The Business Dynamics of Outsourcing for Investment Managers across Public and Private investments: --Briefing Note #1

Briefing Note #1 – Jul 27

How has Outsourcing evolved over the last 80ish years, and what’s next?

Significant Outsourcing on the Public side of the Asset Management industry has occurred in two successive broad waves, the first being Fund Accounting & Administration linked to Custody, which accelerated starting in the 1950s and is now pervasive.?The second being the set of Investment Operations functions collectively referred to as the Middle Office which began slowly starting in 2000 and is now reaching a tipping point.??

The first wave, Fund Accounting & Fund Administration

Although collective funds have been offered in various forms since first offered in Holland in 1774,?the modern market crash of 1929, and the US Investment Company Act of 1940 that followed, led to the wide adoption of a business model in which practically all Asset Managers outsource Fund Accounting for the comingled public funds they sponsor and manage.?The 40Act and similar regs around the world generally require securities held in publicly offered comingled funds to be held in safekeeping at a Custodian Bank.?Because the provision of Fund Accounting (valuing the assets and liabilities to calculate a NAV)?is a very efficient extension of those Custody activities, the vast majority of Asset Managers have chosen to outsource Fund Accounting to the Custodian of their funds.?There are a few exceptions to this, in which Asset Managers perform Fund Accounting themselves (inhouse) but that is increasingly rare.???

The evolution and development of Fund Accounting also includes Fund Administration services which are increasingly Outsourced along with Fund Accounting.?Fund Administration services may include; Compliance, Legal, Tax, and Regulatory Reporting.?The need for these services has continued to increase as regulatory requirements across a wider variety of fund structures have increased.???

Back Office Economics:

Service Providers offering Fund Accounting & Admin in conjunction with Global Custody (aka Back Office services), compete on their ability to maximize their economies of scale to offer competitive fees, while also generating profits from negotiated spreads they can earn on Cash (Net Interest), Foreign Exchange, and Securities Lending.?The very significant investments in tech and talent required to successfully offer these services to global/regional investment managers, has resulted in only a handful of Service Providers with the economies of scale necessary to compete successfully.?Most are also designated as GSIFIs (Global Systemically Important Institutions) by regulators which means they carry more capital and maintain higher resiliency standards than others.??This oligopoly of Service Providers offer commoditized services at commodity-like fees (scale matters!).?Variations in the breadth of markets covered do exist but most providers offer services in most major jurisdictions around the world.??

It should be noted that there are a handful of boutique providers that are not affiliated with Global Custody banks.?They successfully offer Fund Accounting/Admin services on a standalone basis, typically to small (<10B) fund complexes.?They are able to solve for their lack of scale by renting software rather than using proprietary systems.?Their client service is also typically more nimble and tailored as result of their smaller size.??

It is also important to note that fees and spreads paid are generally borne by the Funds shareholders (not the Asset Manager). They are reviewed and re-negotiated periodically by the Fund’s Board.??Over time, and as Funds grow, they can seek reduced fees, or switch providers, because switching costs are relatively low, although fee reductions prevail most of the time.??

Now lets turn to the second wave, Middle Office Outsourcing.

So, what is the Middle Office? Investment Operations (aka the Middle Office – a label that is blandly non-specific, but has stuck nonetheless) includes the following functions, which may be outsourced as individual service components, or as a full service package.?

? Reference Data Setup/Maintenance (Account Master, Security Master, etc.)

? Trade Matching & Settlement tracking

? Corporate Actions (Dividends, Income, Voluntary elections) tracking

? Control/Recon of the Investment Book of Record (IBOR) and Cash Forecasting

? Performance Measurement, Attribution, and Risk Analytics

? Client and Regulatory Reporting?

If Investment Managers are already Outsourcing Fund Accounting for their Comingled Funds, shouldn’t’ they be able to readily outsource these Middle Office functions because they are largely similar to Fund Accounting??????

That would be roughly right if Asset Managers only offered Comingled Funds.? However, most Investment Managers are also hired by Institutions (Pension Plans, Endowments, etc.) to manage portfolios in Separate Accounts (not comingled).?Each of those Separate Account Institutional clients designates their own Custodian.?A typical Investment Manager offering both Comingled Funds (supported by a single Custodian they have chosen) and Institutional Separate Accounts (each supported by a Custodian their client has chosen) has an Investment Operation (Middle Office) team to manage Trade Settlement, Corporate Actions booking, and Reconcile their Investment Book (IBOR) with roughly 25 to 75 Custodians!??

That Middle Office Team and supporting Tech is the glue that connects Portfolio Managers and Traders (sometime referred to as the Front Office) with the cash and securities they are managing in portfolios that span a wide array Custodians (Back Office).?That makes them the primary source of cash and position data required to start their investment processes each morning.???

Furthermore, the Investment Book of Record (IBOR) maintained by the Middle Office is most useful to Portfolio Managers when it portrays timely and accurate Start of Day and Intraday, Positions and Cash.?Whereas, Fund Accounting, produces an Accounting Book of Record (ABOR), using End of Day Positions and Cash on a T+1 basis (a day in arrears).??That is fine for NAV pricing a Comingled Fund, but that data is not useful to PMs making investment decisions in live markets.?

Middle Office Economics:

Unlike Fund Accounting, fees for Middle Office Outsourcing are borne by the Asset Manager because they are a substitute for what had been a direct Investment Operations expense.??Outsourcing Fees paid by Asset Managers generally reflect the better economies of scale held by large scale service providers.?Also, most also prefer to have variable, tiered, fees driven by Volume and AUM, over their own quasi fixed costs operations.?Outsourcing also allows Asset Managers to avoid periodic capital investments in systems development required to meet regulatory requirements and other capability extensions.??

