July-August 2010

BACK OFFICE: new drivers of outsourcing

Dale_LippstreuDoes it make sense to allocate precious capital to an activity that does not differentiate you from competitors? Dale Lippstreu of Maitland comments   Historically, the decision whether to outsource fund administration or not was largely an internal one, driven by business strategy. At the most fundamental level it turned on the question of whether the intention was to build a focused or diversified business. Other factors such as the size of the business and the availability of resources were also key drivers, but these factors too were largely internal to the business.

Many of these considerations remain highly relevant, but what has changed dramatically is that the decision has shifted from being informed by internal perspectives to being driven by the requirements of client investors. Increasingly appropriate and effective segregation of duties is a fundamental and non-negotiable requirement of investors. Whereas size and reputation were sometimes grounds for exemption, even this is changing. Incidents such as the Madoff scandal and the recently settled Goldman Sachs case have highlighted the fact that there is no substitute for appropriate segregation of duties combined with competent and independent oversight. 

At the same time that the need for third-party administration has been highlighted, the case for keeping administration in-house has fast diminished. The rapid evolution of automated transaction processing has led to standardised processing cycles. This has caused a significant portion of administration activities to be commoditised and thereby reduced the opportunities to derive competitive advantage in this area. Concurrently, straight-through processing and the resultant shorter processing cycles have required massive investments in technical systems and the resources to support them. Inevitably, the question arises as to whether it makes sense to allocate precious capital to investing in an activity that does not serve to differentiate oneself from competitors.

While systems have increased in complexity and cost, the skills required to provide the services have also increased dramatically. This is partly the result of the exponential increase in the use of OTC derivatives and illiquid assets which has increased the complexity of middle- and back-office processes. These developments have been accompanied by rapidly escalating investor requirements in terms of reporting and, in the case of hedge funds, increasing valuation frequency. Adding to the complexity of the situation, this is all taking place against the backdrop of a rapidly evolving regulatory and statutory environment. Maitland believes that third-party outsourcing will be given further impetus through the re-regulation of the alternative investment management industry.

In short, fund administration has become a fast-developing and demanding business activity. This has served to raise the bar in terms of the critical mass or scale required to provide these services in-house on a cost-effective basis.

The above factors might impel business decision-makers towards outsourcing, but there are others which might attract them as well. By the very nature of their activities, administration service providers are exposed to practices and developments across the industry and they are consequently well placed to act as purveyors of best practice. Many clients have discovered that they need look no further than their administrator to find out how to improve some of their own business practices.

Furthermore, clients of administration service providers effectively become part of a user community whether they are formally constituted as such or not. The result is that they benefit from a pooling of knowledge, skill and costs when it comes to responding to changes in the business environment. Given the accelerating pace of regulatory reform and rapid evolution of the operating environment this benefit should not be underestimated.

In summary, whereas the decision of a fund manager to outsource or not was in the past largely a matter of business strategy, changes in both the operating environment and investor client requirements have shifted the balance sharply towards third-party administration. But ultimately even if the business drivers and case for internal administration stack up it is no longer regarded as best practice.

• Dale Lippstreu is head of business development at Maitland Fund Services

©2010 funds europe

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