Financial Journalist

FT Mandate June 2006

The ‘lift-out’ days of old have moved on, since outsourcing providers stood up to being forced into maintaining multiple systems on one platform. Gerry O’Kane charts the modern outsourcing landscape.

It was a gleeful announcement. JPMorgan Hedge Fund Services (JPMorgan HFS) had signed an agreement to take over the middle- and back-office of Henderson Global Investors, along with staff for its 14 hedge funds, representing approximately $2bn (€1.6bn) of assets.

It seemed like the world had changed since outsourcing started with State Street’s 1999 agreement with US fixed-income manager Pimco. “There’s no doubt that outsourcing has been around for a long time, especially in the mature custody sector – you can almost take an off-the-shelf solution,” outlines James Hockley, a specialist in the operations practice at consultancy Investit.

And for JPMorgan, a contract with an asset manager with £67.7bn of assets under management is noteworthy, but it did not have the flag-waving, trumpet-blowing feel of past outsourcing deals.

In part this is because the outsourcing business has changed and its largest players are far more circumspect than in the past. Talk to anyone in the securities servicing business a couple of years ago and trying to get them to speak of anything other than lift-outs was akin to getting Tony Blair to mention socialism.

Doubts raised

Now there are indications that there remains a certain amount of doubt among continental European asset managers that outsourcing is offering solution it purports. Julius Baer Asset Management and Robeco Asset Management are two firms who have been adamant that the big outsourcing route simply does not fit their needs.

And among the industry players there is more talk of component outsourcing.

“The outsourcing market has matured. There may be more lift-outs in the right circumstances but there is a new style of component-based work,” says Richard Warne, head of relationship management for JP Morgan Worldwide Securities Services. “It is possible to break up the services within the middle or back office and consider taking out an element of a service or investment style, rather than the whole thing.”

It is a view with which Mark Kerns, managing director of fund management services in Europe with Bank of New York, agrees. “We might take a lift-out with a view to moving to our environment but the idea of multiple lift-outs is simply not sustainable.”

“What we’re seeing is modular outsourcing continue to grow especially in the area of alternative investments,” he adds.

The deal with Henderson, because it is handling an alternative asset class, now falls under that view of component outsourcing so suggesting that the industry has moved on. The style of outsourcing that dominated the market was the lift-out and even those players no longer hammer the message home.

The thesis of the lift-out operation was win enough outsourcing mandates from well-chosen asset managers and run them on a platform that would give you economies of scale benefiting both asset manager and the securities servicing firm. The system could then be considered a strategic asset and be suitable for many more players, especially the smaller players.

The downside is that such a solution could offer only limited customisation for the
asset manager, but they’ve generally been spoiled by the good life and compromise is not a word often looked up in an asset manager’s dictionary.

As outsourcing projects continued it seemed that providers would furnish any bell or whistle the asset managers desired, including paying them for signing the contract. “Three or four years ago I had providers virtually on their knees with an open cheque book seeking deals,” reveals Luc Leclerq, head of operations at F&C Asset Management.

“The way that most asset managers got into big outsourcing was through lift-out, getting an end-to-end structure for themselves,” points out Mr Hockley. But the asset managers made decisions on the back of a higher cost base and declining revenues and custodians bought their way into the business.

“They were like two blind lovers struggling to find something familiar,” adds Mr Hockley.

But something had to give and 2005 brought something of shock to the asset management industry and their consultants. Those most eager to provide outsourcing grew a backbone when they realised they were being forced down the road of maintaining multiple systems, not one platform.

“There have been something like 30 deals, many seeking to put the same asset managers service onto the custodians’ own platform but you’d struggle to find more than eight that have fully migrated to the lift-out platform,” points out Mr Hockley.

Developing back bone

The custodians wanted to show they wouldn’t be shoved around. While the Bank of New York retained the custody and administration business of Merrill Lynch Investment Managers, it walked away from a full outsourcing deal because of Merrill’s refusal to move to its SmartSource platform. Merrill returned to an in-house system. JPMorgan had already abandoned its five-year struggle to implement an outsourcing deal with Schroders and paid back £20m.

F&C Asset Management and Mellon parted company over outsourcing its back office but maintained other outsourcing deals. According to Mr Leclerq there were issues of service provision at the right price, but those were not the only concerns of fully outsourcing the back office.

