Outsourcing has been a significant feature of the asset management industry for at least 30 years, but opinion on the perceived success of outsourcing is still divided. Conventional wisdom holds that back office functions can be outsourced and that this will lead to a reduction in operating costs. In this post, I will challenge this conventional wisdom (note that I am specifically talking about business process outsourcing, not IT outsourcing).
Conventional wisdom holds that outsourcing will reduce operating costs, and this is usually the main motivation for outsourcing.
Let’s apply some common sense to this. There is cost associated with outsourcing. If you outsource you will incur transition costs and so you will want to recover that cost as well as achieve lower operating costs than you had before you outsourced. The outsource service provider will also incur transition costs. This means that they have to deliver the service to you for a lot less than it cost you and make a margin that will deliver an operating profit as well as recover the transition costs.
It’s not impossible to make outsourcing economically viable for both parties but common sense suggests that it is only possible if one or more of the following is true:
- The cost of the service before outsourcing was much higher than market practice.
- The outsource service provider can achieve economies of scale that you were unable to achieve.
- You accept a lower level of service quality allowing the service provider to reduce the service cost.
Achieving cost savings by outsourcing is certainly possible, but it is not a given. And it should not be the only motivation for outsourcing. Another motivation is the desire to enhance service quality by accessing the capabilities of an external party to deliver services, to you or to your clients, that your business is unable to provide.
When capability enhancement is the motivation for outsourcing the aim is not to reduce operating costs, it is 1) to avoid the future cost of building a new capability, or of upgrading an existing one, and 2) to reduce the time-to-market for bringing the enhanced capability into the business.
What to outsource?
Conventional wisdom holds that back- and middle–office business functions can be outsourced, and that front-office ones can’t or shouldn’t.
In practice it isn’t this simple. Investment managers sometimes sub-delegate investment mandates to other managers, or may distribute their funds through another manager’s platform. These are not back-office or middle-office functions that are being outsourced.
There are two main problems with conventional wisdom. First, we shouldn’t think in terms of business functions; we should think in terms of business processes. Second, we shouldn’t think in terms of front, middle, and back anything; we should think in terms of value contribution.
In any business, there are three types of business processes:
- Those that create the value delivered to customers.
- Those that lock in the value created.
- Those that enrich the customer’s perception of the value created.
In an investment management firm for example:
- Decisions to buy, hold or sell assets create value in the form of investment returns.
- Efficient market processing of buys and sells ensures that value is not eroded by delayed execution or late settlement.
- Effective client communications ensures that investors understand the rationale behind investment decisions and enhances their perception of the value being delivered.
Any business process can be outsourced. However, those that create value for customers and those that enrich the customers’ perception of value are more likely to be retained in-house to ensure effective governance.
Business functions are organizational structures of business process groupings. Front-office businesses are generally value-creating processes; but this is not true in every case. It is the decision to buy, sell or hold an asset that creates value; the execution of those decisions locks in the value. So while ‘investment management’ is a value-creating business process, ‘order execution’ is not. This is why some asset management organizations have begun to consider outsourcing their dealing desks.
Also, business processes may be grouped differently in different organizations. In some, Performance may be part of Operations; in others it may be part of the Risk function.
This is why thinking about outsourcing scope in terms of business functions is bad.
The provider’s perspective
Business relationships have to be based on the principle of beneficial mutuality; both parties in a relationship have to benefit from it. So, when considering outsourcing it is important to consider the provider’s perspective; failure to do so will result in an outsourcing relationship that will not be sustainable.
From the provider’s perspective, one of the most important considerations is the degree of standardization in business processes. It is easier to achieve economies of scale for standardised processes. Therefore, the more standardised the business processing that is outsourced, the greater the benefit that the provider will derive from the relationship.
Outsourcing is not a binary decision
In asset management, the decisions on whether and what to outsource are not simple ones. The fact that one organization has successfully outsourced an area of its business does not mean that all organizations would experience the same level of success.
For example, some investment managers produce client reports with the same structure and format for all of their clients; other managers customize the format and structure for individual clients. If in both cases the main motivation for outsourcing is to reduce costs, then outsourcing the business process for the former will be more successful than for the latter.
When considering outsourcing, a framework is required that goes beyond conventional wisdom to ensure the success of the initiative. The table below illustrates such a framework.
Business Process A is a strong candidate for successful outsourcing; Business Process B isn’t. Bear in mind that both business processes could be in the same function, in which case we would be looking at an intra-departmental outsourcing boundary. I am not saying that Business Process B should not be outsourced along with Business Process A. But I am saying that for Business Process B you need to consider the outsourcing decision and transition the process with much more care than for Business Process A.
If you don’t look beyond conventional wisdom and think in terms of a framework like this, you may end up regretting the decision to outsource.
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