Strategic Outsourcing for Fund Managers: Enhancing Operational Efficiency and Focus

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Christy: Hello, everyone, and welcome to today's webinar, "Strategic Outsourcing for Fund Managers: Enhancing Operational Efficiency and Focus." My name is Christy DeMaio Ziegler from the CSC webinar team.

Joining us today I have the pleasure of introducing our moderator Drew McMahon. Drew runs the marketing for CSC's fund business and focuses on growth strategies for CSC's suites of services for fund managers. Prior to joining CSC in 2020, Drew developed products and go-to market strategies for a number of private capital and hedge fund firms in the U.S. and Europe. All right, I'm going to turn it over to Drew, and he's going to introduce our panel.

Drew: Thanks, Christy. Joining me today on the panel is Marshall Saffer. He's the Managing Director and the Head of Global Fund Sales at CSC. Marshall recently joined CSC through our acquisition of Intertrust Group. For the past 25 years, Marshall has provided solutions for many of the largest PE funds, hedge funds, and traditional asset managers, bringing a deep understanding of operations and a strong technical background.

Gerry Polizzi is the Managing Partner and COO of West Tower Group, a multi-strategy investment firm. Gerry is an accomplished senior financial executive with 28 years of experience in banking and alternative asset management. Prior to joining West Tower Group, Gerry had a senior role in Bank of America's prime financing operations. He also spent 15 years at UBS in various leadership roles, including the creation of a major product servicing quant funds.

And finally, Bill Saltus is the Hedge Fund Business Consulting at Wells Fargo. Bill is responsible for best practices consulting around hedge fund operations and the maintenance of vendor and service provider relationships. He also develops strategic content, including thought leadership pieces and benchmarks of hedge fund performance and operational metrics. Prior to joining Wells Fargo, Bill was a director within the Citi Prime Finance Business Advisory Service team.

So today's agenda, we're going to cover the areas of outsourcing available to fund managers, best practices of managing outsourcing relationships, strategies for mitigating outsourcing risks. We'll be providing real-world examples of successful outsourcing arrangements. And finally, we'll end with some live Q&A.

Before kicking it over to the panel, I wanted to quickly call out some of the market challenges currently facing hedge funds, that create this need for looking at flexible and strategic outsourcing solutions. We've seen certainly an increase in fund complexity, be it moving into new strategies or asset classes or expanding into new geographies. Of course, there's an increased need of investor-driven reporting, be it ESG data or fees and expenses transparency. With the expansion into new geographies, there's also, particularly with feeder funds, there's also a pretty big operational burden with staying on top of regulatory requirements across various jurisdictions. And finally, data, it's how to best use this data and synthesize meaningful insights from data that's housed across multiple technologies and platforms. So the confluence of these types of market challenges really have increased this need to look at operational outsourcing solutions to really lower the operational burden for fund managers.

I'm going to turn this over to Marshall first so we can talk about some of the things that we see for the keys to optimizing fund operations.

Marshall: Thank you, Drew. And I'm going to leave it, and we can discuss it with our panel here. But obviously there's some bullet points below regarding the components of where we see outsourcing playing and coming into the fold, whether it be asset class complexity, fund complexity, data complexities, scalability, people aspects, and trying to get new systems or infrastructure to support growth through different business lines.

I think that the real components of outsourcing, we're seeing an uptick over the past couple months, and I think a lot of what's driving these discussions or decisions around outsourcing, it's kind of interesting. Whenever we see a market go flat or returns get harder to come by, we see that fund managers, both on the private equity side and the hedge fund side, looking to figure out how to minimize costs and maximize efficiency, which ultimately impact returns. So I think a lot of with the decisions or the discussions we're having are driven around those two factors.

Bill, I mean, what do you think about all that?

Bill: I agree, right? So I think what we just went through in 2022, coming out of this, knock wood, this pandemic era kind of reminds me of coming out of 2008, right, and some similarities and a lot of differences. But I think Marshall hits on a thread between those two recent eras, which is I had a lot of conversations in 2009 about funds trying to rationalize their infrastructure and all the technology that they had built up and/or bought and all the people that they had hired to run that technology and support that technology, and then they were looking to consolidate down, right, maybe get a unified portfolio management system that could replace five different things that they had built into or bought and maybe outsource some of the work and the maintenance of those systems. So that was now 15 years ago now at this point amazingly. It feels like yesterday in some ways.

