The first wave of middle-office outsourcing deals came on the heels of the the credit crisis in 2008. Given this timing, it should come as no surprise that the origin of these first generation deals was driven by cost savings. At the time, middle-office operations was viewed as a necessity but also a cost centre.
For many asset management firms, the cost of operational staff and overhead made up a significant portion of their operating budgets. An operating model that incorporated full middle-office outsourcing offered an appealing value proposition given the high cost of resources and poor market conditions. Service providers seized this opportunity to expand their platforms and target a cost-conscious market.
In its infancy, middle-office outsourcing typically did not offer asset managers a significant increase in service levels. In many cases, outsourced operations reflected a like-for-like shift, especially those that were full lift-outs. In some cases, asset managers even made concessions in service levels. Emerging now, however, is a new wave of outsourcing contracts, marked both by a more mature provider landscape and more exacting asset managers who are less willing to accept service levels or operating models that are anything less than optimal. With lessons learned from first contracts, and changing market dynamics, including investor and regulatory demands, fee pressures and more complex requirements, managers are demanding an increase in service levels and standard offerings. This results in required changes to standard operating models. Ten years after first generation contracts were inked, cost is no longer the key driver in the decision to outsource middle-office operations. What was previously a binary choice for asset managers – to outsource or not – outsourcing now includes a spectrum of choices to match a wide range of manager-specific strategic operating models that may be customised to each firm’s requirements, desires and future aspirations.
The advent of outsourcing options
Over the past decade, asset managers have expanded investment in more products, asset classes and markets. Further, their requirements for support for various functions, including expanded data management, analytics, attribution and compliance functions, have grown increasingly demanding. The desire for a world-class operating and technology model to support these complex businesses has outgrown the original goals of the first-generation middle-office outsourcing contracts, which was to reduce cost.
Today, the single service provider model remains a viable option for asset managers to remain competitive; however, the service provider market has evolved from a like-for-like shift to a value-add model. With this shift, the outsourcing, insourcing and hybrid permutations available to asset managers has significantly increased, expanding the strategic operating model options available to asset managers. Models in which asset managers use multiple service providers functionally or by product, or where they use a combination of outsourced and insourced functions have made outsourcing suitable for asset managers who may not have seen it as appealing in the past. The expansion of service provider offerings is a notable factor that has contributed to the growing candidate pool for outsourcing.
As discussed in the 2017 SEI/Citisoft paper, ‘Practical Tips to Help Navigate the Middle-Office Outsourcing Transition’, service providers have invested significant time and resources in upgrading their offerings over the years, adding technology and building their teams with experienced staff to support the evolving more complex requirements and better integrate the various applications making up the middle-office platform. Some providers achieved this through technology investments by partnering with clients, others through acquisition of specialist providers, consisting of both specialised expertise and technology infrastructure. As most of the providers leveraged both proprietary and third-party vendor systems, a great deal of work was needed to achieve a seamless integration. Moreover, providers and their asset management clients increasingly recognised the need for a holistic middle-office data strategy to ensure data standards, ownership and processes. Indeed, whether done in-house or externally, middle-office functions should all be working in concert to produce the desired results.
Other contributing factors include the widespread acceptance of storing data on third-party servers or the cloud and an increase in the number of vendors and service providers offering middle-office outsourcing services.
The single provider model for all middle-office functions (or ‘full outsourcing’) is probably still the most common model for asset managers who outsource, but is no longer the only outsourcing option for an asset manager’s operating model. While ‘component outsourcing’ (single function) is not a marketed option for all service providers, there are many service providers who offer services à la carte. This shift is highlighted in a recent FundFire article:
‘Asset managers are responding to shifting currents in investment management technology by changing the way they outsource key operational functions. Instead of using large tech providers that act as one-stop-shops for managers, managers are working to identify ‘best of breed’ solutions, where they select niche specialists to manage key functions across the middle- and back-office, specifically.’
Single or multi-service provider operating models are not the only option being considered, and may not be the most optimal for some asset managers; reviewing current needs and strategic plans is key to determining the best model for the individual asset manager.
The case for a design-first approach
To create an optimal outsourcing arrangement, some asset managers invest in a strategic operating model design project before addressing changes in vendors and service providers. With countless options available, managers who have implemented a strategic operations and technology model will be more clearly able to distill their needs. Identifying the pros, cons, indicative costs, time to market, and most important, alignment with strategic objectives, are key considerations for creating an ideal target operating model and application architecture.
Through this exercise, an asset manager will often find that whilst their current operating model is meeting the objectives they laid out when they put the model in place, their business has evolved significantly from the original parameters. In this case, it is typical that the current model is no longer appropriate, let alone optimal, for their needs. Further, vendor and service provider offerings and technology platforms have evolved significantly over the past decade and many asset managers are not using the advancements the vendors and service providers have made because they have not explored the options invested in upgrades, or they remain on the legacy suite of their service provider. Some examples of services that have evolved over the last decade include support for alternative assets on core platforms, data management (beyond standard reference/master data) including data-as-a-service offerings, more robust IBOR solutions, support for intraday information to the front office, support for risk analytics, FX execution, and regulatory reporting.
