Platform and Industry updates

The first quarter of the year is a busy one for Registered Investment Advisers: those with a financial year end of December 31st are required to file an updated Form ADV within 90 days, so for those watching the private fund industry, there is plenty of information that can be gleaned from looking at this data.

Plenty of firms look at the data to see which firms and their affiliated private funds have changed service providers. Of course, private funds and their advisers changing service providers is nothing new. A range of factors drive the decision; costs, quality of the offering and the customer service function, to name a few.

But one service provider change raises more eyebrows than any other: Auditors.

Reasons that a private fund might change auditors include those listed above. But a change of auditor may suggest potential accounting issues or a breakdown in trust between the fund and the previous auditor. Neither of those reasons receive a green check mark on a due diligence questionnaire and almost always call for a deeper dive by the investor (and can even be a cause for redemptions for those that are at the ‘very averse’ end of the risk spectrum).

So, it perhaps comes as a surprise that, according to data collected by 9AT by aggregating Form ADV filings in the US, 2,346 private funds changed audit firm in the year to March 31st, 2024.

That seems like a high number on the surface. But looking at that in percentage terms, there were 75,468 funds outstanding at the start of the period, so at a macro level, only 3.1% changed auditors.

The SEC splits funds into sub-categories and the manager selects what they think is the most appropriate label for their fund when they file. Figure 1 below shows the breakdown of the number and percentage of funds that changed auditor in the period April 1, 2023 – March 31, 2024, based on the SEC filing category.

Figure 1: Private Funds that changed auditor, April 1, 2023 – March 31, 2024
 

Source: 9AT

Whether the percentage figures above are high, low, or in the middle is a question for the individual, given its subjectivity. 

It is perhaps little surprise which audit firms comprise the top five of the ‘competitor displacement’ table. Figure 2 below shows the top five firms, sorted by most to least, that have replaced a previous auditor. So, Deloitte has replaced the previous auditor most often overall; RSM has replaced the auditor most often in the private equity category, PwC in the real estate category, and so on.

Figure 2: Private Funds that changed auditor, April 1, 2023 – March 31, 2024, Ranked by Auditor and Category

Source: 9AT

Note: The Liquidity Funds category only had two auditor changes in its entirety the time period analyzed so was excluded from the table and analysis
* The Securitized Asset category saw only five audit firms complete a competitor displacement in the time period analyzed

Interestingly, we see non-Big Four audit firms take up a significant number of spots (14) in the top five across the six fund categories. Indeed, in the Private Equity category, which saw the most auditor changes both from an absolute and relative perspective, the top two, RSM and Grant Thornton, are non-Big Four. In the Venture Capital category, which saw the second most changes from an absolute perspective and relative perspective, two non-Big Four names (Frank, Rimerman & Co and Moss Adams) appear in the top three.

Changing auditors isn’t for the faint of heart; transitioning to a new auditor involves a lot of coordination and document exchange. This can disrupt internal processes and be a drain on resources, especially for smaller funds, so regardless of the fund category, those that decided to take the plunge in the past 12 months clearly had what they felt were compelling reasons to do so. And when they did, there wasn’t necessarily a beeline straight to the Big Four.

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Asset managers are spending more time and money on building out a more robust middle and back-office function than ever before. That’s partly because of regulatory changes, which make more demands of an asset manager from a compliance perspective. And it’s partly because they are realizing that this can provide a competitive advantage, helping them to differentiate themselves from their competitors and peers (as this article by Gen II Fund Services explains).

And it’s also partly because allocators / LPs are digging ever deeper into the nooks and crannies of an investment manager’s middle and back office as part of their decision-making process around an allocation.

The operational due diligence (ODD) effort of an investor was not always so intense. In years gone by, asset managers simply wanted to know that the manager had certain service providers in place – and that these providers existed. Less attention was paid to the ins and outs of the provider. Today, however, allocators / LPs want to know why a manager uses a specific service provider, what the terms of the agreements are, whether they have changed service providers, any conflicts of interest, and whether those service providers have been in the news in the past few years (in a good way or a bad way – but mostly bad).

