Navigating Success with Distribution Waterfalls: Transparency, Technology and Trust

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Christy: Hello, everyone, and welcome to today's webinar, "Navigating Success with Distribution Waterfalls: Transparency, Technology, and Trust." My name is Christy DeMaio Ziegler, and I will be your moderator.

Joining us today Marshall Saffer, David Garcia, Silvia Tong, and Alejandro Jr. Tan. Marshall is a strategic and operational business leader with demonstrated success in launching, growing, and managing software and services companies. For the past 25 years, Marshall has provided solutions to many of the largest PE funds, hedge funds, and traditional asset managers, bringing a deep understanding of operations and a strong technical background. David is a director of client services for CSC Global Financial Markets in West Orange, New Jersey. He manages a client relationship team, responsible for fund accounting, operations and overseas investor services, and the fund administration services provided to clients. Silvia joined the Fund Solutions Division of CSC Hong Kong in 2019, specializing in alternative fund administration services. In her role, Silvia is responsible for managing a portfolio of alternative fund clients by leading a team to provide quality and excellent services. And Alejandro joined CSC in December of 2020, bringing 13 years of professional experience as a certified public accountant. He manages a team responsible for financial accounting and reporting for a wide variety of private equity and debt fund structures.

And with that, I will hand it over to Marshall.

Marshall: Well, thank you, Christy, for that great introduction. And we've got a great presentation for you today hopefully. We are going to be speaking about, as Christy said, waterfalls. And we're going to cover some various aspects of waterfall calculations, the importance of the relationship between the GP and the LP, and why we think it's an area that needs to be looked at and understood for all parties involved, whether it be the fund administrator who's servicing you, whether it be the GP or your LPs. So we're going to talk about the regional differences and new expectations and standardization, greater transparency, and the outsourcing versus in-house concepts. And then we're going to touch a little bit on the technology, reporting, and the journey ahead. And we're going to end with some questions and answers potentially. So hopefully this will be a very meaningful conversation.

Let's start with the regional differences and the new expectations. I'm going to start with Alejandro. Hopefully you are ready for us. So let's start with the first question that we've kind of, as a group, put together. Why is collaboration and alignment between general partners, meaning the GPs and the limited partners, the LPs, essential in building greater investment opportunities and investor trust? Let's start there.

Alejandro: Thanks for that, Marshall. I do believe that collaboration and alignment between general partners and limited partners are necessary because they ensure both parties work towards common goals, leading to more successful investment outcomes. When general partners and limited partners communicate effectively and align their strategies, we can better manage expectations, reduce misunderstandings, and build trust. Regular updates, such as quarterly statements, and educational workshops or seminars can help keep LPs informed and engaged, encouraging robust partnership. This transparency and proactive communication can lead to increased investor confidence and a higher likelihood of securing future investments.

Marshall: Okay. All good points. Let's do a follow-up. So in regards to risks, what risks do GPs face if they fail to align their strategies with the expectation of the LPs, as a follow-up?

Alejandro: If general partners fail to align their strategies with limited partners' expectation, they risk creating dissatisfaction and frustration among their investors. This misalignment can lead to conflicts, reduce investor confidence, and potential withdrawal of investments. General partners must ensure their strategies are transparent and aligned with limited partners' goals to maintain a successful partnership.

Marshall: Okay. So in regards to expectations, right, we've been talking to a lot of clients, we've been talking to a lot of prospects, right? There are some industry concepts around standardization that are getting batted around. So how do multiple hurdle rates and waterfall structures complicate the reporting process for these investment strategies?

Alejandro: Well, multiple hurdle rates and waterfall structures make the reporting process quite complex because they require detailed calculations to figure out how returns are distributed among investors.

Marshall: Okay.

Alejandro: Each hurdle rate is a different return level that must be reached before more profits are shared. And waterfall structures determine the order in which these profits are allocated.

Marshall: Sure.

Alejandro: Accurate modeling and calculations are crucial to ensure these distributions are fair and transparent. This complexity means that customized reporting solutions are needed to handle the specific details of each investment strategy, ensuring all stakeholders get clear and precise reports.

Marshall: Okay. And in regards to standardization in the reporting and the benefit to both the GP and the LP in a complex invest environment, where does that kind of play in and fit?

Alejandro: Standardizing reporting can make communication smoother and ensure everyone understands the performance metrics and financial distributions. By using uniform reporting practices, general partners can spend less time on reconciliations and fixing discrepancies, while limited partners get clearer insights into their investments. These boost transparency and build investor confidence as LPs or limited partners can easily compare performance across different funds and strategies, leading to better informed investment decisions.