Designing a strategic operating model
Strategic operating model design projects can vary in depth and breadth, but at a minimum should include a current state assessment, an options analysis for future state operating model design, and a road map detailing how to reach the desired goal. Often, asset managers hire a consulting firm that offers advisory services to achieve this. There are firms who have the experience to look at the current operating model from an outside, unbiased lens and can use peer group and market analysis to help conduct the assessment. If, however, the asset manager has the business analysis resources internally to support such a project, this may be done successfully in-house.
The current state assessment will highlight findings, identify gaps and reveal pain points by analysing the asset manager’s functional areas from an organisational, technology and data perspective. A current state assessment should review current middle-office functions and discuss future business needs that would require changes in function. The current state assessment for an asset manager undergoing an outsourcing or system contract negotiation should consider how the business has changed since the original contract, in addition to how the business might change in the future (new products, asset classes, markets, etc.). The analysis may result in a set of workflow process diagrams appropriately framed to depict the asset manager’s individual products, markets and asset class makeup. These diagrams will inform current competencies and deficiencies, and will highlight which changes could provide the greatest impact and shape in the future state operating model.
A well-thought-out future state design will take the analysis generated in the current state assessment and apply industry context to provide viable future options to consider. Future state design will generally focus on options analysis for the operations’ target systems application and operating model that will meet all current and planned future business needs.
The future state design options should be derived through an open dialogue with the incumbent providers and competitors on how they can address pain points, improve service and support future needs. Depending on the individual firm’s goals and drivers, the future state design could entail several variations of either outsourced or in-sourced functions. In some cases, an asset manager may find they can make changes to the services and service levels with their current provider(s) to achieve their target model. In other cases, an asset manager may find that a full operating model change is necessary. This scenario may result in exploring a change in provider for some or all services or insourcing of some functions.
Once the future state operating and architecture model is agreed upon, creating the plan to get there is the final step before making changes to a middle-office operating model. Depending on the agreed-upon future state design, the road map may include implementing changes with the current service provider, evaluation of service providers (involving issuing a request for proposal/information), transition of some services, or evaluation of in-house systems.
Operating model options and considerations
Numerous operating models are available, but without a thorough assessment, it is nearly impossible to determine the best option for any particular asset manager. However, it is nonetheless valuable to understand the high-level options. When weighing the options, managers should consider:
1 Comprehensive or full outsourcing of all functions with a single provider–more commonly known as ‘middle- office outsourcing’. Full outsourcing was the model for most of the first-generation outsourcing contracts. In a comprehensive or full outsourcing model, a third-party provider will provide operations for trade processing, ivestment accounting/IBOR, pricing and reference data management, derivative life cycle management (where applicable), corporate actions processing, reconciliation, performance measurement and data delivery on behalf of the asset manager. Functions may also include risk analytics, attribution, client reporting, fee billing or collateral management. This could be for all product types, or for a single product type depending on the asset manager.
• Efficiencies are gained in a single provider model
• Cost is typically more favourable for bundled vs. separate
• One provider for all middle-office functions typically simplifies the operating model for the asset manager, given there is only one third party to partner with
• Full outsourcing may provide the most scalable operating model for asset managers looking to expand their business through significant growth, different mandates or acquisition
• Full outsourcing transitions are not small undertakings and can take many months, depending on the size and scope of the arrangement
• Some service providers may not provide all required services or support all product types in the best way
• Additional drawbacks are dependent on the asset manager’s match with service provider capabilities and standard service offering
2 Outsourcing with multiple service providers is a less common option for most asset managers, but has nonetheless emerged, sometimes as a result of shortcomings in a provider’s service offerings. There are generally two use cases for this multi-provider approach: a functional model and a product model.
The functional model exists where the asset manager’s key service provider does not have flawless service for a specific function. For example, whilst an asset manager may be happy with their overall service, there may be some functions, such as parts of the OTC life cycle event management, that they may have to take in-house due to the provider’s lack of capabilities. This also occurs commonly with bank loan processing. In this case, they may wish to outsource the single function to a second provider rather than continue to support this in-house or conduct an evaluation for a service provider replacement.
It would be very unlikely to see this operating model implemented for core middle-office services, such as trade processing, investment accounting, performance measurement or reconciliation, because these services are generally standard across service providers. However, while some service providers do not actively market ‘component outsourcing’, it isn’t unusual for those who do offer stand-alone services to be willing to take a single function from an asset manager, regardless of where the rest of the middle office is supported.
The product model exists where an asset manager uses multiple service providers across product types; typically, one provider will provide middle-office services for institutional accounts, for example, but may not have a desire (or ability) to provide services on retail wrap accounts. In this example, an asset manager would use multiple service providers, one for institutional and one for retail. It is important to note that there are some service providers who provide the gamut of services across all product types.
