October 2009

OUTSOURCING: Time for a change

The complexity of switching outsourcing providers might put many fund managers off, even if they are getting a bad service. But is it really so hard to change? By Nick Fitzpatrick
forklift.jpgProviders of outsourced services to fund managers, such as custodian banks that offer a plethora of functions from finding stock lenders to administering funds, have striven to present themselves as long-term business partners to the investment management industry and not as mere suppliers to be hired and fired.

They are there to take over the tricky back- and middle-office operations of fund management, leaving the client to get on with the front-office business of investing money.

Back in 2005, State Street, the investor services provider, celebrated the renewal of its outsourcing arrangement with Edinburgh-based Scottish Widows Investment Partnership (Swip). The original deal, in 2000, was the first of its kind in Europe and the retention of Swip was seen as a landmark for outsourcing.

It was also seen as a sign that outsourcing could deliver what it said it could deliver, such as a variable cost base for asset managers whose running costs fluctuate over time.

It was a sign also that outsourcing deals in fund management could yield mutually beneficial results.

Yet fund managers and outsourcers, who include third-party administrators, always run the risk that their business priorities will diverge at some point. And what happens then? Would a money manager find that its liberated operations department becomes a deadweight that it cannot move from?

There is a significant chance that fund managers will have to face these questions. Proposed regulations in Europe are forcing custodians to reconsider whether they will want to do business in certain markets where they run increased regulatory risks. If they turn down a fund manager’s request for custody, it is feasible that other services they cross-sell in the same markets might be affected too.

Nick Alford is an outsourcing veteran. He was involved in outsourcing the transfer agency function of LGT Asset Management in Hong Kong, but his main experience came while he was chief operating officer at Morley Fund Management, which is now part of the £236bn (€257bn) Aviva Investors business.

Morley, which had about £128bn of assets under management at the time, outsourced its whole back office to JP Morgan Worldwide Securities Services in 2004. The deal entailed the transfer of 190 Morley employees.

“The Morley outsourcing was very big and complex. JP Morgan effectively purchased our platform from us,” says Alford, who is now a partner at consultancy firm, Kingston Smith Consulting.

Using the lift out
Many outsourcing providers have built their business through ‘lift outs’ – or acquiring an operational platform from a fund manager like Morley.

“Large, complex outsourcing deals would be very hard to move from one provider to another and potentially very distracting for the business. But if you’ve only outsourced fund administration, fund accounting or transfer agency, to move is much more easy,” Alford adds.

“If you’re a smaller asset manager with one or two fund vehicles, then switching providers is not difficult. Auditors would confirm balances and transfer between providers should be quick and relatively low risk.”

Of the complex lift-out deals similar to Morley and Swip, most if not all remain in place. Even if fund managers were not happy with their service – which is not the case if Swip’s experience is anything to go by – the complexity involved could serve to change minds about switching providers.

But Gerard Quirke, a director at Phoenix Fund Services and a former chief operating officer at Hermes Investment Management, says many smaller fund managers also perceive that changing their incumbent providers would be complex.

In some cases, they would opt to stay with an incumbent provider even though they might be dissatisified with the service, he says.

“They feel that it was hell the first time and could only be worse a second time. But the fact is that most of the really hard decisions will have been made first time around,” says Quirke.

Redundancies associated with outsourcing fund administration, for example, will already have been made. Also, original systems would have been decommissioned and internal processes, such as timely delivery of data, will already have been adapted for working with an external provider.

Of the work that is left to do, the vast majority of it lies with the incoming and outgoing providers, says Quirke.

“Years ago managers would not have considered changing custodian for the same reason. Like that market, outsourcing has now matured and there are plenty of examples of very successful transitions.”

Consistent Unit Trust Management changed its provider to Phoenix in order to get a “more personal service”, said Jenny Sculley, a director at the unit trust. The move covered two funds and included dealing functions, registration and accounting. It took three months.

“We employed an outside firm to oversee the changeover, which worked extremely well and the switch went very smoothly,” she says.

But she also says the previous provider, Capita, levied an exit charge.

Quirke says: “Ideally managers should ensure that this is covered in their initial contract. Even where it is not, there is an established practice that providers can only recharge the cost of carrying out the transition on a timer and materials basis.”

There is obviously a big difference between a provider change at the level of a small fund manager, compared to a full-blown extraction from a provider that has transplanted a manager’s whole back-office system.

Yet even for a fund manager that hasn’t lifted out, but simply has a large and diverse portfolio, changing providers can still be a “huge undertaking”, says Ross Whitehill, head of offshore product in Europe for BNY Mellon Asset Servicing.

Big trouble
However, he adds: “Most of the transitions that we see coming down the road are around custody, transfer agency and fund administration activities, all of which can be switched relatively easily. Nonetheless, the larger the portfolio, the more complicated it becomes. No transition is trivial - there is always going to be some pain.”

“It depends on the quality of the provider they are coming from,” adds John Alshefski, managing director of business development at SEI, a Nasdaq-quoted investment manager and service provider.

Most of SEI’s outsourcing business has been built on conversions from other providers, says Alshefski. “A conversion
can be done very effectively, though I won’t say it is something that can be completely seamless.”

A sticking point, says his colleague David Morrissey, a director of business development in Europe, can be when the incumbent provider’s reconciliations are less than precise if not exactly shoddy, leaving follow-up items to resolve in addition to the normal conversion tasks.

When it comes to funds, if records are not in good order at financial year-ends, this can also be a problem.

Alshefski says that many conversions are triggered when a fund manager wants to expand its service offering and the incumbent provider cannot support it and is not prepared to invest. Again, we are back to alignment of business interests, which is crucial to many outsourcing deals.

Philip Keeler, head of IT and operations at Hermes, says: “OTC derivatives is the common issue. These instruments are increasingly used by fund managers, but can providers handle them in the back office? You at least want to know what their commitment is to investment in this area to support these products.”

Previously managed in-house, Hermes is outsourcing much of its operations to Northern Trust.

“You need to know where the provider’s business is going and be prepared to share your business plans with them,” says Keeler.

“Northern Trust made a commitment that they would only do one major client deal in each geographical region at a time until we were fully migrated. This meant they had to cancel other deals, which demonstrated their commitment to the relationship.

Two-way relationship
“But an outsourcing deal has to be financially attractive to both parties, so when our hedge fund of funds business was launched, Northern Trust was the obvious solution because they had a strong offering in this area.”

Similarly, Bill Blackwell, principal consultant at Carne Global Financial Services, a consulting firm, says: “If your first provider has made mistakes that they have not learned from or have not been able to correct, their interests are probably not aligned to yours. It’s good to do a periodic assessment.”

But he also notes that the relationship works two ways. “Don’t forget that you are building a relationship. You are not hiring someone at the lowest cost and then forcing them to extend themselves.”

Blackwell says fund mergers are a driver of outsourcing changes currently.

He adds: “It doesn’t have to be hell the second time around. You’ve have learned lessons from your previous experience and you can use those lessons to repeat the process more effectively.”

©2009 funds europe

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