The Private Capital Strategy Series Episode 12: Outsourcing and co-sourcing for the unknown

Chris Gale  00:02

This is the Private Capital Strategy Series, Episode 12, with Joshua Cherry-Seto and Mike Trinkaus on outsourcing for the unknown and co-sourcing. Josh, can you introduce yourself?

Joshua Cherry-Seto  00:29

I spent about eight years at Citi and finance in the early 2000s, including four years in alternative asset classes across the business. In 2008, I went to real estate in a private equity structure and spent about five years there in the global markets. In 2013 I joined a middle market PE firm just as the industry was registering with the SEC, and LPs increased demands coming out of the financial crisis. I spent nearly a decade at that firm growing the team. The firm grew from about $100 million of assets under management to $3.5 billion of assets under management. I spent my last year in an early-stage VC shop.

Chris Gale  01:22

You’ve been interviewed on outsourcing. How would you describe the environment right now from an operations and finance perspective for private capital? Has that changed your thinking or your playbook when it comes to outsourcing?

Joshua Cherry-Seto  01:48

I think what we’ve seen is an acceleration in the demand from LPs that’s had an impact on us on the finance side. I remember, when I started in the industry, most folks did their own self-administered in house. As there’s been a maturation in admins beyond a transactional capability, to more of a white glove relational capability, that’s really led to all new GPs coming out day one with an admin. Most older firms still do things in-house. There’s a lot of pressure today, not just starting with SEC regulation, but also, as we’ve seen a real growth in GP-led restructurings and secondaries. It’s a much more complicated business than it was in the past, and LPs have demanded more of us as the industry has grown. That’s put more pressure on us to find additional ways to get leverage, which includes outsourcing and co-sourcing models.

Chris Gale  03:03

There are new SEC regulations in the headlines, and there’s potentially slower fundraising. What does that look like from your perspective? Does that change the equation on outsourcing?

Joshua Cherry-Seto  03:32

I think there are always challenges. There are always things that we’re nervous about and working on. Certainly, we have things like what’s going on with inflation, war in Ukraine, etcetera; there’s always going to be challenges. I think the main thing for us is the demand for speedy and accurate information. We used to have a lot more time to respond to requests; we were working on 80 to 90-day windows. Now that’s 45. There are ad hoc requests that are pretty timely. I think it’s now that the speed of business has put pressure on us, we certainly must continue to look at what’s outside of our core competencies. You’re always going to keep your core competencies inside the organization. When it comes to operations, most of those things we want to do well but are not our core competencies. So, finding partners that can help us get that information quicker and faster is the real challenge that’s been driving us. Yes, there are specific challenges today, but that expectation of the speed of business is universal. Those challenges just put a pin in it every time that there’s a request based on a crisis.

Chris Gale  04:48

Is there anything you would say about your preferred process for vetting and finding outsourcers? What kind of criteria are you using right now?

Joshua Cherry-Seto  05:05

We think about it in the same way we think about our investment process. We’ve always been focused on continual improvement. That’s the way we figure out the value of our companies. In a traditional environment, we’re fundraising every three or four years, and we do co-investments all the time. In some sense, you’re in the market all the time. But there’s a more substantial process every three, four years. Depending on your investment site, we always use that as an opportunity to do both a three-year planning exercise and to scale the organization. If I’m going to talk to LPs and explain to them that we can do it on a larger scale than internally, we need to work through what that means. So, we would do a three-year plan. As part of that, we’d also review all our capabilities. Each time we raised a new fund, as we were leading into a launch for that fund, we’d take a moment and look at all our relationships, because just like any company you acquire, they go through stages. What’s good for you when you’re an emerging manager, and at your first fund with $100 million of assets under management, is not going to be the same thing that’s good for you three years later when you have a half a billion and multiple products. So, we would go through all of our relationships. Over the years, we change our legal counsel, we change our audit partner or tax partner. We went from self-administered to having an administrator, we acquired a compliance partner, and then grew that relationship to a new compliance partner. I think that’s the right cycle. Then, when you talk about the process itself, the one thing that I would say is, we all think a lot about the implementation – who’s the right partner, who’s going to walk us through the implementation, and we usually shortchange the review process itself. We all run extremely lean. We’re all extremely busy, and it’s hard to have the time and attention to really take these processes seriously. But they matter. Who you’re working with, as an administrator, matters. If it goes wrong, you’re going to have a lot of problems. But we always feel like we must shortchange the review process. As the CFO, you’re responsible for the process, but honestly, you shouldn’t run it. You have a day-to-day job to do. It pays to spend a couple of dollars to bring in a real expert to help you as a project manager, to be your partner in the review process.  But it’s been very hard to do. When we looked at the administrator process back in 2016, we didn’t take that advice. If there’s one thing I’d share, is you shouldn’t shortchange the review process. Bring somebody who’s really able to take the time and attention to focus on the process so that you can have the best information and a partner to help you think through the information.