• The asset manager does not need to settle for a service provider’s standard offering if it does not meet their requirements
• For asset managers undergoing a contract negotiation, it may be more desirable to move in-house supported functions to another service provider instead of moving all middle-office functions to a new service provider
• Typically, this option is more expensive than a comprehensive outsourcing contract
• Efficiency may be lost when managing data from multiple service providers
3 A hybrid operating model would include both in-house supported functions and outsourced functions. This integrated solution – using internal capabilities alongside targeted outsourcing of a specific function or subset of functions – is a common option. While many asset managers use component outsourcing, a multitude of permutations can apply to this model. Functions often considered for outsourcing include:
• Investment accounting/IBOR
• Performance measurement
• Derivative life cycle management • Collateral management
• Bank loan processing
• Corporate actions processing
• Trade confirmation/affirmation/settlement • Reconciliation
• Regulatory reporting
In addition to this list, some middle-office service providers have expanded their offerings to include:
• Data management
• Risk analytics and attribution
Note that not every service provider markets component outsourcing, since this model can reduce the economies of scale or introduces additional risk compared to what they achieve through their full-shared platform.
The hybrid model also extends to a new market of managed services that are provided by software vendors. These managed services give asset managers the option to license best-of-breed applications with the added value of the vendor hosting the application and providing business operations for functions supported by the application. Examples of more common functions supported by software vendor managed services are data management and reconciliation.
• The asset manager does not need to accept a service provider’s standard offering if it does not adequately meet their requirements
• In-house functions that are less desirable, more expensive or complex can be outsourced to a service provider
• Functions that are managed in-house may benefit from more flexibility; the level of customisation is limitless
• This option may be more expensive than a comprehensive outsourcing contract
• Efficiencies may be lost when managing data from both service providers and multiple internal systems
• Lack of integration across functions and systems is more likely, potentially introducing additional risk
4 Comprehensive insourcing (with internal technology partner/s and operations) is still a common option, but we have seen that the number of asset managers who do not outsource at least a single function is far lower than it was even five years ago. For asset managers who have previously undergone a move to an outsourcing arrangement and are evaluating their operating models, a comprehensive insource would be an uncommon approach. It is rare to find many examples of asset managers who have outsourced their middle offices and then decided to take it back in-house. It is nonetheless a legitimate option if an asset manager has had a considerable change in size, investment strategy, products offered or involved in an acquisition since they originally outsourced. In some instances, this may also take place because of unsatisfactory service levels from a provider.
• Functions that are managed in-house may benefit from more flexibility; the level of customisation is limitless
• The variable cost and effort to maintain technology in-house (investment in upgrades, maintenance, etc.) can be significant
• Specific to asset managers who are considering moving from an outsourcing arrangement to an insourced operating model:
– Hiring and training all new staff with subject matter expertise to support middle-office, as well as a new technology team, will likely be challenging, but not impossible
Moving to a new operating model
Regardless of the chosen operating model, using a contract renegotiation period to address current pain points and strategic needs can set the stage for a successful partnership with service providers and vendors for the next decade, and possibly even beyond. If an asset manager finishes the analysis and determines they do need to make changes to their current provider lineup to fit their desired operating model or goals, these discussions shouldn’t be left to the very end of the contract. If a full service provider change is being considered, or just the addition of new component service provider or vendor system implementation, this should be done many months in advance of, if not several years prior to, the contract expiration. This will ensure enough time for a successful transition. Those considering a change should take heart that transition efforts very rarely extend past a year as they did a decade ago and can be accelerated if the decision-making process is given due course.
The asset management industry faces continued pressure to innovate, capture alpha through complex products and strategies, and attract and retain clients amid unprecedented fee pressure. In order to succeed in this competitive environment, taking a strategic view of technology and operations is critical to long-term success. While operating model decisions of the past may have been driven by cost savings, this narrow view will weed out firms who do not invest in creating an operating model that is scalable and fit for purpose.
Asset managers whose contracts are expiring and those who have not yet outsourced should understand how the service provider landscape has evolved over the course of the last decade. The shift in demand by asset managers on service providers and vendors is marked by increased flexibility, customisation, decreased transition times and innumerable model options. With the number of outsourcing choices now available, it has never been more important for firms to understand their needs and strategic vision. Undertaking a strategic operating model design project that includes a thorough current state assessment can be the cornerstone in designing an operating model that will grow with an asset manager’s evolving requirements. Whether outsourcing for the first time or considering a renegotiation, making the investment in designing a strategic operating model may pay dividends in the future.
Ultimately, the decision of what to outsource and with whom should fit with a firm’s business strategy and vision rather than simply desire for cost reduction. Only when taking this long-range view will firms be prepared to adapt to the rapidly changing asset management landscape.
© 2018 SEI 18ff0e-IMS 156751_UK (09/18)