Nov 29, 2021

This is part three of Cutter’s series on the benefits of outsourcing.

While outsourcing can offer a number of benefits, the decisions you will need to make carry significant risk. Good planning and a clear vision are keys to success. But while the objective should be to solve today’s problems quickly, those decisions should be directionally consistent with where you want to be tomorrow.

For any transformation effort, firms should first assess their current-state business capabilities (and limitations) against their future business strategy. Changes within the client base, distribution model, or investment strategies will drive new requirements for consideration in the operating model, and these will determine which sourcing partners will be the right fit.

Keep in mind that outsourcing should not be thought of as a quick fix ─ it’s more of a journey. Just make sure you know where you’re headed and how you’ll get there. Vision without execution is just a hallucination. But where do you start ─ people, process, technology, or data?

Where to Begin?

The operating models at many investment firms have a number of flaws, many of which will impede future growth if they are not addressed sooner rather than later. A gap analysis will identify those limitations and what will be required to support your firm’s future-state operating model.

This will also drive the sourcing opportunities available to the firm for consideration, and whether a full or partial outsourcing approach is needed to achieve the optimal model. Selective sourcing is more feasible today, now that services have become more modular. But so too are broader transformation efforts, as more service providers offer front-to-back offerings and data-centric models, by leveraging new cloud-based technology. Some of these newer services are still immature, but there is no dispute that technology is changing what’s possible.

Staffing Constraints and Opportunities

Many investment firms are constrained by their ability to hire qualified middle- and back-office resources, which is often cited as a reason for using outsourced services. This is becoming even more of a challenge for firms’ operating models, as these firms invest further in complex derivatives and alternatives. That’s because specialized resources with knowledge of these assets are even harder to find, especially for firms located outside of global financial centers.

Experience and expertise with alternatives and derivatives processing are some considerations that may help determine the right provider. While the specialty providers may not be able to compete on cost, or even the breadth of services that may be required to support your entire firm, they will bring the most experience and expertise to the table for a more complicated book of business. And some of these providers have been focused specifically on these types of assets for decades.

On the other hand, we sometimes hear that asset coverage is a reason for not selecting a provider ─ for reasons related to the 80/20 rule. Such a provider may offer a solution for 80 percent of your problems, but it’s that remaining 20 percent that really causes the most headaches. Even so, perhaps there’s still an opportunity to keep moving forward. That provider might not support your most complex assets, but it covers the rest. So, by offloading your more vanilla assets to that partner, you can now focus more of your attention on the 20 percent that is the most problematic.

The COVID-19 Effect

Proper staffing has been, and will certainly remain, an issue moving forward in the wake of the COVID-19 pandemic and what is referred to as the “Great Resignation.” More employees are looking for greater flexibility or are just making career changes in general, so voluntary turnover is a real issue, especially among staff with the expertise needed for your most complex operations.

And since this expertise was already scarce, the pandemic and the Great Resignation are adding fuel to the fire. This is why outsourcing can help some firms. Firms that decide to outsource investment functions can limit the impact of staff turnover, especially when it is already difficult to find good middle- and back-office staff. While the service providers are contending with the same staffing issues, they are more resilient and have the capacity to deal with a reduction in staff, whereas a smaller organization can’t.

Technology and Future Cost Avoidance

Many investment firms have decades-old systems, some of which are mission-critical and reaching end of life. Many of these same firms have also relied heavily on spreadsheets and manual processes due to their systems’ limitations, as the investment, regulatory, or client needs have changed.

While these issues may have been well known for some time, the pandemic proved how inefficient and problematic these manual solutions have become, especially in a remote work environment. In that regard, the pandemic has accelerated change at many firms.

While some firms will rightly choose to invest in necessary improvements such as new systems or upgrades, others may not be as willing or able. Software vendors are broadening their capability to respond to the increasing requirements, but no single system will meet all clients’ needs perfectly. Some asset managers and asset owners may also see benefits in passing their technical debt to a service provider. Even firms with the ability to make those investments may be better served by allocating those dollars and resources elsewhere in the organization. Significant savings can be achieved when considering indirect costs and future cost avoidance, such as system upgrades and implementations. In fact, future costs may be larger than transferable costs, or the costs related to the business function and staff that will be outsourced.

