Investment management outsource providers

The outsource industry has grown rapidly, but many outsource providers are unable to find good economies of scale, yet have to remain competitive, research by Peter Ellis, Principal at Investit has indicated. In order for the outsourcing industry to progress and be successful, providers need to:

- change their relationship with clients
- find more sustainable business models, away from the ‘lift-out’ practice
- become more specialist than generalist, which will create second generation deals
- collaborate more with each other

If managers had more confidence in outsource providers, the rewards could be great. Investit found that there is no reason why outsourcers cannot provide services to both the middle and front offices.

Investit’s research into the operations of different investment managers and outsourcing providers has provided some useful, and objective, insights into the outsource market.

"If outsource providers want to advance their businesses, they need to change their original client relationships," Ellis states. Clients have specific, and often unrealistic, expectations, which make lift-outs seem the obvious solution – lift out the team currently providing the service, employ them and charge the client less. However, outsourcers often end up with a number of different systems and processes – none of which are compatible – and the only economy of scale is cheaper rent in an office outside the City. This model is now stretched and has led to slipped timescales and confrontational relationships with clients. An individual ‘blow-up’ could harm the entire outsourcing industry. From the outsource providers’ perspective; this has led to an unsustainable, and unprofitable, business model. Changing the client relationship will mean satisfaction on both sides and success at a current service presents the opportunity to expand into more investment management functions.

As the outsourcing industry matures, more providers will move towards specialist expertise – competitive advantages demand this. "Although ‘world domination’ through scale is a tempting goal, at this stage, excellence is preferable to coverage." Ellis advises. Secondly, increased competition and specialisation will lead to more second-generation deals. If one provider can’t meet a client’s needs, the client will look for another provider. And current business models won’t work in these situations. In second-generation deals, lift-out strategies are complicated – one provider would not make it easy for a second-generation lift-out to a competitor. Outsource providers will bear this pain - not their clients.

If outsource providers improve client relationships and find a sustainable business model, there will be more opportunities. Explaining how outsource providers can move into the middle and front office environments – currently a more guarded domain, Ellis says, "We know that portfolio managers want to outsource what they see as the boring administration behind the fun stock picking. The draw of managing a start-up hedge fund has proven that to many investment companies."

But how much would managers be willing to let go, if outsource providers prove successful? Firstly, Investit looked at middle office functions, such as performance, portfolio maintenance and even some client relationship functions, for example producing client reports. He found that, although there are some sensitive areas which could encroach on client relationships, there remains a great deal of scope for providers to expand into the middle office. An outsource provider could supply portfolio managers with performance attribution, create client reporting packs and so on, as long as the client relationship remains firmly in the manager’s control.

And the scope for expansion stretches into the front office in areas such as:

-front office order management systems
-compliance monitoring
-cash management

"The middle and front office are not safe from quality, specialist outsource providers," Ellis continues, "but only if they manage the transition to a sustainable business model."

To solve today’s issues, providers have to collaborate. Too much competition at this stage holds the industry back. Collaboration isn’t a new phenomenon in this industry. FIX, EMU, IMA, AIMA, and so on, show investment managers have been doing it for years. Once providers have solved the problem of clients’ unrealistic expectations and built a strategic platform to take the industry forward, they will find enough competition for the other niche areas of investment management businesses to satisfy all.

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