or more than a year now, the topic of investment operations outsourcing has occupied many hours of discussion among institutional investors in Germany. But the discussions have not yet led to any outsourcing deals. A general reluctance to transfer oversight of back- and middle-office functions, combined with regulatory intricacies that traditionally did not encourage outsourcing, have influenced the industry to keep these functions in-house.
From a regulatory and operating model standpoint, the German investment market is among the most complex in Europe. This is partly due to the majority of the industry’s large KAGs operating on the same proprietary technology systems as commercial banks, making investment operations outsourcing transactions – especially liftouts – extremely complex. This complexity is another factor in the market’s historic reticence to fully embrace outsourcing.
However, “business as usual” in Germany is starting to change. Recent large and successful outsourcing transactions in continental Europe, and the 2003 passage of the regulations that now allow KAGs to outsource fund administration, are prompting more investment companies to seriously consider outsourcing as a solution to current investment industry challenges.
Three factors are driving the slow but growing acceptance of outsourcing in the German market. First, cost pressures due to stock market declines are squeezing profits for asset managers. With no relief to sluggish equity markets in sight, KAGs must now take a hard look at their operations and seek out new ways to improve efficiency.
The second is the need to access better technology. In both established and emerging markets, technological advances are driving the investment business. The ability to access the latest technology is a competitive necessity, especially in declining markets, when the threat of consolidation is on every manager’s mind.
But keeping up with rapid changes in technology requires an ongoing investment in new platforms and capabilities – an expense that must be tightly controlled for all investment managers. In Germany, technology requirements are especially complex, as KAGs must comply with the expanded operational functionality required by recently enacted investment laws, including additional regulatory reporting and derivative risk assessment duties.
The third dynamic in the move toward outsourcing is the increasing complexity of the investment industry. From the emergence of new asset classes to the growing demand for transparency and cross-border investing, investment managers are grappling with how best to develop solutions for investors’ more sophisticated needs while at the same time effectively managing risk. This trend is best reflected by the increasing demand for absolute and total return funds as well as alternative investment strategies in the German marketplace.
Investment operations outsourcing can’t eliminate these issues entirely, but it can help.
The lengthy debut of outsourcing
The growing need for outsourcing non-core operations should come as no surprise. Asset managers everywhere are under the same pressures to increase revenue, control costs, respond to increased regulation and update technology, while remaining focused on core competencies of managing money and serving clients. For many managers, outsourcing non-core business functions has proven to be a powerful tool in alleviating these pressures, and in increasing operational efficiencies.
Germany may not have been an early proponent of outsourcing, but there’s still room for opportunity. Throughout the industry, even as high-profile transactions make headlines, there continue to be long lead times between outsourcing deals – a clear indicator that the outsourcing train has not yet left the station.
Why then, with its promise of long-term cost efficiencies, technology innovation and better risk management, has outsourcing still not lived up to its reputation as the “Holy Grail” solution for the asset management business?
When well-publicised missteps in early outsourcing deals created unease in the market, fund companies were rightly reluctant to become the next casualty of a service provider’s learning curve.
However, well-established success stories such as United States-based Pacific Investment Management Co. (PIMCO)’s decision in May 2000 to outsource US$210 billion of investment operations capabilities – as well as Edinburgh-based Scottish Widows’ October 2000 deal to outsource the custody, trustee and investment administration services on its life, pensions and investment products – have sparked new confidence for managers interested in following in their footsteps.
Setting the bar for growth
In the German market, historically conservative KAGs have been slowly realising that in order to focus on their core investment management functions, they must find new ways to ensure back-office operations are handled properly, but preferably by a third party. However, with little or no precedent of local outsourcing transactions from which to gain perspective, managers were ill-equipped on how to proceed.
In March 2004, AXA Investment Managers announced its intention to pursue an operations outsourcing arrangement that would allow the company to transfer the fund administration and investment operations support of its business in the United Kingdom, France and Germany. When completed, this transaction could set the bar for the growth of the outsourcing industry in the German market.
On the heels of the AXA IM announcement, another large outsourcing transaction was taking shape for a multinational investment manager with operations in the United Kingdom and continental Europe. In May, ABN AMRO Asset Management announced an agreement to outsource its fund administration and investment operations functions in the Netherlands, the United Kingdom, Luxembourg and Sweden.
As outsourcing continues to gain acceptance in the German market, the market will be watching the AXA IM and ABN AMRO deals closely. Effective execution of these deals is essential to ensuring confidence in the outsourcing process.
