Like many financial services businesses, asset managers have suffered in the global financial crisis. As a result, many asset managers are renewing their focus on their core competencies of product development and investment performance, and outsourcing their operational capabilities in order to reduce operating costs. This briefing focuses on the key legal and regulatory issues asset managers should bear in mind when considering outsourcing.
The strategic reasons for outsourcing
Asset managers are increasingly handing out more of their back, mid and even front office work to service providers as the industry comes under pressure from regulation, the need to update support technology and to keep costs down in an uncertain environment. In particular, access to technology has become a key driver to outsource. Many asset managers have historically administered funds using old legacy systems which are costly to maintain and require significant investment to launch new products. Furthermore the costs of changing these systems to achieve compliance with regulations such as the Retail Distribution Review (RDR) can be prohibitively expensive. For instance, one of the consequences of RDR is the unbundling of fees; some legacy systems are unable to cope with the new charging structures that are now emerging. As a result, these asset managers carry high opex costs which can have a negative impact on profitability, particularly at a time when the industry is undergoing consolidation and fees for administering funds are coming under pressure. In order to remain competitive, asset managers are taking measures to reduce operating costs. Some are doing this by outsourcing the administration of their platform to third party providers who have access to better technology.
Setting the business case
Back office functions that are outsourced typically include custody, depository and fund accounting, mid office functions include trade services data management and record keeping and front office functions includes client servicing and strategy formation.
Outsourcing should be a means of supporting asset managers’ strategic business plan. It is therefore important that asset managers identify the outcomes required from outsourcing at both the macro and micro level. If there is no clear business case or success criteria for an outsourcing project, the project as a whole is less likely to be successful; or, at least, any success will be harder to measure. It is then incumbent on asset managers to share their strategic business cases and success criteria with their suppliers. All too often projects fail because suppliers lack an understanding of their customers’ objectives.
Defining the business case
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Once the strategic decision to outsource has been taken, the next step is to consider the appropriate business model. There are several models for outsourcing in the asset management sector:
- Lift-out model - where a supplier acquires and operates the asset manager’s existing IT platform, staff and processes
- Component based model - where only some of the asset manager’s existing IT platform and staff are taken on by the supplier
- Entire investment-operations model - where all middle-office operations are outsourced at the same time.
At any stage above, the supplier may migrate the functions outsourced onto its own enterprise platform. The model which is appropriate in any given situation will depend upon the asset manager’s existing business model and its business case.
Managing risks: key issues
In our experience, outsourcing deals where customers have taken an unrealistic approach to risk are more likely to end in renegotiation or termination than those with a more balanced approach to the apportionment of risk and reward. We consider below some of the key risks inherent in outsourcing transactions in the asset management industry and consider how asset managers can evaluate and manage such risks. In all cases we recommend maintaining a risk register which will enable each party to identify the risks involved and the strategies required to mitigate them.
Regulatory risk is key for asset managers. They need to be able to demonstrate to their regulators that any contractual arrangement for the provision of outsourced services minimises operation risk. There are various regulatory requirements which UK asset managers should bear in mind when outsourcing:
Asset managers must notify the Financial Conduct Authority (FCA) of proposed outsourcing and significant changes to outsourcing arrangements. (15.3.8G (1) (e), Supervision (SUP), FCA Handbook).
Systems and Controls
If an asset manager is outsourcing critical functions, it must take reasonable steps to avoid undue operational risk. It must also not outsource important operational factors in such a way to impair materially the quality of its internal control and the FCA’s ability to monitor the asset manager’s compliance with its obligations under the regulatory system (8.1.1R, Senior Management Arrangements, Systems and Controls (SYSC), FCA Handbook). Asset managers must also exercise due skill, care and diligence when entering into, managing or terminating any arrangements for the outsourcing of critical or important functions (SYSC 8.1.7R), and ensure compliance with a number of specific conditions set out in SYSC 8.1.8R.
