology, fully outsource operations to a fund administrator, or adopt a blended approach known as co-sourcing.
A fourth alternative gaining traction today is the lift-out. This innovative approach involves transferring an in-house team, along with its systems and data or some combination of both, to a specialized fund administrator, offering a nuanced solution to the evolving landscape of fund management as well as offering a new opportunity set for dedicated employees.
For fund managers dealing with multiple funds and vehicles and intricate processes interwoven across various groups, maintaining specialized knowledge and systems is crucial. The lift-out model has emerged as a viable option for fund managers in this situation. Instead of laying off or risking the loss of experienced personnel, phasing out internal systems, and undergoing a time-consuming transfer of information to a fund administrator, fund managers can explore having a specialized fund administration partner “lift out” their team or identified members, along with their systems and data. The team and systems being lifted out essentially move from the fund manager to the administrator and provide service back to the fund manager.
From the fund manager's perspective, a lift-out has several features that make it an appealing option:
Given the nuance and complexity of most private fund managers, no two lift-outs are the same. Each of the above potential benefits must be assessed carefully by the private equity fund manager and its fund administrator to determine whether a lift-out is best for its business. Once that is done, it is critical that the fund manager select a fund administrator with a track record of successful lift-outs to design and execute the lift-out plan.
To provide more detail on how a lift-out works, let’s explore the hypothetical example of a private equity fund manager, ABC Capital, with multiple advised vehicles and a large middle- and back-office team. Faced with the option of investing more capital in technology and internal talent to keep pace with portfolio, LP, regulatory, market, and other demands or lifting out its operations infrastructure, ABC Capital chooses the latter, partnering with Petra Funds Group on this next phase of growth.
ABC Capital has invested significant capital and time in building an eight-person operations team and acquiring best-of-breed technology to manage over $30 billion in assets across four investment partnerships, fifteen segregated accounts, and nine co-investment vehicles. The firm has plans to launch a private credit strategy that would require new systems and a dedicated three-person middle-office team, raising concerns about scalability and cost effectiveness of the current platform. Having heard from a peer CFO about the success she has experienced with a lift-out, ABC Capital’s CFO explores the outsourcing model as an alternative to growing the internal operations infrastructure further.
After an extensive due diligence process and strategic discussions among management, key LPs, the firm’s auditor, and other stakeholders, ABC Capital opts to pursue a lift-out model for several reasons:
ABC Capital selects Petra Funds Group to be its lift-out partner after an extensive due diligence process. Both the Petra and ABC Capital teams invest significant time to define a clear set of goals and objectives and to align on a road map to achieve those goals and objectives. Petra uses its experience executing successful lift-outs and its team’s experience inside GPs to help inform ABCCapital’s thinking during this process, validating and challenging key assumptions along the way.
Petra assigns seasoned individuals who have managed successful lift-out transitions to work with the CFO and others at ABC Capital to execute the road map in stages. In the initial stage, Petra focuses on ensuring that it understands the individuals, including current roles and responsibilities, team dynamics, and anticipated challenges. At the same time, Petra focuses on the technology and systems involved, both hardware and software, to ensure the transition from internal to external will be seamless. Finally, a communications plan is prepared for the ABC Capital team, focused on anticipating questions and providing clear and helpful answers about Petra and the lift-out. In all aspects of the initial stage, Petra coordinates closely with key members of the fund manager responsible for the lift-out.
During the migration stage, Petra focuses on minimizing disruption to the lift-out employees, avoiding unnecessary frustration and works closely with the fund manager’s IT team to transfer access and perform testing, making sure that nothing is done before it is fully tested. Anticipating surprises, and as those arise, Petra communicates quickly and openly with the fund manager to ensure they are addressed.
Once the migration is complete, Petra continues to support the lift-out team as necessary. This may include acting as an interface with their former employer, as well as working with them to establish personal goals and objectives. In many cases, the lift-out team will have opportunities to take on new responsibilities, including for other Petra clients over time.
Working hand-in-hand with the fund manager, Petra coordinated the transfer of assets, data and team members while providing continuity to the fund manager and LPs. Although a few challenges were experienced along the way, the team worked together to ensure a smooth process in the end.
The increasing frequency of lift-outs in private fund management represents a strategic response to the evolving challenges within the industry, including in particular increased costs. Whether prompted by the growing complexity of investment activities, the speed of technology advancements, concerns over staff retention, or the pressures of regulatory compliance, lift-outs can provide fund managers with an ideal solution to position their firms for the next decades of growth with an optimized middle- and back-office solution in place.
PetraFunds Group is experienced in lift-out fund administration models, having successfully executed several lift-outs with large GPs. Leveraging our direct private equity experience and robust SOC I Type II operational environment, we have successfully integrated full middle and back-office teams into our environment, providing continuity to the GP and its LPs.
Please reach out to Stephen Coats, Paul Winters, or Jennifer Fichera to learn more about Petra's lift-out fund administration model.
