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Having enjoyed success in recent years, private equity firms are now transforming tax and finance operations to build for the future.
In brief
- The private equity sector has performed exceptionally well in the past decade, but tax and finance functions are having to contend with a complex tax landscape.
- It is one that will become more challenging in the coming years, especially for multinational firms, as regulation is introduced that will have a global impact.
- Private equity businesses are rethinking their tax and finance models to futureproof operations, provide value to the business, and consolidate recent successes.
Examining the global figures for private equity (PE), it would be natural to assume that the sector is in exceptionally good health. In its most recent Global Private Equity Report, Preqin – a provider of data, analytics and insights to the alternative assets community – revealed that deal and exit values continued to soar in 2021.
It reported that “total private equity deal value reached US$804b on an annualized basis – 70% more than the figure for pre-pandemic 2019”. Similarly, total private equity exit value was not far behind, reaching US$767b – a 92% rise in 2019.
These outstanding figures show that the sector is very hot at the moment, with no signs of slowing down. With US$1.32t in “dry powder” at the end of September 2021, there are clearly plenty of deals to be done. What’s more, according to a survey released by Rede Partners (pdf) in early 2022, limited partner sentiment toward the sector is riding high.
Such a positive picture doesn’t come without red flags, however, and there is a risk of PE becoming a victim of its own success. “PE firms are having to work at breakneck speed,” says Petter E Wendel, EY Global and EY Americas Private Equity Tax Leader. “The pace has accelerated on transactions and fundraising. Firms are deploying more capital but cutting down on the time to invest and the time they have to do due diligence and structuring, which puts pressure on quality.”
Wendel points to other pressures on the broader PE sector, including concentration risk that has come about as a result of the pandemic – with firms becoming highly concentrated in sectors such as technology, healthcare and education.
“And the sector itself is evolving at speed,” he says. “Some of the smaller shops have grown significantly and their funds are increasing in size. Some are also looking at different investment strategies, such as private credit and real estate. And their success is leading other managers to launch their own spin-offs. It’s all moving very quickly.”
In such a rapidly evolving environment, PE firms are typically going to be focused on front of house and deal-making – not least because institutional investors increasingly want to allocate more to alternatives.
But PE firms don’t exist in a bubble outside of the broader economic picture. All of this success and expansion has been happening at the same time as the pace, scope and impact of regulatory and legislative change across the world has continued to accelerate, and a shift to reporting digitally and the need for robust data has intensified.
What's more, specifically with regard to tax and reporting, more sweeping challenges are coming down the pipe in the form of BEPS 2.0 and ESG regulation. This is all creating a series of pressures that is particularly being felt by tax and finance functions.
Yet, according to Gerald Whelan, EY Private Equity Tax Technical Leader, PE firms might not have their eyes clearly on this picture. “The PE world views tax differently to the corporate world,” he says. “The PE model is one of professionals who focus on deals and who invest money – in order to do this, they outsource as much as they possibly can and that usually includes tax. But now may well be the time to rethink whether this is being done as efficiently as possible.”
The need for change
It appears that PE firms are, indeed, recognizing that more attention may well need to be given to tax. According to the 2022 EY Tax and Finance Operations Survey, 69% of PE firms are changing their tax and finance operating models.
This is likely occurring because of a combination of pressures, some of which were outlined above. Indeed, the EY survey indicated that when it comes to the tax and finance function “organizations are having to find a balance between driving value, managing risk and reducing cost. Yet they are attempting this even as they face challenges retaining and transforming their talent, keeping up with legislative and regulatory change and future-proofing their technology and data”.
When it comes to value, the tax and finances function can play a significant role in partnering with the business. The EY survey reveals that 97% of PE tax and finance functions say they are going to reallocate budget from routine activities (such as tax compliance) to strategic activities, such as legislative, planning and/or controversy.
According to Wendel, however, such reallocation requires proper consideration. “While reallocating budget can make sense, are you reallocating it to the right place?” he asks. “Organizations need to take a hard look at what the goals of the business are and try to make sure that tax is supporting that as effectively as possible. We recently undertook some benchmarking which revealed that, at many funds, tax people were solely focused on deals – but is that the best use of their time and skills?”
