Asset management firms getting back to investment basics could set off a tidal wave of systems outsourcing in coming months.
Tighter profit margins in the face of shrinking revenues and the growing need for speed in securities processing are making executives at many large firms at least consider outsourcing their back-office operations, according to industry experts. And outsourcing providers are counting on it. Industry sources think the stage is set as money managers emphasize investment management skills and let the experts handle the back-office technology.
Outsourcing allows money managers to cut capital spending on operations technology and, in some cases, reduce headcounts by turning over operations to outside providers that specialize in delivering real-time customized investment technology.
Outsourcing of investment management operations is a relatively young business. The most likely beneficiaries of this outsourcing will be major custodian banks, which already provide many back-office functions.
While custodians are gearing up for the expected wave, at least one established third-party outsourcing company also will expand its services to the institutional asset management market by the end of 2002.
Officials at SEI Investments, Oaks, Pa., a major outsourcing provider to banks and mutual funds, said the firm would begin offering back-office operations outsourcing to domestic asset management firms this year. SEI will join current outsourcing giants such as J.P. Morgan Chase & Co., Bank of New York Co. Inc., State Street Corp., Mellon Financial Corp. and Investors Bank and Trust Co., all of which have enhanced their offerings in the past 12 months, anticipating an increase in outsourcing activity.
"In the last 10 years, money managers could succeed by just participating in the markets," said Wayne Withrow, SEI executive vice president. "Now they are facing a more normal return cycle and are seeing the need to focus on the operational side, not just the investment piece. They will be moving to outsource operations because they have to, not because they want to."
Need to economize
Interest in outsourcing is driven by the managers' need to economize in a market where returns are off and assets might be shrinking, as well as the need to improve processing quality and speed, he said. "Investment returns are no longer the point of differentiation for money managers to succeed; now it includes a variety of other services, including reporting and communications. The technology and operational investment you need to get there is hard to do on your own," he said.
Outsourcing of operational capabilities by institutional money managers soon will be an "explosive market," said Jim Palermo, president of Mellon Global Securities Services, Pittsburgh. "We think of this as an extension of the custody area, working with the money manager and reaching further back in their shop to handle some of the functions they've handled internally," he said.
Mellon has been upgrading its outsourcing functions and recently acquired Eagle Investment Systems Corp., a Newton, Mass., developer of Web-based investment management software, which is being incorporated into the Mellon platform. And J.P. Morgan Chase, New York, announced last year it was launching a new business unit, Asset Manager Solutions Group, to provide services to institutional money managers.
Large outsourcing firms have signed up several large showcase money management clients. TCW Group, Los Angeles, is outsourcing its investment operations to Mellon Global Securities Services. Boston-based State Street signed on Pacific Investment Management Co., Newport Beach, Calif., and Scottish Widows PLC, Edinburgh. Executives at major outsourcing providers say several large firms are expected to shed internal investment operations and join the parade this year.
"The floodgates are about to open" for large-scale outsourcing of investment management operations, said Pam Brewster, analyst at Celent Communications, a Boston research and consulting firm. She said investment management firms are "pushing" for outsourcing alternatives. "For money managers, market conditions and competition is creating the impetus. Many are facing a squeeze on profits and their business strategy calls for them to focus more on the investment process. They are looking at other areas such as operations and asking `does it give me a competitive advantage?' Another area is the whole movement to T+1 and the reality that money managers don't have the money or the expertise to buy the technology and maintain these systems, whereas major custodian banks have spent billions. That's been a driver, and money managers haven't faced it," she said. "They feel that since custodians have spent this money on systems, they can spread those costs across their customer base and create economies. Absolutely, without question, (outsourcing is) going to be a growing trend," she said.
TCW outsourced its investment operations to Mellon in January 2001. According to William Sonneborn, TCW chief operating officer, the decision was not difficult.
"We looked at straight-through processing and one-day trade settlement and the speeding up of the investment and trading process and the need for data delivery in real time," he said. "Those issues we could have handled, but we saw the technology investment it would take and the cost to keep up with that race as an $87 billion asset management company. This represented something that was important to us but a secondary competency. We gave it to someone who had that as their core competency and who could spread ongoing costs over a greater number of users. That lowers the cost to us."
Mr. Sonneborn estimated it would have cost TCW about $50 million to prepare its systems just for one-day trade settlement. There also would have been ongoing costs to operate, maintain and upgrade the system.
Mellon takes control
Mellon took over all of TCW's existing systems and 120 TCW employees and began transferring operations to the Mellon platform. (In a similar arrangement, State Street assumed investment operations responsibility for PIMCO and absorbed about 300 PIMCO employees.)
Mr. Sonneborn said the transition is nearly complete; only domestic fixed-income systems remain.
"We've been in a bear market for the last two years. For money managers, that has created pressures on the compensation side. Now you have compressing margins," said Mr. Sonneborn. "Some are finding that they haven't focused enough on costs (of doing business) because revenues have grown faster than costs."