Surprising Outsourcing

Barclays Global Investors casts a vote against custody industry consolidation.

Barclays Global Investors casts a vote against custody industry consolidation.

By Tom Groenfeldt
September 2001
Institutional Investor Magazine

When the going gets tough, the technology gets outsourced.

That’s a truism in much of the corporate world - and a tradition in financial services. Banks have outsourced check processing and other back-office functions for decades, just as investment firms have relied on specialized securities depositories and custodians - all in the interest of performing better where it counts, whether in customer service, financial counseling or portfolio selection.

Now that focus is all the rage, companies are increasingly inclined to farm out tasks that don’t fit the definition of strategic priority or core competency. Throw the complexities of advanced technologies into the mix, along with regulatory changes and ever-intensifying competitive pressures, and the arguments for outsourcing become that much more compelling.

By now, half a century into the computer age, one would think that most institutions would have figured out what to keep in house and what to off-load. High-volume functions like stock clearing or global custody should, logically, be thoroughly dominated by a few large and efficient operators, which pass their economies of scale on to clients. It hasn’t quite worked out that way. Many asset managers, for example, are only beginning to grapple with the available outsourcing alternatives.

And their options are proliferating as vendors try to sell more than just basic, back-office processing services. The result? Few big decisions by buyers, and nothing like the bonanza that top outsourcing vendors were expecting a few years back.

“We service providers are in a period of digestion, and the investment managers are in a period of introspection,” says Ronald Logue, chief operating officer of State Street Corp. He is convinced that the logjam will soon break, and in common with custody archrivals Bank of New York and J.P. Morgan Chase & Co., State Street plans to be ready with a broader array of administrative and trading capabilities. “We’re not just in custody anymore,” says Logue.

But now the unpredictable outsourcing business is throwing these asset-servicing giants yet another curve. Barclays Global Investors, which maintained its own back office longer than most investment firms, recently moved in the direction that Logue and others have been anticipating - but neither BoNY nor J.P. Morgan nor State Street won the business.

BGI’s choice to take charge of U.S. custody and related operations - including a 271-employee facility in Sacramento, California - was Boston-based Investors Bank & Trust Co.

Whatever happened to economies of scale? Investors, a niche player to say the least, had only $315 billion in custody assets before adding BGI’s $515 billion under administration. By comparison, BoNY, J.P. Morgan and State Street are each above $6 trillion.

“It was a very difficult choice because there are some very good providers out there,” says BGI head of global operations Andrea Zulberti. Unimpressed by sheer size, BGI went with a company that it had gotten to know gradually - it had relied on Investors Bank for mutual fund accounting since 1996 and for the introduction of iShares exchange-traded funds last year.

The mandate puts Investors Bank - the principal subsidiary of Investors Financial Services Corp., a 1995 spin-off from Eaton Vance Corp. - in the same class as Brown Brothers Harriman & Co., a second-tier custody servicer that has held its own against fierce competition. “A Brown Brothers or an Investors Bank is a little bit better at customer service and has a more intimate relationship with clients,” says Timothy Lind, a custody industry analyst with consulting firm TowerGroup in Needham, Massachusetts. “When the big boys merge, a lot of asset managers don’t want to go with a huge organization.”

In its way, Investors Bank followed the big custodians’ formula of extending its service menu to include such noncustody adjuncts as securities lending and foreign exchange. Buying into that broader vision of outsourcing, and building on a preexisting customer relationship, Investors showed it is capable of winning on terms defined by the industry leaders.

Bank of New York set this more expansive tone in 1999, using a range of back- and middle-office services to win a contract from the old J.P. Morgan. That deal predated the Morgan-Chase Manhattan Corp. merger; the new J.P. Morgan Chase is expected to take the processing back in-house. BoNY and Morgan didn’t immediately touch off a wave of similar “deep outsourcing” deals, but their relationship reflected how buyers and sellers alike are reexamining their core strengths. For example, even while becoming a one-stop shop in its own right, Morgan Chase in April sold off a small segment of its custody business, a 58-employee unit handling $27 billion in assets on behalf of financial advisers, for $42 million. The buyer? Investors Bank & Trust.

Investors owes its BGI breakthrough in part to lucky timing. It wouldn’t have happened if the Barclays unit hadn’t decided to reassess its commitment to technology. “Some of these systems and operational processes have been around for a long time,” Zulberti says. “With the Internet and all of the other changes in technology,” she adds, the firm took the opportunity to do a “holistic” evaluation in the context of overall strategy. Its main concern was that operations were becoming too much of a distraction from core investment activities: 22 percent of BGI employees worked in custody administration, accounting and technology support.