But then part of that is coming out of this 2022 year, where performance was down, right, hedge funds I think, as an aside, did relatively well, which means if you were down 10%, you did twice as good as the S&P . . .

Marshall: True.

Bill: . . . which is cold comfort. But I think we're kind of entering an era here in 2023, and, Marshall, I mean, you and I've talked about this, you're getting phone calls and we just wrapped up the first quarter, where people are saying, "Okay, now that 2022 is behind us, we understand kind of where our revenues are, where the shortfalls are. Now we have to kind of rationalize our own operations and infrastructure. So let's have the outsourcing conversation."

Marshall: Yeah. And Gerry, what's your perspective, I'm just kind of curious, being on the fund side?

Gerry: Look, I've been on the fund side, I've been on the sell side as well. I think your points about 2008 are kind of are spot on. Look, it was a crisis situation. There was a regulatory response to that crisis situation, and there was a set of standards that were applied that have had a pretty profound effect on the industry in the years going forward. And I think if there's one thing that's always constant, there's always going to be some form of regulatory response to crisis situations. I mean, those are politically-driven actions, and you have to be prepared to be unprepared in those situations.

I think that the objective of trying to manage and drive down costs is something that it's a good business practice that I think both sell side and buy side have been kind of forced to adopt. I think there was a trend that, going back 15, 20 years ago, where everybody was kind of driving towards building their own technology and owning their own technology and creating bespoke solutions that suited their business needs because in certain areas, particularly in the derivative space, there was an inconsistency with what the regulatory regime was going to look like and how certain standards needed to be applied so that people, they build stuff ad hoc.

Now that there's been a little bit more standardization around that, it's driven people to kind of think about how they have to re-engineer some of their own proprietary infrastructure to accommodate industry standards. The good thing about building your own stuff is it's your own stuff. The bad thing is it's your own stuff and you've got to maintain it. It doesn't necessarily lend itself to that scalability.

So I think the concept around outsourcing extends in a lot of different areas, whether it's operational outsourcing, technology outsourcing. Like if you look at every single area of any business that is being run, whether it's buy side or sell side, there's a component of outsourcing that people have had to consider and adopt because the expenses for transforming and changing your business to meet regulatory demands or market demands has only accelerated. And if you don't look to leverage that, then you're going to find yourself in a position where you're going to be in a very unprofitable business in a very short period of time.

Marshall: I think those are great points. Okay, so let's look at some of the specific services that we have available and what fund managers are looking at in this world of strategic outsourcing. At a high level we're talking about that middle and back office fund operations, but that includes the daily operations and middle office ops, like trade processing, valuations, reconciliations, cash or market values, settlements. And the treasury ops, like liquidity management, collateral management, and the wires processing. But we're also talking about the more traditional fund administration, portfolio NAV processing, master feeder allocations and investor allocations. And then finally the bank debt services, we've seen a big uptick in the use of credit facilities across funds and the need for some of the ops support there, be it full loan admin and loan agency or just something as simple as like processing drawdowns.

But to our panelists, among this kind of broad list of services, are you seeing funds looking at outsourcing one service over the other or any of these needs or funds that require a lot of skills technology have struggled to build in-house that would be a particularly good fit for a strategic outsourcing model?

Gerry: Yeah. I think it kind of depends on where you are in your evolution. When you're getting a business off the ground, you have a lot of stuff that you've got to get done, and the benefit of outsourcing kind of it gives you the ability to kind of scale an expertise in areas where you just haven't had an opportunity to really build out your staff. And that's a good short-term solution, but even on a longer term basis, like there are certain aspects of it I think that have relevance throughout.

So like if I think about like kind of T0, T1 reconciliation work, I don't know. Like there's not a great amount of an inherent benefit to me to have a staff of people in-house that do that work for me. Ideally if I've engineered my systems, the interplay between my order management system and my accounting system properly, that reconciliation work should be pretty de minimis. And if I can leverage a group to do a lot of that work for me and just have a senior person oversee what they're doing and ensure that anything that falls outside of the scope of BAU gets escalated and addressed appropriately, that's a huge time and money savings for me.