Even if PE firms have recognized there is a need to transform tax and finance functions, the survey reveals there are obstacles to making this a reality – and these seem to vary from one organization to the other.
When asked “What is the biggest barrier to delivering your tax and finance functions purpose and vision?” 39% named a lack of a sustainable plan for technology and data. This was followed by an inability to hire and retain required talent (31%) and an inability to identify, evaluate and respond to legislative and regulatory change (28%).
It's worth addressing each of these challenges individually.
The technological imperative
Technology and data are the spine along which many activities in the tax and finance functions take place, and their importance is only going to increase in the coming years. “The world is becoming a much more tax-sophisticated place,” says Whelan. “Tax authorities are asking for more information and faster reporting, which is putting pressure on PE firms, especially those who are investing globally. This can only be managed by having the right technology in place.”
Indeed, PE firms anticipate that complying with emerging digital tax filing requirements (such as e-invoices and other electronic transactional government filings) will increase workload, cost and their tax risk profile, with the average spend expected to be US$12.2m over the next five years.
The biggest decision faced by organizations when it comes to technology is whether to “build” it in-house or to “buy” it from a third party. Of those who are changing their tax and finance operating models, the EY survey shows that 50% are co-sourcing with a provider who has significant capabilities in data, technology and shared service center delivery.
“The harsh reality is that building an in-house tech solution can be prohibitively expensive in itself,” says Wendel. “And then you have the ongoing cost of maintaining and updating that system, not least because of the incoming regulatory changes. Some firms might like the idea of being in the business of tax technology until the cost becomes clear.”
The survey shows that the expected average investment in tax technology in the next three years is US$3.7m, which appears to be a relatively low figure. This would indicate that most PE firms would be looking to co-source or outsource a significant chunk of their tech requirements.
Challenges around talent
There is a distinct crossover between technology and talent – 95% of survey respondents say their tax teams will need to augment their tax technical abilities with data, process and technology skills in the next three years. But Wendel points to a larger problem that is looming for PE firms.
“I think by far the biggest challenge is a shortage of talent,” he says. “The new generation of employees are far less interested in being accountants. I also think private equity is a very specialized area and continues to become more complex. As a result, it is very hard to find good people, and when you do they are expensive.”
Another challenge identified by PE firms is whether tax and finance personnel are being put to best use on strategic tasks rather than routine ones. For instance, 76% say their teams are spending an inappropriate amount of time on tax compliance, with 74% doing the same when it comes to data collection, cleansing and validation.
“What is interesting here is that PE firms are already outsourcing a considerable proportion of routine compliance work,” says Whelan. “But these figures certainly point to more work needing to be done to ensure that tax teams are delivering real value to the business.”
A complex regulatory environment
As much as technology and talent intersect, the regulatory and legislative landscape cuts across the tax and finance function. It is particularly challenging because it is constantly changing, with legislation being introduced both domestically, regionally and globally, and tax authorities increasing their reporting requirements.
As has already been mentioned, emerging digital tax filing requirements are raising the compliance requirements, but as Alexander Reiter, EY EMEIA Private Equity Tax Leader, points out, increased demands such as these are very much the direction of travel.
“As part of a shifting landscape, tax authorities are becoming smarter and much more robust in their approach,” he says. “It is especially challenging for PE businesses with international operations. Ten or 20 years ago, tax authorities were working in silos but now it feels like they’re all talking to each other and making things happen quickly.”
And the environment is only going to become more complex with the imminent implementation of the OECD’s BEPS 2.0 project, which includes a global minimum tax, and the EU’s latest anti-tax avoidance directive (ATAD 3). On top of these are regulations around ESG, which are likely to be introduced in the coming years.
Not only does this create challenges for the tax and finance function within the PE firm but there are also implications both up and downstream.