Marshall: Well, I think those were all valid points, so thank you for that. I think we'll move on to our next topic, which David is going to cover. So we're going to talk about greater transparency and the concept of whether this function or fund administration in general should be insourced versus outsourced and some of the benefits. So let's start with David then. So David, should GPs provide more transparency to the waterfalls? Should we add an exhibit to the partner capital statements? There's a lot of talk around that. What are your thoughts regarding that aspect?

David: Thanks, Marshall. I believe GPs should add more transparency to their waterfalls. It allows LPs to see how far along GPs are in the steps of the waterfall. This can be a simple attachment to the partner capital statements. GPs have this information. If prepared correctly, it could be a matter of processing by investor.

Marshall: Okay. And what do you think will occur if LPs are provided with greater transparency into the methodology, into the rationale? Like do you think that's good practice, bad practice? What are your thoughts around that?

David: I actually believe it is really good practice if they provide more transparency. For example, the limited partners will be able to review and challenge the GP, make sure it's in alignment to the limited partnership agreement. LPs will gain a level of trust with the GP/fund. An LP may be able to perform its own what-if scenarios if they have the methodology that's in play. This reduces the level of ambiguity and additional cost to the LPs. Many LPs invest in other funds. There's a cost and time savings if they don't have to employ or hire professionals to analyze multiple waterfalls on a quarterly basis. It can also cause a reduction in investor requests and concerns.

Marshall: And what about brand loyalty?

David: I think over time when we would look into things and I think definitely the brand loyalty will develop over time if this kind of transparency is in play.

Marshall: Okay. And then with this transparency, right, do you think it creates awareness in waterfalls or the importance of waterfalls? I mean, I think waterfalls are generally an important concept that the LPs need to be aware of, right? It's essentially how they're getting charged, right? It's impacting their performance. So what are your thoughts around that?

David: I agree, Marshall. I believe the transparency will create awareness. I believe the institutional space is more aware with agreements they sign. However, further transparency may increase a stronger retail base. Providing data would allow investors to compile and compare various GPs. And the transparency will allow investors a stronger understanding, whether European or American, hybrid or multilevel catch-up in the waterfall.

Marshall: I mean, a lot of this is complicated math, right, in terms of how the fund is structured, in terms of how the investments are structured. You agree with that. So let's talk about outsourcing versus insourcing, right? I think there's a choice, right? Some people can decide they want to staff this themselves. Some people might decide that they want to bring in someone with expertise, like ourselves, who does this in scale. So what do you believe are some of the benefits to the outsourcing concept around this?

David: Thanks, Marshall. Some of the benefits to outsourcing, cost savings. It could be cheaper than hiring and training permanent staff. Increased productivity, outsourcing can improve efficiency and productivity to smaller tasks, quarterly annual deliverables, and projects. Access to expertise, it can provide access to specialized skills and knowledge as well as the latest technology and equipment. Improve scalability, it can help in business scale-up while keeping costs down. Access to global talent, it can provide access to global talent pool, which can be more diverse than local talent pool.

Marshall: True.

David: Faster turnaround, outsourcing can help complete projects faster. Many administrators have follow-the-sun model. Administrators have teams in different time zones, different jurisdictions. And last, resource conservation. Outsource staff can help minimize waste.

Marshall: So let's take the contrary. Like let's take the opposite and be the devil's advocate, right? What are the disadvantages, from your perspective, if there are any?

David: Some disadvantages that you may encounter with third-party administrators are potential security threats, potential communication challenges, protection of intellectual product, and sometimes loss of oversight of your files, your documentation, your books and records.

Marshall: Okay. No, those are all good points. So the real question is, outsourcing, is it a positive experience, or can it be a positive experience for both the LP and the GP together, right? Where do you see that falling?

David: No, absolutely. I think it's a positive experience for both parties. For the GPs, for example, the creation of LP reports, the maintenance of sophisticated reports, the data validation to support LP reports, new software and technology implementation, staffing. These some of the benefits for the GPs. For the LPs, secure platform exchange, either to exchange information and to provide an investor portal for them. Comfort that partnership information is reviewed and prepared by a third party, accuracy of data. Administrators provide multilevel reviews before sent to client. LPs benefit for the specialized expertise and advanced technology. Many administrators have, in some cases, waterfall portfolio and accounting platforms that they can capitalize on.

Marshall: All right. So it sounds like the positives kind of outweigh the negatives from your perspective, so.

David: Agreed.

Marshall: Right. And it's not just that we play in the space and that we're a vendor, but we really think that the benefits definitely outweigh the negatives in this case. Okay.

David: Absolutely.

Marshall: Thank you for your perspective. Let's move on to the next topic, where we're going to talk about the technology that supports this, the reporting, and what we think the journey ahead might look like. And we're going to turn to Silvia to give us some of her perspectives. So Silvia, let's start with the first question, right? We did a little bit of surveys of some of our client base and some of our prospects, and it said over 50% of the GPs said they invested significantly in technology infrastructure and updates over the past two years. Question is, why do you think the GP will invest significantly in technology infrastructure going into 2025?