I think that there are certain things about the treasury function that I think are important from an outsourcing perspective, but there's aspects of that that you're going to have to maintain internally as well. And again it depends on what your utilization leverage is, how complex of an organization you're running. Those are all important factors. If you're not running a very, very complex fund that uses a lot of leverage, then I think there's a great deal of benefit to having a team that can do basic outsourced treasury functions for you for collateral management and reconciliation work, and distill down what your liabilities are and give you a clear view as to where your cash sits and what you need to do to insulate yourself from any kind of credit counterparty risk without having to do a tremendous amount of work around managing that process. And again, those funds tend to be less involved in the derivative space, and the complexities around the collateral management needs there tend to be lower.

So that's where I think that benefit can really be realized, and as a business owner and manager, you can kind of focus your efforts and your dollars and your internal staff on things that are kind of accretive to making money as opposed to kind of functionally essential but don't necessarily yield what I would call operational alpha so to speak. I think leveraging the tools of outsourcing actually gives you operational alpha because your internal staff, it frees up their mind space to focus on things that you really need them to focus on.

Bill: So some of the things that Gerry said really resonate, one of which is the concept of (a) it depends on where you are in your life cycle and obviously what kind of fund are you, right? Do you use leverage a lot? Do you not? What asset classes are you in? Are you new, or actually have you been for a while? So to Marshall, to your specific question I will give you a couple of examples that I've seen very recently, and one of which is a startup.

And oftentimes when I'm working with a startup, there's sort of this age-old question of, "Do I hire . . ." It's not going to be a staff, right? "Staff" is probably a grandiose word. Do I hire a non-investment professional off the bat? I always or 90% of the time advocate that that answer should be yes, call that a COO. And if that's the case, then what kind of COO are we talking about, right? So there's a COO who's heavily operational and can run an operational organization. But that might not be the skill set that a brand-new fund needs or wants, right? To Gerry's point about operational alpha, if you hire one person who's not making investments and they're spending all day reconciling trades and chasing down prime brokers for wires and trade settlements and collateral movements , okay fine, but by the way if there's just that one person, perhaps they should really be an extension of the marketing effort and liaise between the PM who's busy trying to generate alpha and build the business from that perspective.

So I always advocate for a new launch of some size, right, not necessarily billions of dollars, but hey enough so that you can have that kind of seasoned professional who can go out there and kind of carry that torch and carry that banner that says this is what we do. I can articulate the strategy. I can help the manager think about developing a strategy and really face off with perspective and existing investors. And so if that's the one non-investment professional, then you need to be hiring an outsourcing firm to basically handle the everything else that maybe isn't the alpha producing part of it. So I had that conversation yesterday, right?

So that's definitely something that's relevant and is a common theme whenever I come across a situation like that. I mean, that's one example and I could give more either now or later, but, you know, Marshall wherever you want to take it.

Marshall: No. Sure, I think we've spent a lot of time talking about these components. I think it's been a great discussion. Drew, back to you then.

Drew: Well, actually, Marshall, as Gerry and Bill both mentioned, just different models of having that in-house and outsourced solution and kind of various mixes of that, would this be a good time to talk about how some of these services are delivered, so how an outsource solution can work with the in-house team?

Marshall: Sure. I mean I think it's important that the nature of the relationship be we use the word "bespoke" around here at CSC a lot, right? I don't think there's one size that fits all, right? So anybody who tells you that their solution is the best for outsourcing probably doesn't really realize what they're talking about.

So when we address an outsourcing client, there are predominantly two ways that we engage with a client. We have systems, such as in-house accounting systems and in-house reconciliation proprietary tools, that we can leverage to bring our solutions to the client base. That's one option. Or for some of our larger clients, who already have invested in infrastructure, we have the ability to work on their systems, in which case it's more of a staff augmentation working alongside their people on their solutions remotely.

So based on the two flavors and that continuum of everything from post-trade processing through NAV production, we can create a business model that is unique and differentiated for each client depending on what they need. Some clients want recon. Some clients just want bank loan processing and agency. So I think the delivery varies definitely client by client, but I think that they all share the same end result, which is that our team or any outsourcing team should be considered an extension of the organization. And if that isn't happening or if the end result is not achieved to where the outsourcing provider is viewed as part of the staff or an extension of your staff, then I think the outsourcing relationship has not really done what it was supposed to, to fulfill the real need. But that kind of summarized the delivery, end to end or anything in between.

