Faulty forecast

When J.P. Morgan Investment Management began handing over the administration of its $321 billion in assets to Bank of New York in May, custodians predicted that a flood of similar large-scale agreements would follow.

When J.P. Morgan Investment Management began handing over the administration of its $321 billion in assets to Bank of New York in May, custodians predicted that a flood of similar large-scale agreements would follow.

By Ian Rowley
November 2000
Institutional Investor Magazine

When J.P. Morgan Investment Management began handing over the administration of its $321 billion in assets to Bank of New York in May, custodians predicted that a flood of similar large-scale agreements would follow. After all, outsourcing makes sense. Freed from back-office chores, money management firms can focus on their specialty -- investing. To date, however, the projected flood has turned out to be more like a trickle.

Why? Many fund managers are reluctant to lose control of their assets because they bear the ultimate responsibility for client relationships. The long implementation time -- the handoff can take several years -- the complexity of the agreements and the costs are additional sources of concern. And not surprisingly, investment firms want to see how some of the early movers fare before falling in line.

To be sure, some big and well-respected fund managers have followed J.P. Morgan’s lead. Pacific Investment Management Co., Schroders Investment Manage-
ment and Scottish Widows Group have announced outsourcing agreements this year. Merrill Lynch Investment Managers and Julius Baer International have begun handing over at least parts of their asset administration businesses to custodians. Nonetheless, many in the securities-processing industry maintain that the number of deals hasn’t met expectations.

“The jury is still out on outsourcing,” says Francis Jackson, head of global custody at Citibank in London. “While there is clear demand for investment administration, it’s still a big decision for any fund management firm to take.”

So far managers’ activity has been mostly limited to information gathering, notes Terry McCaughey, chief operating officer in global securities services at Deutsche Bank in London. Although he has had lots of discussions with interested managers, McCaughey says that the small number of announced deals reveals that few have been willing to put pen to paper.

Even the precedent-setting J.P. Morgan Investment Management decision seems likely to be reconsidered, given Chase Manhattan Corp.'s proposed $30 billion purchase of its parent, J.P. Morgan. In the rapidly consolidating financial services industry, mergers are a real possibility that could upend any deal, say fund managers. BoNY, which has $6.9 trillion in custody assets, is one of Chase’s main rivals in the securities-processing business. Will Chase, which itself oversees $6 trillion in custody assets, want its new acquisition to partner with one of its main competitors? Does BoNY want to take that risk?

A lot of rival custodians don’t think so. “If I were with Bank of New York, I wouldn’t want to spend millions investing in something that I know will be taken away in a couple of years’ time,” says one securities-processing executive. (Officials at Chase, J.P. Morgan and BoNY aren’t discussing the outsourcing transaction, noting the purchase isn’t slated for completion until February.)

Should BoNY’s arrangement with J.P. Morgan fall through, it won’t be the first outsourcing transaction to fail. In March London-based Rothschild Asset Management, which had started moving its investment administration to Mellon Trust in early 1998, chose to bring the business back in-house.

According to Atul Manek, director of operations at Rothschild, Mellon’s handling of his firm’s private client business was one reason for the breakup. “Both firms thought they knew each other’s businesses, but they were way off the mark,” he says. Others note that the fund management culture, rooted in volatile securities markets, tends to be more dynamic than that of custodians, who focus on issues of safekeeping.

Despite such setbacks, custodians maintain that the trend toward outsourcing is inexorable. They argue that by transferring administration to external providers, investment managers can focus on their core competency of money management. “It’s not that fund managers can’t do investment administration -- it’s just that it’s not core to their bottom line,” says Citibank’s Jackson. “But for custodians, outsourcing is a natural extension of their existing businesses.”

Bankers note that as more deals are announced, money managers will become increasingly confident about handing over control of their posttrade investment services. “The industry has known for years that it needs to spend investment dollars on its core businesses, but nobody was prepared to outsource,” says Mark Tennant, senior vice president in global investor services at Chase Manhattan in London. “But since the J.P. Morgan deal with Bank of New York, fund managers have begun considering outsourcing far more seriously.”

The logic of focusing on core skills won over Wesley Burns, head of investment operations at Newport Beach, Californiabased Pimco. His firm started the process of transferring its investment administration to State Street Corp. in May. The deal, which allows State Street to handle all the administrative functions for Pimco’s $190 billion in assets, builds on a custody relationship between the two firms that goes back ten years. “We had reached a point where half the company’s head count was operations and technology employees,” Burns says. Indeed, he notes that 270 Pimco employees have been transferred to State Street as part of the agreement. “We want to focus on what we do best, which is managing money.”

State Street had another success in August, when Merrill Lynch Investment Managers outsourced administration of its $200 billion retail mutual fund business to the Boston-based bank. As part of that deal, State Street will provide fund accounting and pricing services for Merrill’s 227 portfolios and absorb 300 employees.

Ronald Logue, chief operating officer of State Street, says that it is important to differentiate between various agreements. He notes that his firm’s deal to administer Merrill Lynch’s mutual fund business is very basic compared with its contract with Pimco, for instance. State Street will eventually take over the operation of Pimco’s entire posttrade services, a much bigger and more complicated task. “We’ve been in the collective fund accounting business since 1924,” Logue says, referring to the agreement with Merrill. “The [Pimco] deal is less straightforward, but there’s an emerging demand for it among investment managers.”

In Europe, meanwhile, Schroders Investment Management announced in September that it was outsourcing its custody and investment administration to Chase. Schroders, which has $110 billion in assets under management, had been in talks with the U.S. bank since late last year. Also in September, BoNY reported that it would take over the private client custody and fund administration services for Julius Baer Inter-
national, the London-based arm of the Swiss asset management company. An October deal saw Scottish Widows hand custody, trust and investment administration of its £90 billion ($135 billion) in assets to State Street. The Edinburgh-based investment manager had previously outsourced administration to the WM Co., a subsidiary of Deutsche Bank, but opted to move the business to State Street following its acquisition by Lloyds TSB.

Skeptics warn, however, that while firms can hand over the day-to-day running of their investment operations to external providers, there are limits to outsourcing responsibility. Schroders’ relationship with its clients, for example, is unchanged following its outsourcing agreement with Chase. Mark Smith, director of operations at Schroders, says that although his firm has subcontracted investment administration to Chase, it retains responsibility for the assets. Schroders will have an in-house surveillance team ensure that Chase meets its requirements. “There’s no point in having a heavily detailed contract if the service isn’t delivered in practice,” Smith says.

Regulatory responsibility also stays with the investment manager. “If a fund manager goes to the regulator and says, ‘The guy I outsourced to screwed up,’ there won’t be a lot of sympathy,” notes Deutsche Bank’s McCaughey. “While in essence you can outsource certain elements of the risk, the onus must be retained.” McCaughey says that the costs of monitoring an outsourcing agreement, along with pro-
viders’ fees and the costs of implementation, could prompt many investment managers to veto the deals on economic grounds.

Critics also question how profitable outsourcing deals are for the banks -- particularly as the big names in global custody compete fiercely to establish themselves in the outsourcing sector. Hiring client employees, building systems and servicing accounts are all expensive. “Look at the numbers and you have to ask yourself where the margin is,” says one custodian. “You wonder if it’s a case of bankers acting like sheep again -- just because one large bank has done a big outsourcing, we all have to.”

They don’t have to, of course. Custodians need to show investment managers successful examples of firms that have handed over their operations. Until that happens, clients and custody bankers alike will tread carefully.