Until recently, investors had to compile the information they wanted relating to their asset manager’s key service providers – auditors, custodians, prime brokers in the hedge fund space, and fund administrators – manually. But technology is helping them to not only maintain this data but get ahead of the curve in terms of the ODD process by analyzing the Form ADV data to help build a picture of an asset manager ahead of an ODD meeting.

Data collected by 9AT tracks more than 2,000 service providers to private fund advisers in the US. This enables an ODD person / team at a fund of funds, a pension plan, endowment, insurance company or foundation to ask better questions during the ODD meeting. They are using it to confirm that the service providers in the PPM are those on the Form ADV, and if not, asking what has changed; they can see if there has been a change in auditor over time, which many consider something of a red flag; they can ask why a smaller, newer manager may be using brand-name service providers, which are sometimes more costly, when a different provider will be sufficient; and they can even conduct their own risk analysis on service providers from a diversification point of view, in the sense that they may have too much exposure to a certain service provider if that provider is used by many of the investor’s underlying fund managers.

Portfolio analytics technology has been around for many years, allowing allocators and LPs to build a comprehensive picture of the underlying exposures of the private funds in their stable, in turn enabling their investment due diligence (IDD) function to identify areas where they have too much risk exposure, or not enough. Now, finally, technology is providing the ODD practitioners with better tools to support what is an increasingly important part of the overall due diligence effort, enabling them to not only be better at being reactive, but more importantly, be proactive.

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Much of the news media coverage of the real estate market in the United States focuses on the challenges in the commercial space, as office block owners in non-prime locations face the double-whammy of higher interest rates impacting their ability to refinance, and falling rental incomes due to the persistence of the work from home culture that was borne out of the Covid-19 pandemic-induced lockdowns, increasing vacancy rates . It’s something that some industry commentators say will continue, even to the extent of clearing out the regional banks.

The same can’t be said for the residential market, however. Supply issues plague the space almost nationwide, and the average house price in the country is at a record high of $342,685, according to the Zillow Home Values Index, at the time of writing.

That represents a good opportunity for local and/or opportunistic real estate developers to build houses or multifamily buildings and turn a tidy profit. But finding sources of funding is often difficult – you have to know someone who knows someone in order to get access to financing, as local and regional banks aren’t as willing lenders as they once were.
 

But it doesn’t have to be difficult for entrepreneurs to find capital. According to data from 9at, there were 92 completely new Form D filings in the ‘real estate’ category in 2023, representing $6.74bn of capital. And many of these pooled investment vehicles that file form Ds have not yet made a first sale, so they are out raising money from investors, and when they do raise, that’s more money seeking deals.

Obviously, many of these funds are looking to do larger deals. But still, there’s plenty of investment dollars available for smaller developers looking to finance their project.
It’s a similar story for start-ups. In 2023, the venture capital industry took, in some ways, a worse hit than the commercial real estate market, with fundraising hitting a 6-year low. The troubles with Silicon Valley Bank in March last year added short term woes to more fundamental challenges faced by the private markets in terms of fundraising, as investors pivoted out of illiquid assets like venture capital and private equity to more liquid credit investments, buoyed by the comparatively higher yield and lower risk offered by these securities. But there’s another reality facing startups – the ‘new normal’ in the market is that venture capitalists are now being much tougher on due diligence and less flippant in terms of just throwing money at the next great idea.

Add to that, the fact that the capital raising environment is currently as friendly to the venture capitalists than any point since 2010, means that start-ups will need to cast a wider net than ever before in order to secure funding.

But that funding is out there. According to 9at data, there were 13,788 new form D venture capital funds filed last year, that had raised $246bn from their investors. That money will need to find a home at some point, unless the VCs decide to return uncommitted capital back to their LPs.

The reality facing start-ups is that they will need to contact many more potential investors than they did previously in order to secure an investment. And the reality facing real estate developers is that they will also need to be more pro-active when it comes to sourcing capital. But, as the Form D data shows, the money is out there.
 

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