“With outsourcing the custody side it’s very simple and there’s competition allowing you to hop from one provider to another without too many problems and the main reason is that there is a structure in place - we’ve a standard gateway called Swift,” argues Mr Leclerq.

This is not the case with the back office. “When I give that away either getting it back or transferring to another service provider is really difficult,” adds Mr Leclerq. “I need to see a win/win situation – my business partner needs to make money too or we all know what happens then…”

And the providers seem to have got the message. “We’ve had our wave of lift-outs as a phenomenon and over the next 18 months State Street will be on a single platform which will be important for the market since with the next wave you can get scale,” says Wade McDonald, head of the asset management and BancAssurance groups with State Street Investor Services in the UK.

As with the Bank of New York and JPMorgan, State Street’s official line is no more lift-outs, but all have the proviso that should the right deal come along with the right staff and technology it might be considered.

Ironically, even Brown Brothers Harriman (BBH) which had been singular in its approach through component outsourcing says it will consider a lift-out but only to acquire a core technology platform.

What all are emphasising is the ability to provide the single solution a new client might be looking for.

Perhaps somewhat paradoxically the provision of single solutions or components, are often as a result of what has been learned through lift-out and the various manouevrings that took them into that market. “With the increase in derivatives there a shortage of resources and a knowledge base and we’ve already seen the big guys buying up hedge fund administrators so they can cover these instruments,” says Mr Hockley.

“There are always factors in this industry driving costs up - new regulations, distribution, new investment strategies especially in the alternative asset space,” points out Mr McDonald. It is in these areas, as well as the more mature outsourcing areas like custody and transfer agency, that he sees much of the component market.

“We’re seeing in the UK that institutional managers are finding that they don’t have efficiencies in certain areas and they are considering component outsourcing,” he adds.

Modular health

“I’d say the modular business will get healthier especially in the light of the growth of the alternatives market,” says Mr Kerns. “Global collateral management services have been a major success for us because of alternative strategies.”

For BBH it must be galling to find all your competitors, once the champions of lift-out, stepping on your patch. “The industry is continuing to change both for what is on offer and what’s in demand,” says Geoffrey Cook, MD, global head of fund administration at BBH. “Infomediary, the cornerstone of our modular outsourcing, has proved itself invaluable because of its scalable nature and looking at today’s landscape having 85 clients shows it has had value.”

“Our view has been that there are multiple ways to do something all with differing requirements and we try to provide suitable components – we’re not saying it’s right but it’s the space we want to play in,” adds Mr Cook.

And it’s the space everyone else now wants too. “We’re going to see an investment-based component approach develop,” observes Mr Warne. In particular, again he mentions alternative asset classes. “Asset managers want to run hedge funds pricing risk analysis or fund of hedge funds and some of these processes they can’t do with their own systems.”

He points out that going short was deliberately made impossible on their systems due to regulation and it is in these areas that securities servicing arms will find new custom.

“It’s a step-change to support new product lines but the ideal of mix and match remains to be seen,” concludes Mr Hockley.

Far more sceptical is Mr Leclerq. “I’m not sure about component outsourcing although the market talks a lot about it – if you have too many components there’s the question of it working at all and if it couldn’t make money as part of a lift-out bundle, how is it economic now?”custody, securities servicing, outsourcing, component outsourcing, asset management,

FT Mandate June 2006

— Mark Kerns,Bank of New York

Fund administration is developing, but in favour of the larger managers who can use the increasingly complex investment style, more regulation and new demands to their advantage, writes Gerry O’Kane.

Fund administration is maturing. Whether it is the service, the pricing or the attitude from either supplier or client, it is frequently described as a ‘maturing sector’. An asset manager talking about outsourcing fund administration to a third party is not the news it once was: within the space of seven days JPMorgan announced a fund administration contract with Charles Schwab, hedge fund administration outsourcing with Henderson Global Investors, while HSBC picked up business with Royal London Asset Management.

In general, fund administration has been accepted as a non-core competency by asset managers.

The business does remain healthy and in the same week as all those deals, Northern Trust announced first quarter results which showed a 28 per cent increase in the value of assets under administration, boosted by its acquisition of Barings Financial Services Group’s fund administration arm.