The implementation of a Middle Office Outsourcing deal is a material undertaking, with significant one-time costs for both the Asset Manager and their Service Provider which can be structured is a variety of different ways.?More on that in a future Briefing Note, and why this business is far from commoditized!

The genesis of Middle Office Outsourcing:

Prior to 2000, as Investment Managers expanded from country specific, to regional, to global, while also extending into multiple asset classes, their ability to handle that increased complexity via their Middle Office was differentiating for many firms, allowing them to grow faster than their peers.?However, as the industry matured, and standard utilities for things like global Trade Matching (OMGEO), and Trade Settlement Instructions and Statements with Custodians (SWIFT) were adopted, certain Investment Managers determined that Investment Operations would eventually no longer be a source of competitive advantage, so they started to explore Outsourcing.?There were no existing Middle Office Service Providers at that time, so some form of strategic relationship/partnership with a major FundAccounting/Custody Bank was required to establish this as a new business.

A few of the first attempts at Outsourcing Middle Office Services faltered or failed for various reasons.?The interests of the “partners” were not well aligned, commitments were misunderstood or unable to be fulfilled, management changed, or patience simply wore out over the difficult journey to full implementation.?

By most accounts, the first successful Middle Office outsourcing deal was initiated by PIMCO with State Street (STT) in 2000. It was conceived and executed as a “liftout” of an experienced global team of Operations professionals, and proprietary Technology transferred from PIMCO to STT. It was bound by a long term Servicing contract that recognized the synergies with the FundAccounting and Custody, while respecting the different nature of Middle Office Services and the high touch required to support PIMCO’s PMs/Traders.?

Success was heavily dependent on a strategic decision at the top of the house at PIMCO that they needed to focus exclusively on research and meeting client investment objectives (competitive differentiation) in Fixed Income Asset Management, while also trusting their long term partnership with State Street leadership to manage the liftout and subsequent delivery of consistently high service quality.?Both PIMCO and STT benefitted enormously as result of that strategic decision.?PIMCO became widely recognized as the leader in Fixed Income, and achieved record AUM growth over many subsequent years.?STT extended that nascent Middle Office servicing unit into the largest provider of Investment Manager Services, and led the way amongst a group of able competitors that followed, including; BNYM, Citi, NT, BNP, et all.??

Initial Market adoption drivers:

Following PIMCO, a few others - then a several dozen leading Asset Managers made similar strategic decisions to Outsource their Middle Office operations.?Before the start of 2020 less than half of all Asset Managers had Outsourced their Investment Operations, however most of the largest global Asset Managers had done so.??

Some firms were driven by a clear strategy of focusing on elements of their business that were strategic differentiators (ie; Research, Distribution, etc.).?They were clear minded about the difference between their sources of strategic Competitive Differentiation vs Core Competencies.?Many of those firms had Middle Office capabilities that were considered Core Competencies, but realized they were not competitive differentiators, regardless of how critical it was, or how good they were at it.?That insight motivated them to seek players who were focused on this space and investing in their competitive advantages.?This same dynamic can be found in other industries; Airlines, Auto Manufacturing, and even Consumer Tech, where leading firms understand and focus on their secret sauce, and they integrate supply chains of top providers for everything else.??

Other firms elected Outsourcing as a means to solve challenges they were having with merger integration, deferred maintenance and capital investments required for systems, or simply poor quality support of their business.?These arrangements often struggled because they were mostly driven by economics and lacked a clear strategic underpinning.???

Three new value drivers have emerged more recently:

Time to Market:?Asset Managers seeking to enter new markets, or invest in new asset classes, started to assess the time and cost required to do that themselves, compared to how it would work under an outsourcing arrangement where those capabilities would already exist and would just need to be configured for their use upon demand.??

Resiliency:?Following the financial crisis of 2007/8, regulators raised the bar for Global Systemically Important Financial Institutions (GSIFIs) raising capital buffers and tech/ops controls and resiliency standards.??Outsourcing partners with deeper pockets are certainly important, but Tech/Ops controls and resiliency took on a whole new level of urgency as cyber security risks escalated rapidly, and more so after the pandemic struck in 2020.?Suddenly dozens of Asset Managers saw the additional Resiliency value from Outsourcing to GSIFI’s compared what they could achieve themselves.?

Front-to-Back Integration:??Asset Managers are taking Outsourcing one step further by going all in with Service Providers that have built, partnered, and/or acquired a full business Platform of Software and Services required to enable more timely and efficient operation of the entire Investment Lifecycle.?This includes software tools, pre & post trade processes, and the galaxy of data that fuels it all.??While the increased scope of these deals offers potential for greater synergies (read savings), the level of transformation to be undertaken is also significantly higher, so execution is even more dependent on sound strategic rationale, good governance, and skilled decision-making regarding implementation design and sequencing.?

So what does this history tell us about how Outsourcing for Private Markets may evolve???

Investment Managers in the Private Markets* (Private Equity and Private Dept Funds, Real Estate Funds, and Infrastructure Funds) are driving the next waves of Outsourcing, some aspects will echo prior waves, some will not.? I will address this in my next Briefing Note.??

Comments and questions are welcomed, and will indeed shape future Briefing Notes. ?

*Note: For this definition of Private Markets,?I am excluding Hedge Funds, which are often classed as Alternatives, but are mostly privately pooled investments in public securities, hedged or leveraged with various forms of derivatives.?Prime Brokers have tended to own the Hedge Fund Administration/Servicing space given the role they play managing collateral/margin, although several Hedge Fund Servicing firms exist that are not PBs.???