Drew: Great. Thanks, Marshall. So we're going to move on and really kind of look at more like discussing the business case for strategic outsourcing. So there's a lot of ways to improve operational efficiency here, and we're talking about everything from institutionalization, technology, sustainability. But I'd like to focus in a little bit on scalability, being nimble and maybe being able to manage scale both up and down is obviously essential for efficiency. And when you're seeing building in-house infrastructure can be expensive and has a very high fixed cost. I put this to the panel. Are there good examples of managers when say they step into a new asset class, building up in-house capabilities and infrastructure to support that asset class, only by then to have the investment opportunity sort of dry up or the market go south a little bit and they're stuck with that fixed cost? So are there good examples of reaching to, say, a new geography or a new asset class, where doing things in-house is really not maybe the best way to approach scalability and therefore efficiency?

Marshall: I think Gerry or Bill are probably better for that. They see the most. Obviously, Gerry is doing this now, and Bill sees this on a regular basis. So I'm going to defer to them.

Bill: I'll just give a quick overview, and then you can give maybe specific examples. And we touched on some of this already. The scalability is important. We've kind of talked about ramping up and ramping down, right? So 2008 and '09, then maybe '23 is a ramping down conversation. But at the same time, I think 2023 is a ramping up conversation as well, as Marshall said. Private equity firm looking to get into credit, hedge fund looking to get into PE, I need to ramp up capabilities as I just got an investor to give me a slug of money to go do this other thing. So that's definitely easier in an outsourcing sort of model or paradigm.

And so the COO kind of becomes . . . I always think of this, the modern COO as a general contractor, right, managing different relationships and external parties that are performing different functions. But the reason we do that, right, the reason if we're working on a house or building a house we hire a separate plumber, electrician, or whatever else is because that's just more efficient than hiring one person who thinks he can kind of do a little bit of plumbing and electricity, right, or trying to learn it all myself . . .

Marshall: An example, that's great.

Bill: . . . which would never happen. So yeah, so I think the scalability thing is really just the COO being, to mix metaphors, the general contractor or the quarterback, right, just kind of directing it all and ramping down and up, depending on what's called for more likely.

And then the last thing I'll say, which is kind of a common trope when talking about outsourcing, but fixed versus variable costs and the considerations there, and hiring internal personnel that now you have to pay benefits to yourself and not being able to ramp them down as easily let's say as an outsourcing agent. So I think those are common tropes and maybe Gerry can pick that up from there. Yeah.

Marshall, I mean, right, that sort of . . . I don't think we've said the words fixed versus variable costs before, but I mean that's . . . and that cuts both ways, right? If I hire three people and assume that's a big hit upfront. But then if I go ahead and double in assets and I didn't have to hire anybody else, then that ends up working out in my favor, right? But you're kind of taking that risk on as a business manager versus the outsourcing, which the cost might go up as you grow, but I'm not that placing that upfront and have that capital outlay upfront of that.

Gerry: I will add on more to that, Bill, right . . .

Bill: Yeah.

Gerry: . . . because one of the discussions on cost is the assignment of the cost at that point, right? When you start talking outsourcing, and you can speak to what funds are doing across the board, but there is this concept of management company expense for resources versus fund expense and the potential shifting of costs from fund or from management company to fund as a potential discussion as well, correct?

Bill: No, that's . . . I mean, that's right and obviously refer to your fund docs and what cost the investors will bear, etc.

Gerry: Look, technology is probably the most important spend in any budget, and I think it's the most important focus of any organization. If you use technology the right way, it creates leverage and scale for your organization, and it sets you up to do things in a very efficient way. But that design, that blueprint needs to be kind of well thought out ahead of time. And I've always been a big believer in not trying to recreate the wheel on things.

So what you want to do is you want to use technology vendors that are very, very good at the things that you need them to be good at. And hosted solutions I think are way better than locally-based solutions in my view. Cloud-based solutions are ideal. I mean, the amount of infrastructural cost savings that you enjoy by being in a complete virtual environment is extraordinary. Your technology costs are probably less than half of what they would ordinarily be. It saves you the trouble of having to worry about having a hot DR site. I mean, we've built our entire business based off of the virtual environments. We're leveraging all of our VDI infrastructure, and we've embedded everything into our cloud, and that gives us extraordinary scale and leverage to continue to build our business, but while being very observant of what the costs are for having to manage that.