But while it might be considered a more settled part of the investment world, it is not without pressures and changes, especially on the price of securities processing. “It’s an interesting time with a number of costs coming down and some going up,” observes Geoffrey Cook, global head of fund administration at Brown Brothers Harriman in Luxembourg. It’s a view unquestioned throughout the industry.

“Costs are reducing around clearing and settlement in many markets with the underlying service providers utilising technology in a more efficient way,” agrees Mark Kerns, managing director of fund management services in Europe and Bank of New York.

India would be a most obvious example. Once each share certificate had to be individually stamped by hand each time it was bought and sold. Now an electronic system not only cuts the risk of trade failure (losing share certificates was not unusual as they would travel Delhi streets by rickshaw), but cuts cost too.

While European bourses have not had such dramatic changes in processes, the automation, shortening of trading chains and so on, have lessened costs to both the fund administrator and client. “The efficiencies of local markets and local practice along with the expansion of Swift as a low-cost communications facility, for example, means each market becomes more efficient and administrators can eek out additional savings,” says Wade McDonald, head of asset management and bank assurance with State Street.

Pushing costs up

Agreement is rare in the banking community but no-one dares suggest the cost of handling long-only equity funds has increased. “But there have been substantial phenomena which have not slowed pace in five years that are pushing some costs up – regulatory changes and an evolution in investment style such as derivatives, leading to a growth in non-standard practices which are often people intensive,” warns Mr Cook.

The quest for more yield, whether in the pension fund or with the asset manager, has been unrelenting since the new millennium. To find it, new investment strategies have emerged using alternative products encompassing derivatives and asset classes such as property. “Unlike the long-only equity funds, many of these instruments don’t have uniform downstream processes for settlement. A lot of OTC [over-the-counter] products require manual intervention, don’t have a single price and it’s having the effect of pushing costs up,” outlines Mr McDonald.

BBH points out that for most long-only equity products, straight through processing (STP) levels are well over 90 per cent. “These levels come shooting down when dealing with OTC products,” says Mr Cook.

The impact of this changing face of investment strategy on fund administration outsourcing should not be under-estimated. “Providing this sort of service will put pressure on small administrators in terms of having the skill-set to understand the underlying products and the technical infrastructure,” says Richard Warne, head of relationship management for JP Morgan Worldwide Securities Services.

Like the other big boys of the securities servicing industry, acquisition of firms with experience of hedge fund administration and consequently of alternative investments, has been critical in building the expertise to handle this growing business. Apart from JPMorgan’s acquisition of Paloma, Mr Warne agrees that exploiting alternative investment knowledge from its investment banking arm was vital in the early days and even now it is spending $60m (€46.5m) in boosting the technology to handle this product suite.

While it remains early days for the asset managers and their toe-tipping in the alternative marketplace, the implications are more far-reaching. “It’s not a question of how widespread will derivatives become, for administrators it’ll become an absolute requirement even if only 5 per cent of the asset manager’s portfolio is in alternatives,” says Mr Warne.

As new regulations come to Europe, even traditional long-only equity funds could use derivatives on a small scale.

“At the very least smaller administrators will have to become more focused, they won’t be able to afford to be all things to all people,” says Mr Cook.

Collateral damage

Another implication in the growth of alternative investments is that their use goes hand in glove with using collateral services. For the larger players this requirement is another carrot to lure them to their own fund administration product. Not so the smaller administrator. “There’s been a stronger move to handle collateral efficiently and it’s been a major success for us because of alternative strategies,” agrees Mr Kerns.

Other factors affecting how administrators can operate include fund of funds and pooled assets. Both have further implications on technology infrastructure and the administrators’ understanding of underlying assets. Administrators maintain that funds of funds are straight-forward with long-only equity products, but the issue becomes more difficult when elements within a fund may include derivatives, requiring an assessment of impact on the overall portfolio. It also requires an ability to handle data from numerous transfer agents.

Overall, the larger players in the sector are happy with how the business is developing, if only because the increased complexities of investment style, new regulations and new demands (such as pooled assets) play to their strengths. For the rest of the administration world it looks set to follow custody, either specialise, be bought up or go under.global fund administration, securities servicing, outsourcing, settlement, custody, alternative investment strategies, collateral services