“While PE firms and portfolio companies typically handle compliance in a siloed fashion, these changes mean it has become more important to have information flow,” says Reiter. “If ESG regulation becomes more prominent in the future, then this information flow becomes crucial in determining the footprint of the portfolio companies and relaying it to the investor.”
Future-proofing the tax and finance function
As much as PE firms face the same challenges as other sectors, it is clear that they are also dealing with their own industry-specific obstacles. So it is unsurprising that 69% are changing their tax and finance operating models.
Against this, however, 80% of PE firms in the EY survey said they are planning to reduce tax and finance budgets by an average of 7.1% – it’s the longstanding challenge of doing more with less. Unsurprisingly, 81% say they are more likely than not to co-source select tax and finance activities within the next 24 months.
“This is particularly interesting because PE firms already are quite advanced in their use of external providers,” says Wendel. “The focus on deals and the front-office has already led to routine functions being outsourced. And while private equity funds do focus on cost, they are much more concerned about quality, especially considering their investor base. This is probably one of the reasons they would look at outsourcing back-office functions.”
So, if there is already a significant degree of outsourcing or co-sourcing of tax and finance processes taking place, does this mean that PE firms are going to have to rethink their strategies and create a smarter sourcing strategy? And what would that involve?
For PE firms working in multiple jurisdictions, it may mean consolidating the providers they have, as it isn’t uncommon for them to be working with totally separate third-parties in each location. But again, cost needs to be factored in.
“How many providers you have depends on how much you have to spend,” says Whelan. “In a perfect world, I would tell somebody they should have two really good providers. Because then you will have a healthy advisory environment. But if you don’t have enough money to spend you will have to go with one really good service provider, as there is a certain amount of money that it’s going to take to get the best and the brightest to work with you.”
Before reaching a decision, however, there are a number of steps that PE firms should consider when it comes to transforming tax and finance.
1. Conduct a current state review
It’s critical that organizations have a clear picture of where their tax and finance functions stand now, as well as working out where they want to be. Only then can they start to work out a transformation program that will take them from one to the other.
2. Establish priorities
Examine your tax and finance processes and determine which are more business critical and where the biggest challenges and risks lie. Consider areas such as tax policy, planning and governance; fund structuring and investor onboarding; fund tax compliance; and data and technology.
3. Consider time spent
Having established these priorities, examine where you are currently spending time and where you should be spending it. It is common for teams to spend more time on non-core tasks that are administrative and not enough time on core tasks that are strategic and support the business. Non-core tasks are prime for outsourcing and can be monitored at a high level.
4. Break out of silos
“I don’t see a lot of shops thinking of tax as being strategic, and that includes some of the larger and public ones,” says Wendel. “Tax and finance departments regularly have high-quality people, but you don’t get the sense that they have a seat at the table. Are they talking with the people who are running the business and thinking how tax can fit into that in a very strategic way to partner with the business?”
5. Make the most of technology
The bridge from current state to future state will absolutely involve technology, but it will need to be deployed smartly. The options available are not only wide-ranging but are evolving at speed. Technology shouldn’t be introduced purely to resolve current challenges but should pre-empt what will be required down the line.
Conclusion
While the PE sector has seen considerable growth, it is not immune to broader economic pressures. PE firms are having to operate at speed to capitalize on deals and satisfy investors. However, it is essential this doesn’t happen at the expense of critical matters such as tax compliance.
Already accustomed to co-sourcing and outsourcing, PE firms are rethinking their tax and finance operational models to ensure they are not only delivering value to the wider business but are also creating a robust framework for future developments.
Central to this will be the use of technology and data that will improve multiple processes – and firms ensuring that they are making the most of the tax professionals they have in place.
Summary
While the private equity (PE) industry may have enjoyed remarkable growth in recent years, it has to contend with a challenging economic landscape that requires careful attention. Central to this is the role played by the tax and finance functions – not least because of evolving global regulation, the imminent introduction of complex tax laws, and the drive toward digitalization.
By realizing the value of their operating models, PE firms can ensure that the tax and finance functions add value to the wider business and helps chart a path forward that will build on recent successes.
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