30 January 2006

"Hard Graft makes light outsourcing"

By AMIN RAJAN

"One book that always has a sad ending is a cheque book," mused the chief executive of a global fund manager, smarting from a bruising conversation with his back office service provider in 2003.

Then fund managers saw outsourcing as killing two birds with one stone: exporting "problem children" and tackling the cost spiral. Thanks to muddled thinking, an inherently good idea turned into a bad idea.

Fund management is no exception in this regard: other industries, too, have resorted to rationality after exhausting all other possibilities. Now, that attitude is changing as early pain has been followed by clear gains.

"The second wave of outsourcing may well hit continental Europe. As large banks consolidate, their fund managers may look outside their group for administrative services. Regulation plays a part," says Jervis Smith, managing director and head of managed funds and insurance section, Citigroup Global Transactions Services.

"On their part, service providers are unlikely to dangle large carrots, since they already have platforms and expertise. It's a maturing industry in which all the major players want controlled profitable growth."

For sure, some deals have gone sour, inviting disproportionate publicity. They are like isolated air crashes alongside routine safe landings. Elsewhere, the gains have come in two forms: specific and holistic.

The first one has centred on savings in operational and capital costs, alongside access to state-of-the-art technology.

In contrast, the second has centred on creating a new business model that discriminates between doing business and running the business.

Under it, outsourcing is not a panacea, but part of a strategic initiative to re-engineer the business by separating bits that thrive on in-house expertise and bits that thrive on external expertise.

Thus, if the in-house expertise is superior across the patch, then outsourcing is no big deal. Indeed, this approach has been adopted on both sides of the Atlantic by prominent brands such as T Rowe Price, Capital Group, Baillie Gifford and DWS.

However, a growing number of fund managers have chosen the holistic route, but not without challenges. At an emotional level, their divisional heads have yet to buy into the implied break-up of the business. They fall into two opposing camps, with marked variability within each (see figure).

As a chief investment officer of a large European fund manager observes: "Our line managers are red in tooth and claw. They sport red braces and short haircuts. But they remain deeply set in their ways." But he hastens to cite two positives on the horizon.

First, at the fund manager end, there is a new generation of chief executives, chanting twin mantras "product is performance" and "customer first". Following other financial services industries, their business model is about turning the conventional wisdom on its head: growing the top-line and cutting costs simultaneously.

"It requires a clear focus on core capability, backed by alliances with best-of-breed service providers in non-core areas.

Second, at the service provider end, there is a deeper understanding of clients' dreams and nightmares.

"The industry is developing a platform that permits mass customisation for small and medium-sized fund managers, giving them the scale economies enjoyed by large players. We also need to extend our value chain to cover activities like securities lending, foreign exchange and trade execution. The best way to create a win-win is by wrapping ourselves around clients," says Tim Keaney, head of Europe for Bank of New York.

An independent research study published by his bank last year showed that outsourcing by fund managers boosted the share prices of their parent companies by clarifying the strategic intent.

Doubtless, both parties have climbed a steep learning curve in the past five years, as vertical integration within individual fund managers has been increasingly replaced by horizontal integration involving service providers. Equally, there is little doubt among service providers that their added value must extend beyond smart gizmos and slick processes.

"You can't realistically expect the benefits to flow from day one. But the industry has to develop a portable platform that enables the client to reverse the process at any time, if they are unhappy. Although it is vital for us not to over-extend ourselves, we must do our best to advance this proposition," says chairman and chief executive of State Street, Ron Logue.

"For fund managers, outsourcing requires climbing the emotional learning curve: and it requires the same due diligence as in full scale mergers."

In the end, it boils down to trust; hitherto a much used, misused and abused word in fund management. Against the background of mutually demanding expectations, outsourcing is like a three-legged race, where the runners in each pair rely on the other to win.

That means:

*Fund managers must use outsourcing only as a tool of business re-engineering, duly securing the necessary emotional buy-in across the organisation.

*Service providers must develop the necessary credibility, reliability and proximity to attract, retain and grow their clients' business in a symbiotic harmony.

These are the lessons from other industries where outsourcing is routine. Those who undertake it see it as hard graft, not bold fixes.

Amin Rajan is the chief executive of Create, a research consultancy Amin.rajan@create-research.co.uk.