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Hands-off policies

Fund managers are increasingly outsourcing middle-office work, such as data management and performance measurement. Banks are taking it on as a loss leader -- for now.

In the past five months, money managers in the U.S., the U.K. and Europe have outsourced administrative functions associated with more than $300 billion in assets, more than twice the amount they off-loaded in all of 2002. Not only has the volume of outsourcing surged, its scope has widened. Jettisoning back-office functions such as custody and trade settlement is nothing new. But many of these latest assignments include middle-office tasks -- trade reconciliation, compliance, data management and performance measurement -- that money managers once preferred to keep in-house.

No more.

"The level of outsourcing activity is unprecedented," says Paula Sausville-Arthus, senior vice president and head of the asset management solutions group at J.P. Morgan Chase & Co. in New York. "It has reached a real crescendo in the last three months."

The pace began to quicken in November when London-based F&C Management handed over the back- and middle-office functions of more than $108 billion in assets to Mellon Financial Corp. Two weeks later J.P. Morgan won £62 billion ($116 billion) and £107 billion from two London-based firms, Isis Asset Management and Morley Fund Management, respectively. ABN Amro Asset Management, Allianz Dresdner Asset Management, Gartmore Investment Management and Insight Investment Management are all said to be negotiating outsourcing agreements.

For fund managers, the shift promises considerable savings. According to a recent survey by McKinsey & Co., back- and middle-office costs represent 23 percent of the industry's total expenses. Though the percentage of expenditure has remained stable since 1998, the three-year bear market in equities hit revenues hard. Increasingly burdensome regulation and reporting requirements mean that spending on the back and middle offices is unlikely to decline any time soon.

"Outsourcing is not a magic solution to expense issues, but what it does do effectively is translate a fixed cost into a variable one," says Robert Jenkins, CEO of F&C. Rather than paying for an entrenched infrastructure with stubbornly high costs, the fund manager through outsourcing pays the bank a fee based on assets under administration, which rise and fall with the performance of the fund management business.

From a bank's perspective, luring middle-office fund management business offers the prospect of a new revenue stream. "The fund managers want to outsource, and the banks want the expertise that is embedded in these middle offices so that they can create a new product," explains Mark Speller, a partner in the financial institutions group at PricewaterhouseCoopers.

At the moment, banks are looking to build market share, says Speller. In many cases, they're doing deals as loss leaders, in the hopes of developing new, scalable technology platforms that will eventually allow them to handle middle-office chores for other money managers. In some instances, he says, banks have even paid fund managers for their middle-office business. Regardless of the monetary terms, most deals have seen banks take on the bulk of the staff employed by fund managers.

Thomas Perna, senior executive vice president at Bank of New York Co., is concerned that the banks are giving away too much. "At some point soon, these deals have to make money on a stand-alone basis," he says.

But the rush to close these deals shows no sign of abating. "Every fund management CEO is now nudging their head of operations and asking, 'Why aren't we doing this?'" says consultant Speller. Adds F&C's Jenkins: "A year ago outsourcing was a hotly debated issue. Now it is the new orthodoxy."

Fund managers began outsourcing back-office tasks in the late 1970s. These functions were initially limited to the custody of assets and the settlement of trades and only later came to encompass such tasks as the daily striking of a mutual fund's net asset value.

The first middle-office outsourcing deals -- among them, those struck between Bank of New York and J.P. Morgan Asset Management, and State Street Corp. and Pacific Investment Management Co. in the U.S.; and Chase Manhattan Bank and Schroders in the U.K. -- were not signed until the late 1990s, and there were few immediate followers.

The recent bear market, which exposed the bloated cost structure of many fund management firms, has pushed many off the sidelines and into the game. Outsourcing may not explicitly cut costs, but the variable cost structure does offer more flexibility, particularly in tough times. "It improves the quality of our earnings and will allow us to cope better if bad times return," says Jenkins.

Fund executives believe that large banks are better positioned to efficiently handle middle-office work because of their already considerable investment in back-office technology. Says Isis CEO Howard Carter, "To me, it makes no sense for fund managers to replicate IT expenditure when the large custodian banks spend hundreds of millions of dollars a year on technology that can then be used across a broad customer base."

In addition, fund executives want to focus on core competencies such as investment management, marketing and sales -- or, in industry jargon, manufacturing and distribution. Administration is a secondary function. "We increasingly view money management as divided between manufacturing, distribution and operations. As the business unbundles, operations is the logical area to outsource," says Carter.

Even some of the biggest and most technologically proficient fund managers have decided to outsource. Pimco, the world's largest bond manager, with more than $350 billion in assets, outsourced all of its back- and middle-office functions to State Street in 1999. Pimco executives believe that the move has helped its global expansion.

"Our operations were essentially in one place: Newport Beach, California," recalls Ernest Schmider, Pimco's head of global operations. "Allying with State Street has helped us set up trading rooms in London, Munich, Tokyo and Sydney because we have been able to piggyback off their global infrastructure."

Still, some fund managers worry about losing control of their assets. Ultimately, any slipup, from the mispricing of a portfolio to noncompliance with a fund's investment guidelines, remains the fiduciary responsibility of the fund manager. Markus Ruetimann, global head of technology and portfolio services at $400 billion UBS Global Asset Management, has these concerns: "Outsourcing does not change the obligation the manager has to the client and the regulator. The regulatory scrutiny the fund management industry is under makes it a very odd time to outsource."

U.K.-based fund managers, though, are especially enthusiastic about outsourcing, consultants report. State Street's Jay Hooley, executive vice president and global head of investor services, points out that this reflects the greater complexity of doing business in Europe. "The cross-border element makes the European puzzle more difficult for managers, and the need to outsource is more immediate," says Hooley.

Many of the recent deals are lift-outs of entire operations, with the system technology and administrative staff moving from the money manager to the bank. For example, 450 of Pimco's back-office staff joined State Street in 1999; J.P. Morgan Chase is hiring 200 Morley employees; and Mellon now has 93 F&C personnel on its books.

Even if a bank wanted to fire back- or middle-office staff, in the EU it would have to comply with TUPE laws (Transfer of Undertakings [Protection of Employment]), which dictate that in any acquisition or substantial transfer of operations, a new employer can't lay off staff or change compensation packages. A case in point: The 70 Isis staff joining J.P. Morgan will do so with exactly the same salary and benefits packages they've always had. Says F&C's Jenkins, "This is a core business for Mellon, and our employees move out of our back office and into Mellon's front office."

Still, both Carter and Jenkins say they are carefully weighing which middle-office functions should be outsourced and which will remain in-house. In both cases, some IT staff will be retained for marketing and fund management support.

The CEOs also recognize that the success of outsourcing will greatly depend on how well fund executives manage the firm's relationship with the bank. F&C's Jenkins is looking for close cooperation between his firm and Mellon. "I want my audit teams to have the same unfettered access to their organization that they would have to any part of the business here," he says.

At the moment, says consultant Spel-ler, it's a buyer's market for fund managers looking for banks to take on back- and middle-office outsourcing work. But it is far from clear that all banks that want to offer the service can do so effectively. "I question whether these banks are being properly compensated for the risks they are taking," says Speller of PricewaterhouseCoopers.

As the number of banks willing or able to take on outsourcing diminishes and the product becomes scalable, banks should enjoy more pricing power. For some, that can't come too soon. "Deals are getting done because some banks are desperate to get into the game," acknowledges BoNY's Perna. "But in the long run, the economics has to work for both sides."