RSM: Weighing up operating models

This article is sponsored by RSM US

Funds are being scrutinized more than ever in today’s challenging fundraising environment. Investment advisers of all types find themselves at the mercy of demands from regulators and prospective investors alike, and these demands have not shown signs of slowing.

One timely example is the stringent standards issued by the US Securities and Exchange Commission (SEC) requiring more detailed LP reporting and due diligence performed on service providers, including auditors and fund administrators. These increased demands have put more pressure on funds to not only create an effective operating model but also assess that model on a regular basis.

This article will offer insight into different options to consider for a fund’s operating model, which is made up of people, processes and technology. A key decision is whether to insource, outsource or co-source these crucial elements.

What is co-sourcing?

Co-sourcing is a hybrid fund administration model where the people are outsourced but the technology is insourced. In simple terms, it means a fund administrator can log in and utilize a firm’s instance of fund administration technology.

Private fund CFOs are too often putting out fires or are bogged down in their daily work to consider strategic changes to their operating model, so the aim of this piece is to provide a primer on co-sourcing, including some pros, cons and questions to consider when deciding the right model for a firm.

Co-sourcing vs insourcing

One of the advantages of a co-sourcing model over insourcing is operational independence. As we witnessed on the back of the Madoff scandal and the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act, regulators and investors have a growing desire to see the administration of funds being conducted by third-party providers.

Another factor to consider is the cost to the management company. Traditionally, insourced operations teams are expensed as overhead to the management company where outsourcing administration can, in most cases, be passed through as a fund expense, subject to the operating agreements of the fund. When combined with the desire of LPs to have a level of independent oversight, it can be a win-win for both GPs and LPs.

A further benefit is scalability, particularly if the challenges of running a lean back office amid fear of staff turnover are keeping CFOs up at night. While turnover happens at every organization, it can be more effectively absorbed and the disruption minimized at a third-party fund administration organization that brings a deep bench of experts.

Meanwhile, the drawbacks of opting for co-sourcing over insourcing include concerns around the perceived quality of resources. As a self-administered firm, a fund would have thoughtfully handpicked each team member based on experience, education and intangible qualities, such as cultural fit. By outsourcing the people aspect of the team, the firm is instead relying on an administrator to hire and allocate the right team.

Administrator dependency can also be a disadvantage. Any time a fund gains independent oversight of its administration by outsourcing, that can end up lessening its control over processes and timing and increase its reliance on the independent provider. While LPs and regulators find comfort in this, private fund CFOs may find the need to amend how they manage their own expectations.

The final issue to mention is process transparency. Alongside increased reliance on the fund administrator, co-sourcing can also lessen the visibility a firm has into detailed processes.

Co-sourcing vs outsourcing

When weighing up the relative benefits of co-sourcing relative to outsourcing, there are three main advantages to consider. First is transparency, in terms of both information and activity. Co-sourcing ensures a fund has 24/7 access to its data for reporting and/or review. It also allows for greater ability to monitor an administrator’s work. This is even more important with the proposed new SEC rules, including but not limited to the requirement to regularly assess the performance of material service providers.

The second advantage is that co-sourcing allows for a firm’s choice of technology. When co-sourcing, a firm can make sure that its administrator is utilizing the technology it feels is the right fit for the organization.

Third is the impact on administrators. Having an administrator work within a firm’s technology instance allows it to take an easier stance on transitioning to new fund administrators and the level of disruption this can cause. This should also have a positive impact on the performance and potential cost of administrators as a firm’s reliance on them decreases.

The disadvantages of opting for a co-sourcing rather than outsourcing model are mostly technology related, including technology cost, the need for internal IT resources, and keeping pace with tech disruption. Typically, funds will pay a premium for their own instance of any technology while administrators offer clients a license on their instance at a cheaper price point.

On resourcing, administrators have retained staff who are responsible for ensuring all their technology products are working as efficiently as possible. When funds have their own instance of any technology, the cost of that resource falls to them.

Administrators are also incentivized to always maintain the most updated version of their technology and have advanced training on any new features. Funds typically do not pay for upgrades as often as they should, and they may not have the time to remain current on optimizing upgraded features.

Furthermore, administrators have invested many years and countless hours honing their knowledge of their respective tech platforms; they have built libraries of customized industry reporting and have the vantage point of understanding the complexity of reporting provided to investors by leading asset managers.

Finding the right fit

Only by investing the time to evaluate the strengths and weaknesses of a firm’s current operating model can it make necessary improvements to enhance efficiency. With the proper awareness, due diligence and resources there will certainly be an appropriate path for each firm. For CFOs, knowing your firm and your options are the first steps in making the correct decision.

For help in balancing people, processes and technology, it is advisable for firms to look for a service provider that can scale to support growth and demonstrate deep industry knowledge. Afterall, when prospective investors come to CFOs with questions, they will want an experienced adviser that can provide insight into every direction of the market and help navigate proposed regulations. In today’s challenging fundraising environment, a firm’s ability to meet increasing investor and regulator demands and execute without distraction can provide a competitive edge that will help it succeed.

Key questions for CFOs

There is no universally correct answer to which operating model a fund should choose. However, there are some key questions CFOs should consider when deciding how to move forward.

This includes questions around scale and growth: is your firm growing in complexity; does it have sufficient resources to meet this growth; and would it benefit from having unrestricted access to the functionality of a fund administration platform as it scales?

Given the fast-evolving regulatory landscape, does your firm have the right resources to keep up with the role regulators are asking CFOs to play? And, importantly, how would your LPs feel about back-office independence?

Firms should also consider key person risk; will even slight turnover cause major disruption? And what about cost? Do your fund documents allow you to allocate co-source and outsourced administration as a fund expense? Is the firm large enough to rationalize the additional cost of a direct technology license?

There are questions to ask around tech integration, too: do you foresee the need to integrate additional technologies with your fund administration platform, and does your firm want an elevated level of control and flexibility in pursuing these initiatives down the road?

Finally, firms should weigh up expectations around future provider transitions, including how to ensure an efficient migration from one third-party fund administrator to another, in the event they are not happy with the performance of a provider.

William Andreoni is a partner at RSM US, Louis Crasto is a senior director and a national co-leader for RSM US’s fund administration practice (RSM Fund Services+), and Adam DePanfilis is a director in the firm’s fund administration practice