To choose a vendor, BGI didn’t conduct an extensive bidding contest; Zulberti says only that she considered a few candidates. Thomas Theurkauf, an analyst at Keefe, Bruyette & Woods who follows Investors Financial, says that only BoNY and State Street could also have competed because of their ability to handle exchange-traded funds. Investors had a leg up, having worked on Barclays’ iShares.

“We have made our name by putting the functionality for complex products, including exchange-traded funds, right into the main software, which allows us to leverage our technology dollars,” says Investors Bank chief financial officer Karen Keenan.

Aside from its technical proficiency, Investors proved a good fit because it was eager to assume control of Barclays’ processing facility. The West Coast site was attractive to Investors as a gateway to the Pacific Rim, and Barclays liked the idea that its clients would be dealing with familiar service representatives after the takeover. Keenan views that as a morale booster: “It’s exciting for the staff because they have moved from what was the back office of an investment company to the front office of Investors Bank. Now they are a very key piece of a fast-growing company. We haven’t lost a [former BGI] person since taking over May 1.”

Not all Barclays operations went to Investors Bank. Zulberti spearheaded a detailed analysis of the business from end to end, diagramming every process, from portfolio management to trading. The management committee spent half a day going through that mapping, then decided to outsource fund accounting, settlements and some trading.

BGI chose to keep in-house all direct dealings with clients, including client relationship, order entry, contracting and client reporting functions. “The information may come to us from the Investors systems,” says Zulberti. “We would never let our clients be serviced by somebody other than ourselves.”

BGI ISN’T THE ONLY PARTY TO THIS DEAL THAT faced outsourcing decisions.

Investors Bank views its software, the Fund Accounting and Custody Tracking System, as its strong suit. Unifying custody and fund accounting on a single platform, Facts is designed to give a relationship manager all the information necessary to service a given client. Analyst Theurkauf sees this one-stop approach as “very customer-centric rather than product-driven. The bigger players tend to have information silos; if you have an accounting issue, you have to make a separate call to the accounting professional.”

State Street’s Logue scoffs at that issue, saying that Investors has a more critical challenge to meet in terms of scale, capacity and global reach. “I know what it takes to do three, four or five of these [deals], the kind of capital you need to build the capacity, and small players just don’t have the capital to make that investment up front,” says Logue. “You can’t afford to be overwhelmed.”

Investors Bank undeniably lacks State Street-type scale. It compensates by outsourcing: Electronic Data Systems Corp. handles its mainframe and network operations. If the bank adds clients and requires more computing capacity, EDS fills that need.

TowerGroup’s Lind says that this doesn’t necessarily put Investors at a disadvantage. In fact, Investors has an opportunity “to take the BGI platform and scale it so they can serve additional customers with those same people and processes,” says Lind. “You do need a lot of capital, and this is how Investors chose to go after it.”

Computer operations “isn’t a place where we think we can make a difference,” says Investors’ Keenan. “It’s like a utility. We pay EDS on a variable basis, whereas if we owned our data center, it would be a fixed cost.”

Costs are understandably rising at this fast-growing asset servicer. Parent Investors Financial reported a 52 percent increase in operating expenses for the first half of 2001, to $125 million; that included $8 million in the second quarter for the BGI conversion, plus added head-count expenses. At the same time, net operating revenues were up 50 percent, to $158.5 million, and net income rose 45 percent, to $22.2 million. The company’s stock has recently been trading at about $70, up from $61 just before it announced the BGI contract on April 11. Investors’ price-earnings multiple of 55 compares favorably with State Street’s 29 and BoNY’s 22.

Investors Bank expects to grow like its competitors: by doing more work for current customers. Keenan notes that existing clients - they include college endowment fund manager Commonfund, Eaton Vance and some Goldman, Sachs & Co. private equity funds - have $9.5 trillion under management, and Investors services less than $1 trillion of that. “So even if our existing clients were our only playground, we have a lot of toys,” says Keenan.

State Street’s Logue agrees that satisfied custody customers will seek more trade and pretrade support. State Street recently added pretrade services for Pacific Investment Management Co., he notes, “because for eight years we have done their posttrade well. They trusted us, and there were good personal relationships built up over time.”

Yet the harsh reality for custody servicers is that “we haven’t seen too many people sign on the dotted line,” notes BoNY senior executive vice president Thomas Perna. He sees a pickup in the number of prospects doing evaluations, and BoNY offers a system to guide decision makers through the process. But the results are muddled: “Talk to ten managers, and you get 11 opinions,” says Perna.

Logue says it’s only a matter of time before buyers are sufficiently educated to act. “We have been building capacity,” he explains. “You have to make bets, and the reason we are making large bets is that we already have many customers who we believe will gravitate toward this outsourcing.”

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