Aztec Group: Outsourcing’s perfect storm

This article is sponsored by Aztec Group

Outsourcing is increasingly a top priority for CFOs, according to Private Funds CFO’s Insights Survey 2024, conducted in partnership with Aztec Group. For fund administrators, this comes as no surprise, as managers are grappling with how to manage their fund processes against a challenging market backdrop and amid increasing regulatory and LP scrutiny, as well as advancements in technology.

As such, outsourcing has become increasingly appealing to managers that want to hone in on the key issues affecting their business while leaving their back-office functions to their outsourcing partner.

What is the principle behind outsourcing?

The principle behind a fund manager outsourcing back- or middle-office activities is essentially to free up time and resource to focus on what the fund manager is good at – deploying capital and creating products to distribute to investors. The processes chosen to be outsourced can vary, but we support fund managers with all aspects of their fund operations, particularly core services like accounting and administration.

There is a spectrum of options available to fund managers in terms of how outsourcing is utilized and leveraged. Activities may be managed end-to-end by a third party, or the manager may opt to target outsourcing specific processes or functions.

Outsourcing can also encompass the provision of support services and we are seeing variability in how fund managers utilize outsourcing, particularly around technology. One trend we are observing is the increasing prevalence of the co-sourcing approach, where activities are outsourced to a third-party fund administrator but delivered within the firm’s own tech infrastructure.

Why might a manager choose not to outsource?

Fund managers in the lower mid-market or mid-market, which we would define as those with between $250 million and $10 billion AUM, may feel they are better placed to manage processes in-house. Some may have concerns that the link between an outsourced back office and deal teams might be hindered, or that their ability to access their own data may be compromised.

A strong outsourcing partnership should mean the fund administrator is considered an extension of the fund manager’s in-house team, where data is readily available, and in a flexible and efficient way that best suits the front-office. What is clear to me is that, as the regulatory environment becomes increasingly complex and investors demand more from their managers in terms of operational rigor and reporting, the task of managing activities in-house has become increasingly challenging.

What do LPs think about outsourcing?

The main thing LPs care about is risk: is their data safe, can they access it securely, are robust controls in place around their back-office processes? With this risk-averse approach in mind, LPs are scrutinizing fund managers’ operating models more closely than ever before, and in some cases they are becoming active in the process of appointing a fund administrator.

LPs are also very aware of the fact that their experience of dealing with the fund manager is shaped and delivered by the fund administrator. They want the due diligence and onboarding procedures to be as seamless and robust as possible, and to have secure on-demand access to communications and standardized best practice reporting.

What role is technology playing in fund manager operations today?

Technology is playing a fundamental role in the evolution of our industry and specifically in fund operations and administration. Fund administration is often perceived to be manual in nature and, in some respects, quite antiquated. Automation will enable those activities to be done in a fraction of the time, with reduced errors and enhanced cybersecurity.

Leveraging data is one of the biggest challenges that fund managers face. They want to be able to use technology to analyze, interpret and liberalize the data they hold. Machine learning and artificial intelligence will help with predictive analytics around portfolio monitoring and fund-level monitoring, with platforms such as Aztec’s spin-out Lantern ai helping provide managers with greater insight into how their activities are performing.

Technology will also help drive the democratization of private markets, enabling retail investors to participate in these products by providing digital channels and marketplaces. In short, technology is going to disrupt the industry in a plethora of ways, and we are heading into a period of profound change. In some respects, we are in the midst of a type of arms race, where fund managers and fund administrators are looking at how they can evolve their operating model to embrace technology, digitizing the user experience to execute activities in a quicker, safer and more consistent way.

What are the advantages of working with a third party when it comes to embracing this technological change?

The advantage for outsourced administrators is that we can observe best practice across the large constituent of the market that we are serving. The challenge for those managing activities in-house, by contrast, is that they have a singular view. Technology can play a huge part in a fund manager’s operations, from onboarding to transaction administration, board meeting automation, investor communications and reporting.

