FINANCIAL SERVICES - PROJECT MANAGEMENT & DELIVERY THE CHANGING LANDSCAPE FOR FUND ADMINISTRATION OUTSOURCING This article, written by Bluerock's Paul Hampden, will be published in Global Investment Services magazine, March 2002. Despite the current climate in the financial services industry, 2001 has proven to be a very active year for those involved in outsourcing fund administration services. Millions of dollars continue to be invested by the leading outsourcing companies to create integrated and scalable administration platforms capable of supporting the diversity of product and distribution channels now demanded by fund managers. Whilst headlines deals announced by outsourcing companies in the UK and US during last two years have accounted for the transfer of well over $1,000bn assets and 1,500 staff, this probably represents only the start, not the end of their global ambitions. So what then can be expected over the coming few years? The changing shape of the fund management industry has an important part to play, as this will largely influence fund managers' appetite for outsourcing. As has already become evident, the consolidation in the industry is likely to continue with "large scale" or "niche" fund managers having the most profitable business models. Equally, as channels to market become more diverse and complex, and selling third party investment products starts to become the norm across Europe, fund managers will increasingly consider whether their core expertise lies in product manufacturing or distribution. The larger investment houses chasing scale will have to embrace a fragmented European market and they will be only too aware of the large amount of capital and management resource tied up in running a pan-European administration capability. Conversely, the niche players will not have the capital to seriously contemplate internal administration, and those middle ranking investment houses that survive will need to aggressively drive down costs to stand any chance of generating a profit. So it would appear that the outsourcing companies have made the right call when embarking on major investment programmes during the late 1990's. But what sort of outsourcing arrangements will fund managers be looking for, and how will they be managed? In the early to mid nineties, before outsourcing became mainstream, pioneering investment houses such as Mercury and Henderson hived off their entire back-office operations as separate divisions, eventually, in one form or another, to be opened up to provide administration services to other fund managers. As the UK market developed, new suppliers emerged bringing with them greater choice and competition. Faced with an increased number of options, fund managers began to selectively outsource parts of their back office, often adopting a "best of breed" approach to supplier selection. With declining margins on their core business, and already providing accounting services for their existing clients, the large US custodians spotted an opportunity to move up the chain. This was achieved by either swallowing up existing outsourcing companies, as Mellon did when it took on Premier Administration, or by assuming responsibility for large parts of a fund manager's back office, as Bank of New York did for JP Morgan in Europe. There are also a handful of more recent deals which are at varying stages of digestion, but what is clear is the emergence of large scale platforms that will be marketed as complete solutions offering everything from trade operations, accounting, and settlement processing through to transfer agency. These will be marketed aggressively to the major fund managers in the UK and increasingly continental Europe. Paul Hampden "The more enlightened fund managers, the ones with battle scars...are starting to think differently about how they work with their outsourcing partners in a number of areas." So the market has now come full circle again, but how successful will the "one-stop shop" approach be? To some extent the jury is still out, as a number of the larger deals have yet to complete implementation. However with so much riding on a successful implementation, they will no doubt be made to work in some shape or form. Undoubtedly the one-stop shop approach will be popular with many of the larger fund houses, who will value their service provider being able to match their own geographic coverage and scale. There will still be a significant number of small to medium fund companies seeking a no frills, low cost or specialist solution which will continue to be provided by a number of smaller outsourcing companies. Whatever approach fund managers take, selecting the most appropriate outsourcing partner is only part of the equation. Whilst this typically takes centre stage and is devoted most attention, equally as important, but somewhat less glamorous is the ongoing day-to-day relationship management that actually makes the chosen outsourcing arrangement deliver. This will increasingly become important as fund managers expect their outsourcing arrangements to evolve over time, providing more efficient service delivery, and adapt, supporting new product or distribution capabilities. This places greater demands on relationship management skills, not simply as an escalation point when things go wrong, but as a way of continually aligning the requirements of the fund manager and the capabilities of the outsourcing partner. This should not be considered the sole territory of the outsourcing company, as is often thought when a "headache" such as administration is handed over to a third party. In fact outsourcing companies have long recognised the need for relationship management, and this has always formed a key part of their sales and client servicing function. It is only more recently that fund managers have started to understand the importance of this role within their organisation, and the part it has to play in ensuring that administration becomes an enabling factor for their business rather than a constraining one. The more enlightened fund managers, and this tends to be the ones with battle scars from previous forays within this area, are starting to think differently about how they work with their outsourcing partners in a number of areas as follows: Service Performance - Simply measuring service levels, which is the basis of most outsourcing agreements, is not enough. Understanding what drives over or under performance is what really enables you to take control and drive up performance. Knowing that, for example, the introduction of 50 different commission arrangements for intermediaries over the last six months has doubled the administration effort and is responsible for 75% of incorrect payments, enables a fund manager to re-evaluate whether this is a conscious business policy or a lack of co-ordination amongst the sales teams. Issue Management - Whilst most outsourcing agreements start off with some formal process for issue management, changes in personnel, systems and priorities often mean that the actual practice becomes quite different. Taking time to analyse the occurrence and handling of each new service breach enables the fund manager and outsourcing company to continually optimise their approach so that issues are identified sooner, their impact assessed faster and the necessary remedial actions implemented earlier. Charging Structures - In most businesses, operational processes are expected to become more efficient over time, as experience grows and investment in technology takes effect. What incentive however, is there for an outsourcing company to invest in technology to reduce the time taken to complete a valuation if the outcome benefits only the fund manager. Increasingly, financial arrangements are being sought that are both transparent and more importantly, provide incentives to both parties to improve service performance whilst also reducing costs. Service Developments - How often are requests for new services such as processing complex derivatives for example, treated as bargaining pawns to recover income lost in other areas of a contract. The more progressive fund managers and outsourcing companies are however, turning away from this adversarial approach, preferring to see such opportunities as a way of strengthening their relationship by working, and sometimes jointly funding such developments. This mind-set is typified by fund managers who involve their outsourcing partners early on during the product development cycle, and outsourcers who seek to build and share generic components across their operations and client base. Information Flows - Externalising an administration function cuts it off from the normal flow of information that occurs with an organisation. Knowing that an asset allocation committee has just changed house policy is something that an internal department would typically be aware of, and would plan accordingly for the increased transaction volume. Identifying such key events and ensuring they can be communicated between fund manager and outsourcing partner are vital to ensure service performance is maximised. Few fund managers can really say that they have optimised their outsourcing arrangements along the lines of, say, the car manufacturers and their component suppliers, and with today's pressures most cannot afford not to. Slowly however, it is being recognised that a new set of management skills are required and that actively developing a supplier relationship is the key to unlocking the real benefits of outsourcing. Bluerock Consulting has been engaged in a wide range of business process outsourcing projects for Investment Managers and Investment Banks. We have also undertaken a number of reviews of existing outsourcing contracts between Investment Managers and their third party service providers. Paul Hampden, a director of Bluerock Consulting, can be contacted on 020 7743 6780 or paul.hampden@ bluerock-consulting.com