“Providers are better regarded now than two or three years ago. I put that down to going through the crisis, which inevitably brought us closer together.” Littleboy now sees a stronger propensity in the fund management industry to use the capabilities of investor service providers, he says.
Standard Life Investments outsourced most of its middle and back-office operations, such as fund administration, to Citi in 2003 and renewed this agreement in 2009. It also uses around five other providers for distinct parts of its business.
Custodians proved their value to fund managers following the collapse of Lehman Brothers by acting as stable safekeepers of assets and by mining their extensive data banks to enable clients to untangle counterparty risk. Custodians have since leveraged the crisis to talk up the benefits to fund managers of outsourcing their back- and middle-office operations. They say this can do anything from position fund managers for growth when markets recover, to aid them tackle the increasingly complicated jigsaw of risk management.
The same opportunity to market operational outsourcing was grabbed by custodians in the immediate wake of the dotcom crash too, when the first wave of middle-office outsourcing took off around 2000.
But relations between fund managers and custodians – until recently it appears – were strained from time to time over the past 10 years as they tried to forge common, standardised platforms capable of supporting back- and middle-office activity in a joined-up way, across geographies and across asset classes.
For example, fund managers and other investors have, in some cases, challenged the rate of spreads they get on foreign exchange trades or the interest received for cash held in deposits. Both activities are major revenue earners for custodians that stem from their custody activities.
For their part, fund managers have not always been supportive enough in helping custodians build the desired common operational platforms, which are critical for efficiencies and cost savings on both sides – not to mention for the underlying investor.
“If providers are not able to generate economies of scale through common platforms then the whole strategy basis for outsourcing is flawed,” says Littleboy. “If providers say they need everyone on one platform then that is what they need and fund managers have to help them even if that means compromising on what might ideally be wanted on a bespoke platform.
“In my view, because they want a bespoke service, it is these clients of outsourcers that have not let the providers completely build their single operating models.”
Perhaps this deeper understanding of their providers’ business needs after the financial crisis will soften managers’ attitudes as they realise the synergy between a custodian’s profitability and stability with their own is much closer than they thought.
But at the same time as this détente, there is another sticking point that is just coming to light: custodians are likely to use more force in asserting their right to run a profitable business. This is seeing custodians declining to bid for certain contracts – and it may well see them go further and rid their books of unprofitable clients.
James Hockley, business director at Investit, a consultancy, says: “Outsourcers have to make money over the length of a relationship and to do this they now want not just one element of a fund manager’s operations such as the middle office, but downstream functions too such as custody and transfer agency.
“In the past year a number of providers have declined to bid if they cannot obtain the middle office along with the downstream functions like custody and, if possible, fund administration.”
Jim Connor, a consultant at Navigant Consulting, adds: “It is very likely that some custodians will manage-out clients that are not profitable enough. It is a different world now and they are becoming more selective.”
Connor says he has spoken to two “top-tier” providers that are taking this approach, though he declined to say which.
He adds: “They are uncomfortable about just getting one service. Providers are looking to make custody the core and then they want much of the surrounding functions too, like fund administration or transfer agency. It doesn’t have to be the whole bundle, but it is unlikely they would now do transfer agency alone. In part, this is because of profitability.”
Littleboy, at Standard Life Investments, says that one of its providers is managing the firm out of a contract in a particular area, but he did not give further details.
Asked about the possibility of managing non-profitable clients out of outsourcing contracts, Ken Back, managing director of Emea strategic solutions at Citi Global Transaction Services, says: “If there is a client that is not growing and the rate card is inappropriate then a discussion will be had. If the economics are not right then the partners need to address the problem rather than heading for the exit.”
Lou Maiuri, global head of outsourcing at BNY Mellon Asset Servicing, says: “There are many middle-office opportunities in the marketplace today and you can’t pursue all of them. We have developed a qualification filter that helps us to assess which opportunities we would pursue and which opportunities we would pass on.” He says BNY Mellon is not managing-out clients at present.
Susan Ebenston, global head of fund services at JP Morgan Worldwide Securities Services, says: “Some clients are more profitable than others and if we have an unprofitable client and that client won’t change then we will manage them out, but we would first look at all of the options to try to make the relationship as beneficial as possible to both parties.”
Ebenston adds: “But it is not just about profitability – it is also about risk, particularly given the way certain legislation is moving.”
She cites the Alternative Invesment Fund Managers Directive in Europe, saying that as it stands now, it would make sense for custodians to have custody of a fund that they also act for as a trustee.
Similarly, John Campbell, a managing director at State Street, says: “If we can work with clients that are fully integrated then this is better because it means we do not have to deal with as many other external providers. It is less complex and more efficient.”
A greater control of the disparate investor-service duties would clearly increase margins for a custodian, but the greater oversight of a fund manager’s business that comes with it could also reduce complexity and enable outsourcers to control fees better.
However, bundling these services might not be easy to achieve when there is a strong risk-management trend towards separation of duties. Where the large banks are concerned, a fund manager could find its administrator is also a swap counterparty, says Ron Tannenbaum, a cofounder of GlobeOp, another service provider.
“We’ve recently landed several mandates from banks where they have been told they cannot act as fund administrator any more.”
He adds: “For the investor services industry to return to credibility with investors, the different roles that service fund management businesses have to be completely independent. The changing relationships of depositaries and trustees in Europe does make commingling attractive, but this is because regulators do not understand they are pushing things backwards, not forwards.”
All clients are important
Custodians will always say that all clients are important but fund managers that are more profitable for them are inevitably going to bubble to the top in terms of support from custodians when it is needed.
Philip Keeler, head of operations and IT at fund manager Hermes, says it is important for fund managers to carry influence with providers, although relations are not always about cost and profitability.
“Hermes was keen to make sure that we would be an important client to the provider and would therefore be able to exert some influence over their strategic decisions,” he says.
This can be done not just in terms of revenues but also by being a reference site, meaning providers may want potential clients to speak to existing ones. Fund managers can also help providers develop their products.
One of the best ways to try and ensure outsourcing relationships are successful is for providers and managers to share business plans and identify what areas of business are priorities for both parties.
Back, at Citi, says: “Outsourcing deals are in excess of five years and as long as ten, so the two parties have to look at the term of the deal and explore how to make a reasonable margin.”
Similarly Ebenston, at JP Morgan, says: “We lay out our expectations of each other at the beginning of a relationship.”
She adds: “If a client wants us to support them with fee holidays when, for example, they launch new products, then that’s fine but we have to make it clear that we will want to recoup this further down the track. It’s an adult conversation that has to be had.”
No longer picking up slack
Custody-related fees may well be significant revenue earners, but whereas in other crises these additional services, such as securities lending and holding cash for clients, picked up the slack on falling custody revenues, it is a different matter now.
Low interest rates have hit the revenues that custodians make from holding cash balances; leverage opportunities around securities lending have been slashed; hedge fund activity is down.
On top of these problems, legal and regulatory developments mean custodians face greater liability for safekeeping assets.
As these factors put pressure on fees – which could have to increase in order to reward the greater risk in their businesses – there is little wonder custodians are reevaluating who they work with and how they do it.
If there really is a new era of understanding between fund managers and service providers, then fund managers will hopefully be sympathetic.
©2010 funds europe