Chris Gale  09:07

Do the benefits come in any particular area? At the beginning, you mentioned there’s an acceleration of reporting, and I don’t know if there’s a technological component to that. It’s also having a relationship with someone – technology or not – who’s going to be accountable to you if things go poorly. What are the gaps that you’re trying to address? Are there particular gaps that a partner can facilitate addressing?

Joshua Cherry-Seto  09:42

I think the point you made about the relationship is key, particularly as things get faster. In private equity and venture capital, we’re not looking for someone who can process a lot of transactions. This isn’t a hedge fund space. It’s not public trading. I’m not looking for unit cost for you to just push a lot of entries through. It’s complex transactions that are fewer, so the relationship is key. And that’s where the focus should be. I think that one of the biggest changes in service providers in our industry over the last decade is becoming more relational focused. That’s what we really need. We don’t need to unit cost a ton of transactions. Wwe need somebody who can be our partner to do what we need, to help us think through how to react and deal with issues as they come up. That that’s been the key for us, to focus on relationships. As you think about relationships, one side of it is a CFO being able to tell your story and explain what you’re doing. But it’s also understanding your partners and what their model is and what they’re trying to accomplish. This isn’t adversarial bargaining. What I need to figure out is how we can expand the pie by having a better relationship. That’s true with our partners, too. If I want to react quickly and intelligently, then I’m not looking for the lowest cost solution. I’m looking for the most effective solution in partnership and in collaboration.

I’ll mention one thing as people think about the processes they’ve run. You should be asking not just are we important to your business, but also asking them about margins. How am I going to be a profitable client to you? What I love is being able to help my partners make more money. I want to be a good partner to my vendors. So, I think it’s very important as we think about relationships, to not just think about how they can add value to what we need done, but how are you aligned with what they’re trying to accomplish. You really do have to think about it from their perspective and have those conversations. You have to say, I want a long-term relationship, table stakes, and you’re going to have to do a good job and provide what I need. But we’re also not going to have that if I’m not giving what you need, as well. I think that that’s a key to healthy long-term relationships with vendors. There’s been an acceleration in what we need from vendors. Outsourcing provides operating leverage, and we’ve needed that over the last decade. But, what co sourcing provides is greater control and an extension of internal capabilities, allowing for us to have more nimble and timely deliverables. The traditional model of outsourcing, there’s a little bit of passing things back and forth, but that’s going to break down as the speed continues to increase, and we really need to look for solutions that are more collaborative.

Chris Gale  14:13

You’re saying that acceleration is one of the contributors that are necessary to have a strong relationship. And then the speed can break down the relationship, too. I want to come back to speed and relationships. Can we define co-sourcing as a hybrid work environment? What is co-sourcing?

Mike Trinkaus  14:51

In terms of co-sourcing at a high level, it’s when the general partner and the administrator jointly operate on the GPs at a price software to manage all the operational aspects of the business. All the day-to-day stuff that we typically engage them with allows the GP to retain possession and control of their data. It also simultaneously allows us, the service provider, to work with the software, to manage all of the fund deliverables as well as other needs. In a way, it is an innovative approach to managing fun administration compliance while also trying to leverage it for business insights to put the velocity of information at your fingertips much faster than what we’ve been able to do. It’s just making the operations for the general partner as well as the fund administrator more effective and more efficient in meeting newer, more challenging, and complex demands.

Chris Gale  17:12

To clarify, when you’re saying jointly working on the same enterprise software, who has the license? The fund administrator? The GP?

Mike Trinkaus  17:27

The general partner will hold the license of the actual software. What we do is, we come into the general partners environment within that particular software, and we operate our fund administration duties within that world. There’s lots of benefits. But yes, you’re in the general partner license environment.

Chris Gale  17:57

I hear speed is driving the importance of relationships. But speed can also degrade those relationships. How does that relate to co-sourcing as a variation on the outsourcing theme?

Joshua Cherry-Seto  18:27

I think it’s about control of information. One of the reasons why, a decade later, many of the legacy companies still do their own books and still don’t have an administrator is because we’re all type A personalities, and everybody wants to control their information. There’s tension with this idea of “We’ve been doing it in house for 10-15 years” to pass it off. There’s this wall where you’ll pass information back and forth. That’s where the tension is. In order to be quicker, you need to let people in. The problem with out-sourcing is that, by its nature, it was maybe putting too much control outside the organization. But the tradeoff is you’ll be able to do more, and I’ll be able to review. But the idea of something like co-sourcing is inviting that capability inside me. We used to think of it as insourcing. How do we bring the folks into our house. The challenge had been, from the vendor’s side, thinking about compliance, and whether you have enough control of the controls themselves. The other thing that’s working in line with this is that LPs are demanding a third-party touch, and much deeper controls, not just for cybersecurity and fraud and issues like that, but also private equity and real estate restructuring. Those are the last bastion of self-administered funds, most of the rest of the market has gone to professionals doing that side of the house.