Learning from the ghosts of outsourcing deals past
The outsourcing process is not without its risks. The complexity involved in transferring back-office operations and converting technology platforms makes an outsourcing agreement difficult to retract in the event that either member is dissatisfied with the arrangement.
That is why the decision to outsource – and the selection of a service provider – is not a choice to be made lightly. The outsourcing relationship should be viewed as a long-term partnership, and not entered into for short-sighted gains. At the same time, there may also be a risk for those asset managers who wait too long to consider outsourcing.
If, as predicted, the investment market sees significant growth in the demand for outsourcing, some managers may find themselves at the end of a long waiting list. The supply of outsourcing services is limited; providers can only accommodate a finite number of transitions at one time. Outsourcing deals are typically large and complex and the transition process can be intricate.
If there is an oversubscribed rush to vendors who are not prepared – whether because they lack the necessary experience or because they lack the required capacity – what are the implications for the industry?
In business, perception can shape reality. We have already seen what happens when outsourcing transitions are viewed as not meeting expectations. A newly publicised misstep could cause considerable damage to the industry’s reputation, setting the expansion of outsourcing back several more years.
Therefore, it is essential that industry newcomers implement their solutions successfully the first time. Likewise, experienced providers must maintain high standards for existing clients as they take on new ones – and they should refuse to take on new clients unless they are confident that they can supply an appropriate solution. Execution and delivery will be decisive factors.
Selecting an outsourcing partner
It is reasonable to assume that more German investment managers will begin to conduct their own operational “due diligence,” evaluating the extent of their appetite for outsourcing against their bottom line. Once the German market is ready to consider outsourcing, the most vital next step for investment companies is choosing a provider.
The publicity surrounding large outsourcing deals has also attracted a host of new providers, some with little or no outsourcing experience. These newcomers, anxious to get into the outsourcing arena, are at a disadvantage against more experienced participants who understand what it takes to successfully execute a transaction of such significance. There is a real distinction between outsourcing providers who are implementing scalable solutions and those who are just now trying to figure out how to build a model that will work in the long term.
As asset managers look for a suitable outsourcing arrangement, they should weigh these four important attributes:
A demonstrated commitment to the business. Among the most important characteristics of a capable outsourcing provider are stability and credibility. Investment managers must consider the long-term implications of an outsourcing deal and how the business will operate 10 years later, not just one or two years down the road. As industry consolidation continues to change the landscape of providers, the most successful outsourcing partner is the one who has been in the investment services business for a considerable number of years – and will show every sign of remaining there.
An in-depth knowledge of back- and middle-office functions. An asset manager’s back- and middle-office should not be viewed as separate components, but as a broad collection of systems and operations that must be tightly coordinated and integrated to achieve maximum efficiencies. In Germany, the integrated operations model of KAGs with large commercial banks adds significant complexities that only the most systems-savvy provider can handle. Providers should have considerable experience with back- and middle-office challenges in order to design and implement effective outsourcing solutions.
Recognised technology expertise and scale. Technology is the engine that powers today’s investment industry. Asset management firms should seek out providers who are committed to investing in scalable technology: contemporary platforms woven together to deliver integrated and transparent solutions. Outsourcing can facilitate a move away from legacy batch processing and manual processes, resulting in the delivery of more timely information, a reduction of costly processing errors and a more automated environment that easily supports straight-through processing.
A proven track record in handling large and complex deals. As previously discussed, the early promise of outsourcing was slow to materialise in part because of a lack of precedent-setting deals. Asset managers wanted to see the results of a successful partnership. Clearly, the best choice to handle a complex transaction is the provider that has demonstrated outstanding ability time after time. Today, with so many more providers from which to choose, asset managers can use history to their advantage when determining which provider can best handle their needs.
The outsourcing relationship: a
After a series of false starts, forecasts of the growth in investment operations outsourcing could finally be realised. In this broadening market, asset managers must be vigilant about choosing a provider with whom they can maintain open and honest communications. After all, choosing an outsourcing service provider is not just about finding a vendor, it is about making a long-term commitment to a strategic partner.
With this in mind, managers and providers should remember that short-term benefits offered with some outsourcing arrangements may be tempting, but they won’t pay for the long-term damage as a result of choosing an incompetent or inexperienced provider. It is only through a sustained history of productive partnerships that outsourcing will achieve its true potential.
With the positive attention outsourcing is now receiving, more deals are sure to follow. This is good news for German asset managers and investment servicing providers alike – as long as both sides of the partnership proceed thoughtfully.
Stefan Gmuer is a senior vice president of State Street based in Munich.