But my philosophy has always been, like I said, don't recreate the wheel. Pick vendors that are very good at doing the things that you need them to do. But also don't underinvest in the types of people that you have employed in technology. So if you have vendor applications that have an open-source API infrastructure that allow you to harvest data and information into your own data warehouse, then you can start to spend development dollars on building out applications to supplement where some of the things that you may need, like that might be might be more particular to your organization. So you're leveraging the tools that are given to you by your accounting system or your order management system, and then you're supplementing through your own user interface build, if you have the right developer on your side. But it makes it so much easier to do if you're doing that in a hosted environment in the cloud, and then you just . . . Your IT person, your internal IT person should be a developer, and then the people that are actually managing the actual IT infrastructure I think there's a tremendous amount of value to having an outsourced team that just manages that for you.

Bill: Yeah, Gerry. That's great. This is Bill again. Some build versus buying concepts, and they're obviously very related to outsourcing. And I like the way you think about technology and technologists. And 20 years ago, you'd have an IT organization at an asset management firm, and this half was the infrastructure team and this half was the development team. And somewhere in the middle there might be desktop support or whatever it is. And really on the infrastructure side, I mean, depending on your size and scale, you probably don't need that because you've outsourced that.

And on the development side, even that has changed insofar as you don't need someone to build core capabilities around accounting and trading and things. Their time could be better spent, to your point, tapping into the resources of the third parties and service providers, that you've contracted with, to really kind of customize and work on integration and work on really a little more front office technology, right, a little bit more alpha generation, right? How can I harvest the data from my outsource partners and maybe work on investment models, right, or things of that nature?

So it really allows you to focus differently than maybe you had to 20 years ago. I mean, you had to do that 20 years ago as well, but your effort was just getting to the point where you were able to do that and now you can lean on other parties to maybe do that heavy lifting and you can kind of focus on operational alpha, just more alpha producing endeavors.

Gerry: Yeah, I think focus on the things that are going to make you money.

Marshall: Drew, back to you. Do you want to move?

Drew: This slide is kind of what are we working towards with these fund operations. It's getting that balance of the outsource and in-house model corrects, where you would get improved operational control, analytics, that operational alpha, and risk mitigation. But Gerry, as COO of a fund, do you have some final thoughts on outsourcing? I know you talked about the tech stack and what we would call being tech agnostic with your service providers. But other tips or ways to avoid pitfalls in building out that mix of in-house and outsource solution and how to really manage that outsourced vendor selection and relationship?

Gerry: Look, I mean, okay, so first of all, you want to make sure that the folks that you're choosing are the right counterparts, that have a demonstrable good track record of service delivery to the clients that they are dealing, that are part of their framework. I think it's a good practice to either have a vendor DDQ or obtain everybody's SOC 2s and make sure that folks are doing what they're supposed to be doing, to ensure that they're adhering to their own policies around data protection and cybersecurity risk. That's always something that I think you want to be observant of.

So there's some clinical things I think you want to do to ensure that you're choosing the right counterparts, and then there's some software things that you want to do. Like once you've committed to an outsourced relationship, treat them as your partners. This is kind of like . . . maybe it's management 101, but everybody is a human being. You want to be respectful of folks. You want them to feel like they're part of your team as opposed to just some utility that can be used and abused quite frankly. And I've seen it from both sides. You're not going to motivate people to work hard and work well for you if you're not treating them properly. And I've seen the negative effects of when people mistreat the folks that they're dealing with, and interestingly enough they're surprised that the results are not what they would have expected it to be.

And that seems intuitive to me, but not everybody has an appreciation for it. And it's easy to lose sight of. That whole idea of like they're over there, out of sight, out of mind, like you've got to free yourself from that, and you have to recognize that if you're interacting with them, then you've got to treat them like they're on the team.

Drew: Marshall . . .

Marshall: Yeah, I think just to add my two cents. Yeah.

Drew: Please.

Marshall: So from an outsourcing standpoint, another thing that I hear a lot of is, right, the relationships with outsourcing, you might get more benefits than if you do it yourself, right? There are certain things that if a firm specializes in say reconciliation, right, if you do it yourself, you're worried about doing the match and then maybe doing the resolution. And you're in this I've got to get the task done, right? Every day I'm getting the task done. But the whole level of operational oversight and alpha, meaning researching how many breaks you've had for a period of six months, solving actually the root cause of breaks, or getting analysis to why that break is happening, through outsourcing relationships or collateral management or accounting, I think you get some of these higher-level functions that you don't necessarily get when you do the job yourself.

