Outsourcing: Three Steps to Preparing for a Possible Exit

If the experience of outsourcing operations or IT infrastructure is something like being married to the third-party service provider, ending that relationship can be just as painful and messy as a divorce.

Fund management executives shouldn’t assume their outsourcing relationships are going to last forever or even to the end of the agreed upon timetable of seven years on average. Rather, as part of their vendor-management practice, they should consistently factor in the risk that a relationship can go bad and have a solid transition plan for the potential divorce, say buy-side operations experts.

Even more importantly, so do some regulators who are now paying closer attention to outsourcing agreements and the potential for disruption to client services if a firm falls out with its third-party service provider.  For fund managers, those providers are typically custodian banks, fund administrators, data management services, and IT integration shops. Investment funds may rely on them to handle anything from basic recordkeeping to more complex operations in clearance and settlement, collateral management, reconciliation, data quality and oversight, and application hosting.

The reason the likelihood of a divorce might increase over time, buy-side consultants tell FinOps Report, is a matter of simple amortization. While the outsourcer’s client should see the benefits of outsourcing relatively early in the relationship, for the third-party provider it may be years before it sees a profit from its investment in implementing and tweaking a service for a firm with unique requirements and evolving service demands. Once that corner is turned, the third-party provider may have less incentive to go the extra mile to satisfy the client, and more inclined to milk the relationship with small cost increases and service reductions.

Of course this isn’t true of all outsourcing relationships, and it’s not the only reason they start to deteriorate or actually fail. In the worst case, a service provider can just go bust and disappear — leaving its clients waving their service-level agreements in the air in an empty room. Many fund managers have reason to remember well when Lehman Brothers went bust, because they depended on the firm as a prime broker or counterparty in swap contracts.

The potential for operational disruption on end investors has taken on particular concern for the UK’s securities watchdog Financial Conduct Authority (FCA), which has just asked fund managers to devise concrete gameplans for the possible parting with their key outsourcing providers. “The FCA is insisting that, as part of their normal operations, fund managers take their exit strategy seriously,” says Cosmo Wisniewski, executive director of buy-side operations consultancy Citisoft in London. “What started off as resilience and oversight checking, following “Dear CEO” letters, has developed into a proper assessment of whether a voluntary or forced exit can be achieved [without operational interruption], and is the ultimate test of whether resilience and oversight is properly under control.”

While US regulators may not have developed an equivalent approach, many global fund managers are viewing the FCA’s tack as a best practice and following suit. There are no official figures on just how many outsourcing contracts fail to last for their entire contractual duration, but some US and UK fund managers project that at least 30 percent of fund managers and their service providers start to feel the itch to part company half-way into the marriage. The so-called seven-year itch could easily end up being a five or even four-year itch.

From regulators’ perspective, the reason for the breakdown with a service provider is less important than the risk it poses to the investors and the market as a whole. In fact, the funds need to keep these transitions as smooth as possible to continue to meet their fiduciary obligations. Funds can ill-afford to be unable to execute an order, clear or settle a trade or manage their books and records. “It’s best to be prepared with a well-thought-out and documented transition process,” recommends Wisniewski, whose firm has just launched an “exit strategy” outsourcing service.

For firms that have not yet created their transitions plans in case of divorce from a third-party outsourcing provider, here are three steps to get started:

Know Your Options

Facing divorce might feel catastrophic, but it helps to know that options exist. Fund management firms can decide to take suddenly orphaned operational functions in-house, or they can move them to another provider who continues to have a good relationship with the firm. They can even decide to clean house of all of their providers, and go to another provider who may offer a more sophisticated approach. Two operations experts at UK investment management firms tell FinOps Report that the most common alternative is to return operations in-house. “Transitioning to yet another provider is considered far too cumbersome and costly,” says one.

Organize the Team

Bringing in family members to help throw out the leftovers and congratulate you for getting rid of the villain is a time-tested therapy for break-ups. Firms in the throes of outsourcing divorces should do something along the same lines. Gather the experts from operations, technology and compliance to review the operational gap, analyze costs getting through the transition, and come to a decision about how to solve the problem — whether the choice is in-sourcing the function, outsourcing to another provider, or taking the opportunity to do some reconfiguring of  operations beyond just reassigning the same tasks to someone else.

Decisive Execution

Knowing what is required to get to a decision is the first half of the plan; executing the decision is the other half.  The same committee of specialists who decided what to do are likely to be overseeing the transition. Part of transition management includes establishing a timetable with milestones, making sure that data assets are stored redundantly, and allocating sufficient resources for testing and re-testing the new systems. “Change can be tough and Murphy’s Law applies,” says one New York-based fund management operations specialist. “Back-up is essential. Critical data could easily get lost in the shuffle leading to an array of costly recordkeeping, valuation, and even trading errors.”

As to what a firm can expect in an outsourcing divorce, as a rule of thumb, it depends on the size of the assets under management and the complexity of investment services and strategies. Smaller, simpler firms can probably make the transition with less drama. Firms with complex hedging maneuvers reliant on multi-leg products may have to break a sweat to reorganize or replace contracts with multiple resources, data management and collateral management requirements.

Fund management firms which relied entirely on outsourcing their operations from the start will likely have the hardest time adjusting. They simply haven’t dated anyone else for a long time or even been on their own. “These firms need to start with a proper analysis of what their operating model really is or should be, rather than rely on just what they’ve inherited from their service provider,” says Wisniewski.