Chris Gale  21:24

It sounds like there was a time when things were internal, and that satisfied a need for control. I don’t know if the Bernie Madoff scandal might have contributed to things being external. Which might have also helped things be somewhat faster, as funds scale, but you’re losing a certain degree of control, and you’re losing some of the internal team value. Mike, you’ve talked about how one of the joys of your work as a CFO on the private capital side was working with that internal team. It seems like co-sourcing is an attempt to have some sort of synthesis between these two poles, where you can have internal control, an internal team, but also the ability to scale? Is that true? Would you say that co-sourcing is an attempt to synthesize between the merits of internal and the benefits of outsourcing?

Mike Trinkaus  22:38

For me, it’s an evolution of those two eras, so to speak. It’s the next logical step to get to a place that’s the most efficient for both sides. Markets change, deeds change. Initially back in beta, that was a pivotal point in the PE/VC world in terms of how we transitioned from primarily self-administered to primarily outsourced. We’ve grown, and the market has grown over 100%, from insource to outsource during that period. The first reaction was outsource, outsource, outsource. Now we’re at a point where we continue to do that. But what is the best model going forward? I think one of the next iterations needs to include outsourcing, because outsourcing addresses the needs that were created based on some of the items that Josh mentioned earlier. We’re hearing a lot of folks that say, “We need to integrate data.” If we’re outsourced to you, it’s really hard for us to integrate different pieces of data that may need to go in multiple places. So, they’re starting to come up with this broader data plan. This data plan concept is moving down into the middle market as well because of the velocity around data requests. Whether it be from limited partners, or from the regulators, you need to have access to this data. How do you do that in the most efficient way? Co-sourcing allows you to have a broader data plan where you can integrate pieces of data from different software to bring them together. We’re at a point where co-sourcing fits that bill.

Chris Gale  24:57

There’s a part of the market that’s still internal. They have not outsourced. And there’s a part of the market that is outsourcing. Then, there’s a part of the market that is probably the newest and most interesting part, which is formulating what co-sourcing looks like, similar to what you’re describing. If this is a synthesis, one of the things pushing the outsourcing model was ensuring that reporting was from an external third party, from a safety perspective for investors. On the co-sourcing model, if the GP has access to the data, how do you how do you balance that? How do you address the LP’s need to ensure that reporting is not being fiddled with?

Mike Trinkaus  26:06

You’re in no worse position than somebody that’s currently self-administered. We, as a firm, have our own audit that we go through. All the controls that we have in place regarding a co-sourcing situation remain in place. All the sign offs that we need, client approvals, etcetera – all these things still happen in a co-sourcing situation. Further, when it comes to co-sourcing, we ask our clients to give us the ability to act transactionally within the platform, and they essentially have read only access to the accounting piece. We try to control as much as we can, with the rights on the back end, related to the accounting platform. That doesn’t guarantee that they don’t go and try to do some things, but there’s at least a process and mechanism in place to ensure that nothing further than that happens. If there is a real concern around that sort of thing, you could put all kinds of controls in place to make sure that the data that was signed off on, and the data that went out only to the limited partners. What we often do is look at banking activity on a daily basis. More of the mundane, day-to-day functional stuff, we’re in doing that every day. If something arrived, we will notice that very, very quickly as an administrator, but in terms of the control of sending information out, you could have all the best controls in the world, but you can’t put in a control environment on top of your normal stock environment. That would put you in a position to understand what’s gone out in the platform that may have not come from the fund administrator. It’s case by case, GP by GP, but we feel comfortable that you’re in a much better position than if you were just in a self admin environment.

Joshua Cherry-Seto  28:32

I wholly agree with that. LPs demand that even smaller managers have a real institutional look and feel to them, that you’re not a small emerging manager. Cutting corners about expectations is beginning to go away. So, partnering with someone allows us to accelerate that institutionalizing of the organization, because they come with an operating manual, on the accounting side. It’s something that dozens of clients are also using. It’s not a special case. It’s the same one that dozens of other clients are using bigger and smaller. That’s another reason why it’s helpful; operational due diligence at LP meetings, starting from the very first time you’re trying to raise capital have become much more intense as well, as a CFO, this last time of fundraising. We were presenting decks to the LPs to go through our operational due diligence, and what are they trying to do? They’re going into the details, but they really want to see an institutional look and feel to the operations. That’s vastly helped by having partners that are bringing in those pieces. Same thing on the compliance program side. Having a partner on the compliance side helps you package the program and is extremely valuable.

Chris Gale  30:12

We’ve run out of time for my second question. Thank you very much, both of you. I really enjoyed this. And we look forward to following up.