The FCA has recently published its long awaited interim report, in respect of its asset management market study. The report found overall that there is weak price competition in a number of areas of the asset management industry and the FCA is now consulting on the report, with responses due by 20 February 2017. We recently published an overview on the report entitled 'FCA asset management market study: Interim report sees the FCA flexing its competition powers.'

The purpose of this article is to highlight some of the key conclusions on asset manager outsource arrangements, and what this means for what has become an important element of the asset management industry.

Introduction

The report includes a detailed summary of the asset management sector and also a specific chapter (chapter 7) on how asset managers contract with third party service providers, and particularly how asset managers help control the cost and quality of those providers. The chapter makes interesting reading for those that are responsible for the services arrangements that asset managers have entered into, or are considering entering into.

In addition, the FCA provides a helpful overview of the main services that are usually outsourced which range from custody and depositary services through to fund administration (including transfer agency), fund accounting, middle office (including IT) and more ancillary services such as market data. The report identifies the key reasons for these services being outsourced, such as to enable the investment manager to focus on core activities, to benefit from the expertise available from third parties and to manage or reduce cost. These reasons are typical to the outsourcing market more broadly.

Key conclusions

Transparency of third party costs

The report identified that ancillary service costs are generally transparent to asset managers. In addition, managers were found to be incentivised to control the cost of these services, because this (in most circumstances) is disclosed to investors via the Ongoing Charges Figure (OCF).

Procurement process

The report identified that there is a fairly typical procurement process that is run by asset managers for key outsource arrangements, usually starting with an initial request for information and running through to implementation of the service. When comparing providers, quality of service was the key factor, particularly for ancillary services which are more core to the business. Price was (of course) also important, but often the quality test had more of a focus in the procurement process. The report also concludes that services are not frequently switched between providers and although some procurement policies required periodic retendering, the reality is that there was little movement of services from provider to provider in the market. However, the risk of this resulting in an ability to adequately control third party costs, was seen as mitigated by careful tendering processes which took into account the potential risks from infrequent movement between vendors. The role of third party investment consultants to help with the procurement of these services was also highlighted as helpful in tackling some of the obstacles of not being able to move services.

Competition

The report states that competition appears to be working effectively in most of the ancillary service markets, which enables asset managers to control both costs and quality. This was demonstrated by asset managers being able to successfully push for better quality and lower costs, both during contract terms and also at renewal points. Asset managers were found to be relatively sophisticated in their approach and able to put pressure on the ancillary service market. There were a number of areas called out as creating some concerns in terms of competition. In particular, the custody banking, retail transfer agency and index and data provision markets were seen as relatively concentrated. The report identifies that the largest transfer agent in the UK market estimates having a 65% share and the top three custody banks represent approximately 55% of assets under custody in the UK (with the top seven firms being approximately 85%.) In relation to the index and data provision market, the report identifies examples of limited opportunities to switch to another index provider, even where the quality is not acceptable or prices too high. This was seen as a particular issue where an index has become the market standard and also when moving to a new index is too challenging, because of internal systems and documentation.

Bundling

It is noted that many of the service providers offer a range of services and typically sell them in a package (or “bundle”) to asset managers. The majority of asset managers surveyed said that they buy at least two of their ancillary services in this way, and it was noted that it is particularly common for custody and fund accounting to be bundled. The FCA considered whether this bundling practice created competition concerns for the market. Service providers had informed the FCA that the main reason why services are bundled is to achieve economies of scale and the FCA indeed found the potential efficiencies from bundling to appear to be passed on to asset managers. Over two thirds of the asset managers responded to state that price was the main reason they purchased a bundle of services. The FCA suggests that stand-alone service providers would still be able to compete if they offered products at a competitive price and asset managers are typically not required to buy a package of services on a “take it or leave it” basis. The report does flag that the small asset managers, with lower buying power, may not find it as easy to benefit from the market dynamics.

Overall, the report is fairly positive on the use of third party service providers in the asset management industry. It concludes that “procurement of some ancillary services appears broadly appropriate and effective”, that “asset managers are incentivised to control the quality of services by both reputational effects and regulation”, and “bundling of ancillary services is frequent but raises no significant competition concerns”. However, there is a clear finding that certain of the ancillary services markets (notably transfer agency, index and data provision) do face competition issues, and this limits the asset managers’ ability to control both price and quality.

The report does emphasise a few points around best practice when procuring services. First, it is important to run a robust procurement process and that this and indeed the contract should take into account the challenges around moving a service from an incumbent to a new provider (so embedding continuous improvement into the contract is key). The report correctly identifies the fact that bundling of services is common practice and although this can have cost advantages, any customer needs to understand early on whether it can terminate in part and what the commercial consequences are of taking away one component of any bundled service offering. This is not something that should be left to be discussed late in the negotiations, as it can result in difficult conversations that should have been better managed at the outset.

There is a no doubt that there are elements of concentration risk and there is an acknowledgement in the report that the outsource market is becoming increasingly concentrated. This is not news to the industry - it was the focus of the Outsourcing Dear CEO letter that the FSA published back in 2012 and continues to be a topic where the FCA is keeping the pressure on the industry to respond and react. It remains as important as ever that firms continually review and improve their oversight and resilience plans, in line with the findings in the FCA Thematic Review (TR 13/10) that followed the Outsourcing Dear CEO Letter.