May 2012

BACK OFFICE VIEW: The changing shape of outsourcing

James_HockleyIn the world of investment management, outsourcing is used as a sourcing solution for everything from portfolio management to technology. However, although investment operations – or “middle office” services – have been increasingly outsourced over the past ten to twelve years, they cannot yet be considered mature for a number of reasons. First, firms with outsourced operations are still in the minority. Second, there are few generic multi-client models; and, third, nor has there been much activity in the secondary market, where a manager with outsourced investment operations has successfully moved from one provider to another. Why? From our research and work with those managers with outsourced operations, common themes emerge, including:
• Conflict between standard services and bespoke requirements
• Disappointment with limited capabilities, poor change delivery, lack of innovation
• Difficulty in establishing a fully co-operative broad based relationship and
• Determining true commerciality of outsourcing end-to-end. The leading providers also articulate common themes why their clients fail to maximise the outsource opportunity:
• Investment firms need to be outsource ready and focus on revising their end-to end business operating model
• More standardisation and focus on outcomes not processes
• Increased business engagement and partnership leads to a better understanding of commerciality, and that risk and liability transfers cannot be underwritten. There is some synergy here. Managers and providers recognise the need for increased standardisation as key in developing a mutually satisfactory commercial model. Both sides recognise their relationship is too day-to-day service biased, leading to insufficient engagement at strategic levels and consequent frustration around delivering change and supporting innovation. The commercial question is interesting. A simple profit and loss analysis of where custodian revenues come from – service fees, execution spreads (for example, for foreign exchange) and interest income from cash positions – demonstrates that service fees and execution spread income barely cover operating costs. Profit margin is wholly represented by interest income – the basic banking service and the principal by-product of being a custodian. So as a service, outsourcing – being wholly fee based – is a non-profitable activity… unless there is a sizeable pool of assets in custody. From an investment manager’s perspective, the commercial benefit of outsourcing is not clear. Investit’s annual benchmarking surveys identify the most efficient firms in the industry – those with a cost/income ratio of circa 55% or better. Few have outsourced operations. Our view is some that outsourced were fundamentally broken before – and so outsourcing by itself will not cure that. But a well-executed outsourcing as part of an end-to-end redesign of a firm’s operating model can bring a step change toward improved operating and commercial efficiency. Will outsourcing continue? Yes. The drivers are sound, but execution must continue to improve. For example, the end-to-end operating model must be considered and aligned to the business model, and the focus should be on the total cost of ownership over five to ten years. We are seeing an increasing range of services being considered for outsourcing. Two stand out: IT infrastructure (more applications and their architecture are moving into the “cloud”), and dealing for all asset classes. Outsourcing is sensible provided it is undertaken for the right reasons and with the right approach. Some first generation outsourcings strayed from these principles. As the move to second generation outsourcing increases, we see “green shoots” appearing as firms take a more mature approach. James Hockley is business director at Investit ©2012 funds europe

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