Why Hedge, Private Equity Fund Managers Need To Pay Attention To Expense Allocation

A sponsored article by aXpire LLC

Expense allocation for hedge fund and private equity fund managers is a task largely not undertaken, except at the very largest investment houses. Small and medium sized investment managers of all strategies could benefit by implementing an expense allocation process, and/or system, to ensure they are maximising the bang for their buck regarding expense management.

Why is expense allocation important?

To begin, expense allocation is a compliance requirement. Expense allocation is mandated by accounting frameworks such as Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). This is to ensure that the full cost of all activities contributing to funds are captured in financial statements. It is known as “full absorption costing.” It is important to have a solid grasp of expense allocation fundamentals, given that it is a key compliance requirement that has implications on business profitability and LP/investor satisfaction.

In February 2018, the U.S. SEC identified expense allocation as a priority for compliance exams, which was reiterated to all private fund advisers (such as hedge funds and private equity funds). Proper expense allocation ensures that companies stay on the right side of the law and prevents audit findings - and potentially adverse publicity - that can derail a manager’s momentum and growth. Look no further than “expense allocation fines” on Google to see penalties ranging from $400,000 USD to $30,000,000 USD, excluding reputation damage.

Expense allocation can help a business optimise its expenses. When carried out effectively, expense allocation lays bare the various cost centres of a fund and how these contribute towards reaching the fund’s objectives. Research from EY ^[1] indicates that when institutionalised, expense allocation efforts will help hedge fund and private equity fund managers identify the 3 cost-related pitfalls that stand in the way of cost management:  

1. Removing stubborn costs. These are costs that fund managers unnecessarily continue to incur, which are a result of the fund not transforming or updating processes; 
2. Avoiding myopic cost cutting. This involves cutting costs that are critical for helping to realise key strategic objectives; this will eventually affect the bottom line negatively;
3. Managing stranded costs. This involves identifying expenses that are not directly tied to a revenue generating activity and considered an independent overhead.

With an accurate expense allocation software system in place, expenses can be controlled more effectively because costs are attributed directly to activities which fund units are directly accountable for; other common methods include AUM, NAV and LP/investor commitments.

Expense allocation can help with capital allocation. By providing the GP with an overview of how different expenses incurred are mapped to revenue generating activities, the fund can arrive at a view on the cost effectiveness of its various fund strategies, and where the marginal returns for every unit of expenditure are the highest. This allows the fund manager to maximise their capital allocations – more to higher-performing tasks, less to lower performing tasks.

Expense allocation can help with future capital raising efforts. Proper expense allocation demonstrates accountability to LPs/investors and earnest capital stewardship. With an ever increasing focus on operational due diligence, investment managers need every edge available to them. The Bain and Co. 2020 private equity report highlighted operational excellence as a key differentiator between top quartile funds alongside specialization in a given strategy. Maintaining a comprehensive, defensible record of expense allocation would strengthen the confidence of investors, improving the firms’ chances of receiving an allocation.  

Different Allocation Approaches

Across various methods for allocating cost, there is a trade-off between precision and ease of implementation. In situations where cost estimates are used as the basis for a management decision, greater precision is required. Here, having a closer relationship between the cost of the item and the basis of allocation is important. Such approaches are more complicated to implement, and often require customised tracking systems to facilitate. However, in most other cases, businesses may rely on a simple formula to allocate expenditure across various cost items with less precision, such as AUM, NAVs or LP commitments. This strategy is what we recommend as “best practices” unless you can tie expenses to a specific fund strategy, i.e. CLOs or real estate or middle market private equity, or portfolio company. Allocation on an asset basis helps to minimise the complexity and labor intensity of expense allocation, which tend to be already quite high. At aXpire, we have developed an expense allocation software for hedge funds and private equity funds, with an expense allocation rules library, with options ranging from AUM to NAV to LP commitments or time spent per fund.

The table below lays out various approaches for allocating indirect expenses, of varying degrees of suitability for different businesses. Choosing the right method of allocating costs is important for businesses, as the selection of the right output indicator is a low hanging fruit that can be tapped to dramatically increase the accuracy of assigning expenditures:

Pain Points for Expense Allocation

Regardless of which expense allocation method is chosen, most hedge fund and private equity fund managers face a common set of pain points during the process:

1. Technology limitations result in application of overly simplistic methodologies: in the absence of extensive software support, most companies tend to harness allocation monolithic methods (i.e. spreadsheets) that are overly simplistic. This means that indirect costs are usually allocated based on a single indicator that is common to all the fund’s business units, regardless of how varied the operations of each unit may be.
2. Poor data quality: in the absence of an expense allocation software system for collecting and processing expense related data, hedge funds and private equity funds will find it challenging to make well-informed decisions, as the data they have access to is often inaccurate or outdated. At aXpire, we find integrating a travel & expenses (T&E) system, such as Concur, with an expense allocation software, such as Resolvr, vastly improves data quality.
3. Incomplete Coverage: most funds approach expense allocation in a siloed fashion, where the records of various strategies or underlying entities are not made available across the entire organization. It is even harder to consolidate expenses, when they originate from a variety of internal and external sources. This makes it difficult for units that have a similar basis of expense allocation to carry out benchmarking to improve cost competitiveness. Again, something like a Concur/Resolvr combination can alleviate headaches here.
4. Lack of resources: tracking and monitoring expenditures can be a labor intensive process which smaller funds cannot afford to set aside headcount for. This is particularly if indirect expenses are incurred on a high frequency, and distributed across different parts of the fund. It is also difficult to automate this process, given that some indirect expenses may be incurred on an ad-hoc basis, and not on a predictable schedule. For a small unit or strategy, the cost of setting aside resources for tracking may significantly outweigh any benefits from resource allocation derived from doing so. Software materially leverages small teams’ outputs.
5. Difficult to keep track of how complex allocation formula are applied to different units: ultimately, funds have found that applying different cost allocation formulae to different investment strategies can be difficult to handle. This is exacerbated particularly for conglomerates which operate business units with vastly different functions and few synergies. Such entities often have to keep a repertoire of complex cost allocation formulas on hand. These will need to be tracked, and customised for different business units. The institutional knowledge on how the various cost allocation formulae are applied should not be restricted to a single professional.

Solutioning

The pain points above can be addressed readily with the installation of an end-to-end expense allocation software system which can:

1. Store application of multiple different expense allocation formulas.
2. Allow inputs to be entered in a standardized format, which can be extended across disparate business units.
3. Automate tedious and labor intensive tasks, such as the addition and the manual entry of expenses.
4. Integrate into a fund’s existing technology stack and expense management systems, including fund administration software. Examples we’ve worked and integrated include Concur, QuickBooks, Geneva (SS&C) and ebilling software systems, such as Bilr.

With over a decade of expense management experience, aXpire developed an end-to-end expense allocation software platform, Resolvr, by working hand in hand with a top 10 global hedge fund as a digital transformation partner.  We differentiate through a willingness to work with you as a partner in digital transformation, a believe we can deliver the #1 expense allocation software for hedge funds and private equity funds. Starting at $3,000 per month, we can install a dynamic expense allocation system that fits seamlessly into your existing technology stack.

If expense allocation software or digital transformation may be needed within your hedge fund or private equity fund, reach out to us at info@GetResolvr.com.

Matthew Markham is COO at aXpire

[1] https://www.ey.com/Publication/vwLUAssets/EY-the-allocation-game-white-paper-july-2017/$FILE/EY-the-allocation-game-white-paper-july-2017.pdf