Silvia: Technology can streamline operations obviously and improve overall efficiency. So the drive for more technological support takes place alongside demand from LPs for greater transparency, as said by David earlier. So GPs tends to receive more inquiries from LPs, especially on fee calculation, distribution breakdown, and performance waterfall calculation. So technology can improve transparency by providing investors with real-time access to information about their investment and performance. This transparency can build trust and strengthen the relationship with investors, and this definitely is a value-added point for GPs to attract investors.

Also, recently the regulatory requirements in the industry are becoming more complex, and technology solutions can help GPs to ensure compliance with regulations and manage risk efficiently. Besides regulation, consistency of data, cybersecurity concern also drive GPs to invest more in technology infrastructure. GPs handle many sensitive financial information and personal data for clients and for the investor. So strengthening cybersecurity measures is critical to protect the data from unauthorized access. If there's any breach of cybersecurity, it will severely damage the reputation of the investment firm.

Marshall: Okay, so go ahead. I'm sorry.

Silvia: Yes. Yes, I think it is. Yes. This is why the GPs will invest significantly in the technology infrastructure recently.

Marshall: Okay. Another poll question that we had when we were doing some research is that, over the next 2 years, 61% of the respondents of some of our survey responded they we will be upgrading technology significantly and making minor upgrades. Why do they still need to make additional significant updates in the next two years? Like what areas are they not invested in currently or you think that they should be investing in going forward?

Silvia: Yes, even half of them has made significant upgrade over the past two years, they realize that they need to do it again. And it may be mainly because there's a variety of underlying investment and market uncertainty that make the investment disposal and liquidity management a challenge. And fund reaching different stages of waterfall level and different stages for underlying investment, they may realize there will be more issues or bucks in the calculation upon realization. Therefore, they need to enhance and upgrade their calculation. So it will make the calculation more efficiently, accurately, and so they can provide more accurate data to the LP.

And for the GP who keep their fund management technology in-house, the continuous upgrade has become a financial burden to them. By outsourcing the required system or the waterfall calculation to a third party, like CSC, not only we could provide technology that could process a large volume of data and perform comparison and scenario analysis, we could also provide expertise to help them to deal with the inquiry from GP.

Marshall: Okay. I think that that's great. Okay. And then regarding looking forward and the recovery, right, given the renaissance of private markets after a couple of challenging years, right, is it expected to see a gradual recovery in private market activity over 2025, 2026? What do you expect to see over the next few years in terms of also the GP-LP relationship?

Silvia: Obviously, the LPs will be more sophisticated and more experienced. As we mentioned many times in this webinar, they are seeking for greater transparency, better alignment of interest, and improved reporting and communications. So LPs are likely to demand greater transparency from GP regarding management fee, performance fee, investment strategies, or the waterfall calculations. And the GP will need to provide more details and timely information to meet the growing transparency expectation from LPs.

There will be a continued focus on alignment in interest between GP and LP. So GP may introduce more complex waterfall calculation structure and co-investment opportunities. It also ensures that their interests are closely aligned with the LP. And the LPs are likely to continue pushing for more favorable terms and increased access to information about funds that they're invested in.

And also, LP will place greater emphasis on risk management within the investment firm. GP will need to demonstrate robust risk management framework and procedures to reassure LP for the safety of the investment. And with firmer standards and tighter industry regulation, GP will likely need to demonstrate the commitment to responsible investing and integrate those standards and regulations into their investment strategies to meet LP expectation.

So both GP and LP are expected to increase and leverage technology for communication, reporting, and data analysis. GP may leverage their advice too and platform to provide more comprehensive and timely reporting to LP, while LP, on the other hand, may utilize the data to evaluate their fund performance, monitor the investment, and assess the overall risk return profile.

Marshall: Interesting. Those are all very valid points, and I think they're all very well covered. So the last question is, how can CSC help? What do you think?

Silvia: I think with the growing availability of the technology and the demanding for outsourcing calculation and report to independent third party, in order to free the GPs to focus on their business investing and certify the LP with more objective, transparent information, CSC as the world-leading provider of global business administration and compliance solution, we specialize in tailored outsourcing and supported the complex operation of the alternative asset manager across jurisdictions and asset type, we could surely assist them.

As expertise, we can apply our extensive knowledge and experience to respond to the client needs. And with technology, we could provide distribution, waterfall calculation platform. We could cope with the complex structure and the calculation. So for those in the audience who want to have more information, feel free to have a look within our website or contact us if needed.

Marshall: Okay. Well, thank you. I think that's covered pretty much everything that we wanted to cover as a group.