As operational focus turns to middle- and front-office functions, alternative asset managers increasingly are embracing new sourcing models not just to cut costs, but also to create scale, improve risk management and compliance, and generate alpha.
Driving down costs through traditional outsourcing of back-office functions has long been a widely adopted solution on both the sell side and the buy side. For purposes of control and independence, however, buy-side firms resisted adopting enterprise-wide outsourcing as a viable option for managing growth. Today, in an environment defined by risk management and regulatory compliance, the need for institutional scale, and the challenges of generating alpha, this view of outsourcing is undergoing a fundamental change as operational focus turns increasingly to middle- and front-office functions.
According to Opalesque, the top 100 alternative asset management firms have a cumulative asset base of more than $3 trillion. Estimated spend on internal, operational services is approximately 30 basis points, or $9 billion. That excludes payments to outsourced fund administrators, which are absorbed by their clients. Reducing these operating expenses to 15-20 basis points would result in $3 billion to $4.5 billion savings for the industry.
Today’s alternative asset management industry poses a unique set of challenges – and economic opportunities. It is with these opportunities in mind that a new, highly collaborative form of outsourcing is emerging. Co-sourcing is a breakthrough model designed for the next generation of managers who are embracing truly innovative ways of building for scale in order to have the freedom to invest, innovate and grow.
Co-Sourcing vs. Outsourcing Co-sourcing is a partnership in which the asset manager and service provider collaborate to create workgroups that provide customized support across various business functions. Support is delivered as a service over an extended period of time, typically 3-5 years. These workgroups can be located at the client’s site, remotely or both, depending on the type of support being provided. In turn, the service provider is able to reduce and accurately forecast its cost of doing business over a long-term contract by servicing a larger volume of business from one client while at the same time sharing work group management with the client. Contracts are usually administered as part of a larger master service agreement.
Fully realized, a co-sourcing model provides alternative investment managers with an operating model that supports five essential attributes. These attributes, which evolved from a highly successful engagement executed in partnership with one of today’s largest global alternative investment asset managers, are:
- Quality. Asset management firms demand business models that deliver a consistently high level of quality. Such engagements must provide access to skilled resources and quality infrastructure.
- Control. Managers need complete control in selecting resources, scale of operations and quality of infrastructure required. They would like to retain control across business functions, including outsourced processes. Managers increasingly seek service models that can be extensions of their existing businesses. This helps ensure seamless delivery of processes in line with desired quality and timelines, using the same underlying processes and technology platform.
- Independence. Managers require third-party independence to mitigate conflicts of interest and control. Furthermore, engagements that are flexible and can be customized provide greater ease of integration between in-house teams and third-party services.
- Scale. Growing investor demands and regulatory pressures pose operational and budgetary challenges. Operating models must enable managers to leverage and manage significant increases in assets and complexity through economies of scale.
- Economics. Staffing costs represent about 70 percent of overall expenses for asset managers in the US, with an average split of 40:60 between front-office and other operations. Non-front-office operations account for 40 percent to 50 percent of total expenses, of which 10 percent comprise IT and systems costs. Managers are seeking solutions that will provide reduced expenses and convert fixed costs to variable costs without compromising on scalability or quality.
Under co-sourcing, most of the functional work flows and priorities are controlled by the client, while the service provider is responsible for the staffing, operations and management of the staff from a quality-control and scale perspective. With co-sourcing, the alternative investment manager and provider become true partners in their mutual goals, building in scalability without sacrificing quality.
The Dividends of Co-Sourcing The long-term nature of co-sourcing relationships makes it imperative for both the client and the service provider to partner with true synergies in mind. Co-sourcing also provides stability for both the client and the provider. The relationship allows issues to be tackled in a holistic manner with a longer-term perspective than is the case when working with conventional outsourced or consulting providers.
Unlike traditional outsourcing engagements, co-sourcing involves transparent billing, which provides the fund with operational advantages and related cost savings. Use of offshore workforces can provide time-zone advantages and added scalability. Co-sourcing also provides the client and its employees with the freedom to focus on critical value-add activities, as more routine work is co-sourced to the provider. As the co-sourced vendor grows its client base, it cultivates higher-value expertise and, in turn, the ability to provide higher-value services.
The level of integration and strategic alignment that it affords sharply distinguishes co-sourcing from conventional outsourcing. Under an outsourced agreement, little ownership resides with the client and the lion’s share of accountability rests in the hands of the vendor. With co-sourcing, the vendor team is a vital extension of the client’s onsite team, fostering a measurably greater sense of ownership and accountability while reinforcing confidentiality.
Co-sourcing is not a blanket panacea for every situation. Implementing a co-sourcing model poses specific challenges to firms with large outsourcing businesses, such as a fund administrator, since it requires close adaptation to a client’s established business model. The more mature the client’s business model, the greater the demand for an innovative service provider that can leverage people, processes and technology to provide a tailored co-sourcing solution.
The Emergence of the Co-Sourcing Era Considering the steady embrace of alternatives by institutional investors, the growing preference among investors for larger, well-established firms and the industry-wide matter of succession, 2013 marks the beginning of an exciting new era of mainstream adoption of co-sourcing. We believe that the next two to three years in particular will bring dramatic growth in this model, with co-sourcing increasingly recognized as providing a sustainable competitive advantage. In this way, instant scalability and breakthrough operational efficiency will become prerequisites on every savvy investor’s due diligence checklist.