Asset Management Outsourcing Considerations
Middle & Back-Offices: Should They Stay or Should They Go?
As rapid advances in technology and AI continue to disrupt and present unprecedented opportunities for asset management operations, industry leaders are not deciding “if” to transform, but “how” to transform their business to further enable their front office and optimize their supporting middle-to-back-office functions. One option is to modernize technology by migrating to the latest, best-in-class investment technology (frequently cloud-based systems). A second option is to move legacy middle and/or back-office operations and technology to an outsource provider. Which choice is best – should the middle office stay, or should it go?
The decision around how to transform business operations can be daunting. As asset managers contemplate what is right for their organization, the following five considerations should be weighed based on their impact:
Front Office Enablement
Asset Manager’s Question: Why would an outsourcer better maximize our front office capabilities than implementing best-in-class technologies?
For asset managers that are more closely analyzing outsourcing, it is safe to assume that the largest outsourcers have virtually limitless geographic reach via their sub-custodian networks and purport to have supported every major asset class from an asset servicing perspective. Based on the very nature of their business, they achieve economies of scale that most asset managers could never dream of. In terms of capabilities, outsourcers have generally solved every problem that your operations have ever encountered for not only one asset management organization, but dozens of them. While a manager's team may be leveraging the best available technology, they cannot reasonably expect to have the institutional strength, policies and procedures, internal controls, and technology spend that a major outsourcer will have.
To illustrate these points, if an asset manager’s front office identifies six moderate-to-critical operational improvement initiatives, the organization may only be able to undertake two based on limitations in budget and/or resource capacity. Based on the outsourcing provider’s (asset servicer) consistent focus on operational excellence and the input of its long roster of clients, it is likely that its top 20 priorities would already include all six identified by the front office. These top 20 will receive the funding to be deployed on a more accelerated schedule than that of a standalone asset manager.
The asset manager’s core competency is the investment process (i.e., focusing on maximizing returns for clients). If middle and back-office operations are outsourced, the organization can improve its laser focus on the investment function and generating alpha for clients.
Outsourcing is not for everyone. For many asset managers, the relative lack of complexity, scale, and outlook for growth would not warrant serious consideration to undertake a massive outsourcing initiative. Some firms use operations as a training ground for them to nurture and identify talent for product, front office, and other high-profile roles. In other cases (especially in niche asset classes), asset managers may view their operations as a competitive advantage that attracts clients and investors.
Variable vs. Fixed Costs over the Short and Long Term
Asset Manager’s Question: What would be more cost effective for our organization in the short and long-term: outsourcing, or modernizing middle and back-office system architecture to the latest, best-in-class technology? How will this answer differ in stagnant or low growth environments vs. significant growth environments (bull markets)?
To measure the cost effectiveness of outsourcing, asset managers need to understand the variable cost structure outsourcing provides. For example, if the accounting function that supports a $20 Billion dollar portfolio of private placement securities costs $X million one year, and the following year – half the portfolio is sold, then the outsourcer’s cost will adjust accordingly (e.g., become $0.6X million). The same would be true for a scenario where private placement AUM is doubling. This contrasts with an in-house accounting function that will carry fixed costs of employee overhead required to support the highest level of AUM for that asset class throughout a given period of volatility.
While the outsourcing cost structure is attractive for businesses striving for rapid growth and increased flexibility to scale up and down in various asset classes based on market behavior, reaching this state comes at a very high short-term cost. The upfront costs and strain on the business of outsourcing far exceeds that of an internal technology modernization initiative but comes with potential for higher long-term cost savings.
Justifying the high short-term costs for long-term value is easier for asset managers who can achieve an end state where a significant portion or all their middle and back-office functions can be outsourced across most or all their asset classes. Prime candidates for outsourcing can range from relatively young asset managers who are experiencing rapid growth and do not have the expertise or ability to appropriately scale middle and back-office functions, to long established managers who have too many legacy systems, high employee overhead that operate in silos (by asset class), and a 5–10-year investment strategy that would be very costly to execute through internal transformation.
Human Capital: How to Protect and Nurture Your Most Talented Employees
Asset Manager’s Question: Knowing that outsourcing vs. improving internal technology can be interpreted as “lose vs. keep” employees in the middle and back office, how do we improve investment and operational capabilities while continuing to leverage our most talented employees in the front, middle, and back offices?
Understandably, notions of outsourcing incite panic among middle and back-office personnel and can be met with unwanted attrition. Managers need to consider the impact a decision of this magnitude may have on all their employees, not just those directly affected by the outsourced functions. Managers need to carefully roll out organizational change initiatives in a way that provides transparency, security, and a clear vision of growth opportunity to their most valuable employees. Meanwhile, there must be continued focus on recruiting, including full-time hires and contingent workers to accommodate the transformation project “bubble.”
In some cases, part of the manager’s competitive advantage is the strength and subject matter expertise of the underlying operations. If that is the case, managers should consider keeping operations in-house and focus on continuing to improve infrastructure. Before making the final decision, leadership needs to do an impartial assessment of whether that competitive advantage is truly in the middle and back offices or solely in the front office. There may be inherent bias against outsourcing due to leadership teams being naturally resistant to give up control and perceived transparency into middle and back-office operations.