Where an asset manager outsources critical or important functions, it remains fully responsible for discharging all of its regulatory obligations and must comply with a number of conditions set out in SYSC 8.1.6R. It must have a written contract in place with the supplier which clearly allocates the rights and obligations of each party (SYSC 8.1.9R). It must also make available to the FCA on request all information necessary to enable the FCA to supervise the arrangements’ regulatory compliance.
Impact of the Directive on Alternative Investment Fund Managers (Directive)
Under the Directive the provisions governing delegation of alternative investment fund manager (AIFM) functions are highly restrictive. Before an AIFM can delegate any functions, it needs to notify its regulator and certain conditions need to be complied with. In particular, any delegate must be qualified, experienced, capable, have sufficient resources and be of sufficiently good repute. An AIFM’s own liability will be unaffected by delegation. These provisions of the Directive will impact directly on outsourcing arrangements. In particular, the AIFM will need to demonstrate the supplier has been selected with that due care, can be monitored effectively, that instructions may be given at any time and that the agreement can be terminated immediately when it is in the interests of investors. This means that not only will any future outsourcing arrangements to which an AIFM is a party need to comply with the Directive, but all existing arrangements will need to be revisited to ensure compliance.
Security issues are closely tied to regulatory risk: witness the FCA and its predecessor imposing the Financial Services Authority (FSA) substantial fines on firms which have lost client data. For example, in 2010 the FSA fined the UK branch of Zurich Insurance Plc (Zurich) £2,275,000 for breaches of the FSA Handbook rules. The FSA found that Zurich had failed to take reasonable care to organise and control its affairs responsibly and failed to establish and maintain effective systems and controls to counter the risk of financial crime.
Zurich’s general insurance business had outsourced the processing of certain customer data to Zurich Insurance Company South Africa (ZICSA). Zurich’s failings came to light following a data loss incident where an unencrypted back-up tape was lost by one of ZICSA's subcontractors. The FSA found that under the outsourcing arrangement Zurich had relied to an unreasonable extent upon ZICSA to follow Zurich Group policies and procedures and had failed to treat the outsourcing arrangement as if it was a third party agreement. As a result, Zurich had failed to ensure it had effective systems and controls to manage the risks relating to the security of customer data under the outsourcing arrangement and had failed to prevent the lost data being used for financial crime.
Security risk can be minimised by carrying out proper due diligence on suppliers’ facilities and technology, and by including appropriate audit provisions in the outsourcing agreement which will permit the asset manager to continue to audit them on an ongoing basis.
Service failure risk
It is essential that the outsourcing contract is fully aligned with the strategic business case. In particular, asset managers should ensure that the services are properly scoped. Thereafter it is essential to set the standard for the services performed by the supplier. Key performance indicators (KPIs) and service level agreements (SLAs) should be identified at the business case planning stage and included in the invitation to tender (ITT). Potential suppliers can then be scored against their ability to achieve KPIs and SLAs. Asset managers should be careful that they do not include unnecessary KPIs and SLAs in the ITT as this may have an adverse impact on charges (see diagram below).
To achieve cost certainty it is important to build flexibility into the contract. For example, the changing regulatory landscape including the implementation of RDR is causing investment firms to change their pricing model, and other market providers are following suit. Asset managers should consider the flexibility of the contract – if the market charging structure for administering funds moves to a different pricing model, the outsourcing contract should be capable of adapting to that change, hopefully without a wholesale renegotiation.
Furthermore, as funds become more accessible to direct investors and the fees for switching between platforms reduce, this could lead to greater volatility of volumes on the platforms. Asset managers should consider how the outsourcing contract addresses changes in volumes outside agreed tolerances and the cost consequences if agreed tolerances are exceeded. Ideally, the outsourcing contract should provide as much cost certainty as possible for both parties including how the outsourcing contract is priced where volumes fluctuate inside and outside of any volume caps and collars.
