5th January 2004

"Outsourcing may be the majic bullet"

By AMIN RAJAN

Fund managers talk about the outsourcing of non-core activities such as marketing and administration. And rightly so. It is essential for developing a variable cost model for their business, which can shift as the markets shift.

Yet, fewer than one in five fund managers around the world have done it so far. Even in settlement and custody - which are routine servicesand certainly not central to the fund management business - the proportion is one in ten.

US fund managers have been the quickest to opt for outsourcing. In the UK, Schroders, Scottish Widows Investment Partnership, F&C Management and, most recently, ISIS have chosen to outsource parts of their business.

Yet, given the sheer intensity of cost pressures in the bear market, these companies appear to be the exception rather than the rule. Are fund managers missing the magic bullet?

A number of reasons are often cited for their reluctance: there are few credible service providers, there is a lack of critical mass at the supplier end to generate big cost savings, and there is a lack of control of service quality to customers.

At a deeper level, however, the approach of many fund managers is best described as more haste, less speed. They are influenced by lessons learnt from companies that have long relied on outsourcing to create a variable cost base.

One that has been studied is BP, which has successfully converted many costs into variable ones in order to cope with the extreme volatility in oil prices.

How did it do it? And what stops fund managers emulating it?

First, it ensured that its senior managers understood that outsourcing gave them a strategic choice: doing business or running the business.

By letting somebody else run the business, the argument went, managers could focus on creating excellence, generating high returns for shareholders and pride for employees.

Outsourcing of important functions such as exploration, information technology and logistics was not an end in itself.

Instead, it was part of a broader initiative to reshape the business.

Few fund managers have as yet sought to transform their businesses by a judicious analysis of what analysts call the "value chain": which bits of the business are central to profitability and need to be held in-house, and which bits are not.

This is partly because the majority did not expect the bear market to last for so long and partly because of lukewarm support from their parent companies - typically, banks and insurance groups.

Second, BP recognised that few suppliers had the ability to meet the needs of a global energy giant. So the buyer-supplier relationship had to be evolutionary. In each area, it set metrics on performance, relationships and quality.

It also engaged more than one supplier under a partnership arrangement that ensured the sort of seamless delivery that would be expected of a single supplier.

Getting a handful of suppliers to work together reduced the risk of escalating fees and inflexible quality. In the fund management industry, suppliers - such as State Street, J P Morgan and Bank of New York - are few in number: competition rather than collaboration is the name of the game.

Third, over time, BP introduced a balanced scorecard, using financial and non-financial targets. The latter included qualitative factors such as response time, time to fix, product innovation, business process improvements, customer satisfaction and skills enhancements.

Importantly, these non-financial factors determined the margins that suppliers could earn on total costs. This meant that they had to maintain transparent books and operations. In information technology, for example, the head count was reduced by 80 per cent and the budget by 66 per cent within five years, with a win-win all round.

In the fund management industry, outsourcing of middle and back office operations has so far been driven by cost factors.

Fourth, when choosing suppliers, BP paid special attention to their management capabilities, business strategies and understanding of the oil business.

It favoured outfits with an entrepreneurial culture that were aggressive in controlling costs and impressive in generating ideas. Suppliers were regularly benchmarked against their competitors.

If there was notable divergence on key measures such as cost and quality, the laggard was expected to use its competitors as sub-contractors if it could not match them.

In turn, suppliers forced BP to be clear about its 10-year strategy.

Again, service providers to fund managers have yet to grasp the new market dynamics or present a compelling value proposition that goes beyond cost control. The whole outsourcing industry is still in its infancy.

I have come across examples where outsourcing has generated no more than a one-off reduction of 5 per cent in total operating costs - a quick win for sure, but with no parallel focus on "doing business". These companies' managers continue to run the business, while staff see it as a cynical ploy to break up the company.

Unless outsourcing of activities in some parts of the value chain can create excellence in others, it will be perceived as a testimony of failure at the top.

It is worth saying that outsourcing is not a panacea. Pimco, the fixed income specialist, outsources extensively, whereas T Rowe Price, the mutual fund specialist, does not. Yet, both are widely admired. What matters is how they conduct their business in order to generate excellence for their investors.

Amin Rajan is chief executive of CREATE, a research consultancy specialising in new business models in financial services: amin.rajan@create-research.co.uk.