Some established asset managers have top-heavy organizational structures in their middle and back offices and would benefit from outsourcing those functions to take advantage of the economies of scale of a global outsourcer and significantly reduce labor costs. With an outsourcer or asset servicing provider, the people supporting the front office more heavily rely on technology and data skills than years of experience in the same operations environment.
Whether pursuing outsourcing or other forms of operations and technology modernization, the employees with the greatest potential to contribute to these initiatives will rise to the top and continue to excel even if their role expands from solely operations to transformation leadership.
Organizational Strain
Asset Manager’s Question: Which type of transformation puts the least amount of strain on our employees?
All large-scale transformation projects will create strain on the organization, but there can be differences in the intensity and duration of the stress and strain. Outsourcing projects inherently have a few additional layers of complexity and stress, including but not limited to the impact on employees (layoffs and departures as discussed above), the pressure being applied by service providers to go live (based on contractual penalties and the provider’s desire to initiate the revenue process), and the expanse of the scope.
When executing in-house technology modernization initiatives, the organization has the option of phasing the scope, even sequentially tackling individual systems and operational areas one by one to reduce the impact. In this way, managers can ease the business through operating model changes.
Large-scale outsourcing projects require massive data migration from many systems onto one or few systems that will support operations across multiple asset classes. The combination of previously disparate systems and business functions requires that the service provider become almost a fifty-fifty owner of the operational scope of the project. During this multi-year window, working with an equally motivated outside party creates additional layers of consensus building, adding to the overall complexity.
Even with the acknowledged need for additional resources, key subject matter experts are generally stretched well past their normal capacity, which will have an impact on morale and potentially on employee retention.
All transformation projects will require heavy involvement and education of Risk and Internal Audit stakeholders. The burden on operations and technology resources related to this stakeholder involvement is typically much greater in outsourcing projects vs. individual technology modernization initiatives.
Attainable Goals for Go-Live vs. Target End State
Asset Manager’s Question: Given the evolving state of asset servicing capabilities (and the associated investment technology), can I be confident that the capabilities defined in the contract will be delivered in the timeframe promised and the go-live operating environment will enable the front office to the greatest degree?
Before deciding whether to outsource or build up and enhance internal middle and back-office capabilities, the asset manager needs to clearly define the success criteria for the large-scale transformation. The most effective projects, whether including an outsourcer or not, have a collaborative approach and effective management on behalf of the asset managers and the service or technology providers where both parties are transparent with their objectives and in agreement with what is achievable.
As an example of collaboration between an asset manager going through large-scale transformational change and one of its software providers, a mortgage loan manager needed to sunset their old loan servicing and accounting system in one year and was looking to implement a best-in-class product that could automatically feed their General Ledger (GL) and provide access to correspondent servicers to eliminate email traffic around loan payments and annual reporting requirements. While the software provider knew that all requirements could be satisfied over time, they strongly recommended to define the success criteria in phases such that the new servicing and accounting system go-live was prioritized for year one, and year two would include peripheral enhancements to the GL feed and outside party data collection and interaction. The go-live timeline was met, and the automated GL feed and correspondent servicer access was established the following year. Confidence in achieving transformation objectives is built on transparency and collaboration between the client and software or service provider.
In the outsourcing world, given the evolving state of asset servicing capabilities, the outsourcer or asset servicer likely has not fully developed their offering. In other words, all outsourcers in the industry are working on some component of developing additional functionality. It is common that asset managers enter contracts with these asset servicers that have specific functionality that is not yet "live.” The best asset servicers are transparent about their evolving functionality and look to continually educate clients on their product and services roadmap. They are partnering with clients to provide the best possible service, which includes imagining and implementing next generation capabilities. As such, the teams should collaborate from the start of the project on the achievable end state and the overall scope of work, as well as throughout the project on decisions regarding potential changes and impacts to the timeline throughout the project. Ultimately, decisions on go-live, potential delays, or those to move requirements to “Day Two” all impact customer satisfaction, the client’s perception of the health of the partnership, and the overall success of the transformation initiative.
There is not a ''one size fits all” recipe for asset managers to scale their operations. The key stakeholders in asset management firms need to be aware and informed about all the considerations and potential impacts of an outsourcing project or other large-scale technology initiatives. Middle and back-office outsourcing is an incredibly complex and challenging industry. In addition to engaging experts, we recommend that managers should stay current on the latest capabilities in the industry, perform research, and see representative asset servicing demonstrations long before evaluating a potential outsourcing initiative.
How Clarendon Partners Can Help You in Your Decision on Whether or Not to Outsource
At Clarendon Partners, we have extensive experience working on large-scale transformation initiatives all along the investment management lifecycle, including middle- and back-office outsourcing transformations. Our expertise in asset management operations, conversions, implementations, and outsourcing allows us to help deliver at the Program level – managing organizational change and vendor relationships, as well as at the ‘hands-on keyboard’ level – writing and communicating requirements, documenting new business processes, migrating/entering data, reconciling breaks/communicating root causes, and working with vendors to troubleshoot exceptions or recommend enhancements. Our direct experience with leading service providers allows us to direct the initiative's focus to capitalize on the most relevant of the providers powerful capabilities.
Whether leveraging industry leading service providers or maximizing the benefits of the latest investment technology, a modest investment in a large program can help avoid costly mistakes and pay big dividends in the long run. Please reach out to our team of asset management experts to help in your approach to modernizing your technology architecture.
Contact us at evolve@clarendonptrs.com to discuss how we can help.