Sourcing tech in-house to serve these requirements, not to mention hiring the skilled workers required to operate these systems, will come at a huge cost to a fund manager – something a third-party administrator can provide more efficiently through economies of scale.

What should a fund manager consider when first exploring outsourcing?

The whole business of managing private markets funds is becoming increasingly complex and in many different ways, ranging from the growing demands of LPs to the labor challenges that have become prevalent, increasing staff turnover and making it difficult to sustain in-house fund operations.

For any manager facing these kinds of challenges, my advice would be to get a clear understanding of the firm’s direction in terms of the strategies in play and jurisdictions covered, and then to assess what that means in terms of the types of structure you are supporting.

You then need to ask yourself whether you are set up to consistently deliver against the requirements of the business, and if the answer is no, you need to assess the level of commitment that exists to invest in the internal operating model. That might mean further investment in technology, in people, and in understanding how core processes could be improved.

I would then recommend having conversations with third parties to understand whether your requirements could be met through a strategic partnership. During those conversations, you should try to understand the third party’s philosophy as it relates to technology and how that could help you transition to a different operating model. You should also get a good understanding of their service philosophy because if you are outsourcing for the first time, you are going to need a partner that will be attentive and help you through each stage of the journey. It is certainly a big decision to make.

What does the future of outsourcing look like?

First and foremost, I believe the future of outsourcing will involve the greater use of technology. We continue to embrace automation and explore ways to leverage tools to deliver increasingly platform-agnostic solutions to provide our clients with increased flexibility and access to their data.

However, it will still be critical to retain high-quality staff to lead the delivery of the service model. The future of outsourcing relies on the successful fusion of people, process and digitized platforms.

I also believe that different models of outsourcing will increasingly gain traction – co-sourcing being the obvious example. Co-sourcing represents an interesting and novel approach to outsourcing, even if this method has its own limitations, as the traditional form relies on the fund manager dedicating the necessary investment to maintain technology at the required level as one such factor.

“Co-sourcing represents an interesting and novel approach to outsourcing, even if this method has its own limitations”

It also restricts the amount of innovation that can be delivered into that tech architecture, which will have been configured to reflect the needs of the fund manager at a particular point in time and may not be scalable.

For example, there are tech platforms that lend themselves more to the needs of private equity managers but that may not offer the same operational efficiencies for a real estate manager. Increasingly, we see our clients operating across multiple strategies. These firms run the risk, therefore, of having to manage, maintain and invest in multiple systems. This may create inefficiencies that an outsourced model would solve by having a progressive and strategic partnership in place.

That is not to say that the co-sourcing model cannot work. There are situations where the traditional outsourcing model is not necessarily the best solution. It is, to coin a phrase, a question of horses for courses, which is why it is so important to have a thorough understanding of a GP’s operating model, both now and envisaged. What are the strategic objectives of the firm and how could outsourcing, co-sourcing or a combination of the two, help achieve those outcomes over the short-, medium- and long-term? That is the question that firms need to answer.

What impact have recent regulations from the US Securities and Exchange Commission had on the outsourcing debate?

The recently announced Private Fund Advisers ruling generated a backlash in the industry even before it was formally passed, with some bodies reacting vociferously to the proposed changes. So much so, that there has been a lawsuit issued to contest the new rules.

One aspect of the ruling seeks to compel fund managers to increase disclosure to investors. In addition, reporting must be provided on a quarterly basis and delivered within a 45-day period. Quite clearly, those requirements will increase the workload for those firms that are managing operations in-house.

The intentions of the rulings are correct; seeking to create safeguards and increase transparency for investors. As a result, I believe this rule change could encourage fund managers to consider whether now is the right time to reassess their operating model and potentially seek third-party fund administrative support. The Alternative Investment Fund Managers Directive in Europe, for example, was certainly a catalyst for outsourcing and PFA could potentially have a similar impact in the US.