Defining the business case
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Good project management and governance are vital for ensuring performance of services. A project team comprising representatives of both the supplier and the asset manager is best placed to monitor the provision of the outsourced service, identify any problems and work together to resolve such problems before serious issues arise. The effectiveness of project management is wholly dependent on the quality and calibre of the individuals tasked with project management or governance responsibilities. The skills required by the retained team at the asset manager are very often different from the actual skill set of most management staff “left behind” in an outsourcing arrangement. Indeed, suppliers often raise this concern. Asset managers should therefore give careful consideration in selecting and retaining their project managers. Consideration should be given to offering incentives to project managers to ensure they remain in role, at least until all functions have successfully migrated to the supplier. All managers should be backed by executive level commitment.
No business environment remains static. Without the ability to make changes, the outsourcing arrangement risks becoming obsolete. Changes in the asset management industry are likely to result from regulatory changes (affecting the entire industry), new products/new lines of distribution, changes to the business and acquisitions/disposals. However, the process of change and attendant risks are rarely given significant focus. This can often result in unanticipated costs. Asset managers must consider from the outset the likely causes of change and agree with the supplier how any changes will be implemented and at whose cost. There is an inherent tension between the parties to an outsourcing contract when it comes to requesting and paying for change as the diagram below illustrates. The contract should therefore contain a mechanism for managing contractual and operational change. The best change control mechanisms allow change to be delivered at a fair price with no party feeling unduly disadvantaged.
The dynamic of change
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A report by Fitch Ratings on the pressures facing the European asset management industry said it should adopt a more flexible cost structure by outsourcing more activities. Outsourcing permits asset managers to move from a largely fixed cost base to a more variable cost structure. However, asset mangers are not just looking for flexible cost structures; they also want certainty. The financial terms of the outsourcing arrangement will be key. Asset managers should consider the following:
- scope of services - are they drafted wide enough?
- cost transparency - is this required?
- achievement of planned cost savings - what are the implications under the contract if savings are not achieved?
- costs of business as usual.
When it comes to VAT it will be key to the project to analyse which party is taking what cost. This will depend on the nature of the supplies. However, the parties should also consider what happens if either the nature of the suppliers or the law and HMRC practice changes. If the services are likely to be VATable, the parties should consider how, if at all, it is possible to mitigate any VAT cost (although any such mitigation may itself be challenged).
The relationship between cost and liability provisions
In our experience one of the key areas of dispute between asset managers and their suppliers is who should be responsible for transaction/pricing errors. Such disputes are often complicated by the fact that there may be two outsourced suppliers: one providing administration services and the other custodian services. The only way to avoid disputes as to liability is to have very clear drafting in the contract setting out clearly what actions the supplier is liable for and what losses he will recompense. In this regard it is necessary to be clear as to whether transaction/pricing losses will be regarded as direct or indirect losses. For example, if any ex gratia payments were to be made to the customers of the asset manager would the asset manager expect to recover these? Equally, if the supplier fails to execute a valid instruction and a fund suffers a retrospective adjustment loss due to adverse market movement, is this treated as a direct or indirect loss and, if direct and recoverable, is the supplier’s liability for recompensing the fund a capped or an uncapped liability? If a supplier successfully excludes or caps its liability for such losses, the asset manager will bear any irrecoverable loss; this may ultimately render the outsourcing arrangement uneconomic and mean the asset manager does not achieve the desired cost savings from the outsourcing.
Parties like to focus on entering into relationships; they do not like to focus on how they will extricate themselves if things go wrong or where the arrangement comes to its natural conclusion. However, asset managers need to focus on the exit planning process in the contract itself; agreeing to such a process only after termination has occurred is to make oneself a hostage to fortune. Ideally, exit management should be looked at as part of the business case process. Asset managers should ask for proposals relating to exit as part of the tender process, taking into consideration how easy it will be to exit the contract and at whose cost. They should consider how they would manage service continuity if they were in dispute with their supplier dispute or in contract wind down. Asset managers should also be realistic as to how long it will take to find and appoint a replacement supplier. We set out below a timeline which provides a useful overview of all the issues that need to be considered when preparing an effective exit plan.
The termination timeline
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