However, while the costs related to technology are not the only savings that can be realized, you should understand that rationalizing the costs and potential savings with outsourcing is a complex endeavor with many variables to consider, such as the number of staff replaced, the residual staff needed for oversight roles, and the complexity of the functions and asset classes outsourced.

Data

Data presents a number of challenges at many firms. Unstructured data requires intervention that is error-prone and manually intensive. What’s more, data in general exists in multiple silos across many organizations, which makes it difficult to view total fund exposure or to make other actionable insights. At the same time, investment teams are continuing to push for access to more data and ways to share information across the organization.

The good news is that some service providers’ data tools are becoming more sophisticated with increased flexibility for clients. Many large service providers are focused on data democratization, and they are in the middle of developing solutions to aggregate and normalize positions to display liquidity and exposures across multiple asset classes. Their dashboards are designed for the business, enabling non-technical users to interrogate their data. Some are also investing in behavioral analytics, data science, and other services tailored to portfolio construction and ideation. And this is where the industry is headed.

The bad news is that while these services are rapidly maturing, firms should understand that although the envelope is being pushed, the vendor models are not quite there yet. Therefore, these offerings should only be sought to complement your firm’s internal data architecture in order to ensure control over your data assets.

Buyers should set appropriate expectations for the near term, while aligning their longer-term vision with their providers.

Transformation ─ not Replication

Outsourcing should be viewed as an opportunity for transformation, not replication. High risk or proprietary functions should remain in house, and firms should try to standardize other processes in scope for the outsourcing arrangement, where possible.

In general, the large-scale centralized business processes are the most suitable for outsourcing arrangements. When these are not available, there might be some work ahead before you can transfer those responsibilities to your provider that are more bespoke ─ but it is still possible. Well-documented and repeatable processes increase the ability of a seamless transition to a provider, and with the improved modular service options available, clients now have the choice to outsource components of their investment operations, such as functions required for alternatives or derivatives to supplement internal business capabilities. Clients may also retain some functions in house that may require more rigor, while outsourcing other functions that are more standard.

However, it’s important to have mutual agreement on how business processes will achieve the required outcomes in a scalable and effective manner, with minimal support outliers. This can be a challenge when existing system limitations have driven highly bespoke internal processes, but it is achievable. Consider best practices within core workflows and look to a partner that understands your business for opportunities for transformation. The outsourcing market has improved, and providers can help support bespoke processes though their ability to integrate with proprietary and third-party applications, consume various data sources, and provide flexible data output options. This should help to support consistent practices across the organization and reduce process complexity, which will lead to lower operational risk.

It may also be the right time to consider the alternatives to how your business operates and what your future-state operating model can look like. Your process might be the way that you’ve always done it, but that doesn’t mean there isn’t a better way.

The Journey Ahead

Outsourcing delivers a number of benefits. The largest providers have the resources and capital to leverage the latest technology at scale, and the specialty providers have the expertise and know-how to support your most complex assets.

When choosing sourcing partners, it’s important to focus on the strategic benefits that the service provider may bring to the table and the provider’s fit for your firm’s future-state operating model. Each provider’s value proposition will vary in its ability to meet a client’s individual needs, and so too will pricing and cost. These elements will ultimately reveal the best path forward, but there is a lot to consider before your journey can even begin.

Outsourcing requires considerable planning and a clear vision of where you want to be tomorrow. Find a partner that understands your business and whose capabilities and road map align with your vision for tomorrow. Build agility into your operating model in case your needs change ─ and always have an exit plan.

Need Help?

Firms have a lot to consider when it comes to outsourcing, and it can be challenging to navigate the current landscape, with more partner choices today than in the past. Even among the leading providers, services vary by region, and you will undoubtedly find that many offerings are more comprehensive in some regions compared to others.

With our expertise in target operating models and selection, Cutter can help you navigate these challenges. Also, look for our upcoming research on outsourcing solutions that will evaluate some of the leading service providers as part of our report to be published later this year.

To learn more, read Outsourcing: Where to Now? and Outsourcing Is Not What You Think It Means. If you have any questions or would like to speak with a Cutter analyst or consultant, please contact us at connect@cutterassociates.com.