So I think there are some benefits that should be looked at, that are beyond just cost or timing. But it's actually raising the level of service and the components of what you can get out from the relationship. Bill, what do you think?

Bill: Yeah. So let me pick up on that and then pick up on another point that Gerry kind of mentioned and I think that gets us to a good spot with this slide. So Gerry was talking about the back office being an extension of the team. And then, Marshall, you were just saying, and literally I was focusing on two things and I just dropped what you were just talking about. Give me a quick cue.

Marshall: About how the nature of the service can be elevated, right, rather than just going from a task that has to get done. That's all.

Bill: Oh, yeah. Yeah, sorry. Just thinking back on that, we've seen that a lot. And I know like in what I do for a living or part of what I do for a living, I'm working on spreadsheets all day. And there's one part of the brain that ends up being 85% of your brain which says, "All right, is the data in the right format? Did I pivot it correctly? Is the data clean? Okay, I think I got the machine kind of set up." And now, boom it spitting out numbers. And then it's like I've got to just take that hat off and put on this other hat, which ends up being only 15% of my brain, that goes, "Now let me analyze what the heck the numbers are actually telling me." And oftentimes that hat gets lost and/or I don't have time to find that hat because I'm worried so much about like hedge fund some performance numbers or whatever it is that I'm trying to kind of process.

So I did reconciliations maybe 25 years ago in my career and things like that. So that it's not that. But I just know that the way that my human mind works, it very much resonates everything you just said. So therefore, if you have one team kind of working on the everyday, the numbers are lined up, and here's the results, then another party or the people that you have on your own staff can really focus more on root causes and get more efficient over time. And it's better for the bottom line and all that good stuff.

Gerry was talking about being an extension of the back office. I was just explaining to a colleague of mine yesterday, who was kind of getting muddled between here's an admin, here is an outsourced provider, and remind me of the difference again. And yeah, obviously it's muddied, and everybody [inaudible 00:36:21] or whatever. And the admin certainly [inaudible 00:36:24] extension of your team to an extent, but they have a very significant function, but they need to do it for everybody. They've got [inaudible 00:36:30], and they have to do shareholder services and everything else and kind of auxiliary to that.

And so versus the outsourcing agent really is like, okay, to simplify it, you either hire somebody to do this task either on your staff or you outsource it. And so if you think about that, it's completely fungible between being outside the organization or inside the organization. That's what that is, right? So it's kind of like the [inaudible 00:36:57]. You can kind of explain it that way.

And then everything Gerry said very eloquently about management 101, treat them as people and as part of the team and make them feel like they're growing with you and learning along the way. So yeah, all that resonated.

And I'll kind of leave you with this last example as we come up closer to time. Yeah, just a client of mine who's looking to get a PMS after transitioning off of some technology that a service provider was giving them. And so there's no [inaudible 00:37:30]. They had a service provider doing a lot for them, and now they need this new piece of technology. They realize not only do I not want to run this myself, I've never done that before and I don't have the people. So gee, it makes sense for me to go get a third party that I can get one and a half people, right, it's a little bit of the person and backup coverage to do this for me for half the cost of what would it cost me to hire one person with no backup, right? So it economically makes sense. The model is better because there's backup.

I lied. I've got one more related sort of client. Client had launched sometime just pre-pandemic. New client of ours and doing very well. One non-operational person, they're in California, he wanted to take a vacation to Hawaii, right? S market hours are like midnight. He was waking up at midnight just to start the trading day. So there's all these things that kind of crop up when you say, "Oh, if I had that third party with some backup, when I'm gone for a week with my family, right, or God forbid I get sick," the backup is important.

So it is a cost thing, right, and variable versus fixed and ramp-up versus whatever. There's just this ancillary benefit of having extra skilled hands that can kind of do this for you and/or serve as a backup to what you do already. So just myriad benefits, and it's hard to cover them all. I think we've done a pretty good job covering many of them.

Marshall: Yeah, we tried.

Bill: But I wanted to kind of get that in as well.