Case for outsourcing bolstered by industry shifts

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By A Paris - The case for private equity outsourcing has been bolstered in the past year as general partners (GPs) are having to handle larger volumes of data and compliance teams are stretched to their limit. Industry participants have attested to the growing burden that private equity operations are facing and the potential fragmentation to which they may be vulnerable.

“Technology and data-gathering pain points that are a source of irritation for principal investors in normal times have become a source of critical risk. A patchwork of systems, complicated processes, and fragmented data often require teams to run a gauntlet to complete routine analyses, with many resorting to manual workarounds,” note partners at Boston Consulting Group in a report outlining the optimal post-crisis operating model.

This state of affairs has been thrown into further relief by the Covid-19 crisis. John H. Eley, chief executive officer at GoldenSource reflects on the increase in outsourcing witnessed after the dotcom bubble and the 2008 financial crisis. He writes: “These historical events and their impact on asset services outsourcing form a precedent for another spike in outsourcing due to the current economic crisis.”

A survey by Northern Trust revealed almost half of the 300 asset managers included in the study were considering outsourcing their data management within the next two years. A third were also mulling delegation of their middle-office functions.

In the view of Michael Tracy, director, Lionpoint, the two – data and middle-office – are linked. He says data-heavy tasks in the middle office are prime candidates for being outsourced. Tracy notes: “External support for asset management, portfolio analytics and valuations, is a nascent kind of outsourcing framework that is growing significantly. This includes data collection for portfolio companies. In these situations, the outsourced provider collects all the financial data and operational KPIs from the portfolio companies and aggregates it within a system – be it their own or that of the PE firm itself.”

PwC’s 2020 Private Equity report finds that 84 per cent planned to invest in digitalisation and 81 per cent of this group specifically aimed to focus on data analytics. In addition, 95 per cent of these have used analytics to source deals.

Given analytics are expected to play a significant role in PE firms going forward, investment professionals need time to focus on their analysis and insight. Data alone does not provide value-add, it is the investment acumen which will lead to sound investment decisions. In view of this, it can make sense for the data-gathering exercise to be delegated to a third party.

The sustainability challenge

Another industry trend which further supports the argument for outsourcing is the rise of sustainability and ESG investing. S&P Global’s 2021 Global Private Equity Outlook, finds 40 per cent of PE/venture capital firms report they are planning to work on improving ESG standards within their current portfolio companies. The number of firms not considering ESG in the decision-making and post-investment process decreased from 25 per cent last year to 19 per cent this year, whereas the number of firms just starting to introduce ESG in their strategy increased from 18 per cent to 24 per cent.

“The results show a clear shift indicating that many firms that had not tackled ESG last year will be working on it this year. ESG was already gaining in momentum but the pandemic amplified and accelerated the need for improved social welfare and governance,” write Ewa Skornas and Elisabeth Bautista Suarez at S&P Global.

This additional focus on ESG factors means more data to process. In addition, increasing regulation, like the Sustainable Finance Disclosure Regulation (SFDR) in Europe, means firms are facing a growing reporting burden. These are administrative tasks with which outsourced providers can support.

However, when selecting data providers, alternative asset managers need to make several considerations. Mackenzie Hargrave, VP, content and technology, Factset says: “As more firms consider how to incorporate ESG into their workflows, they are faced with the challenge of determining which sources of ESG information best align with their investment approach…. While the lack of consistency of data on the market can seem overwhelming, it is essential to understand the differences between vendors and establish a flexible framework for evaluating them.”

She goes on to remind players that “ESG data is only one component of the investment process – it is never used in isolation and always needs to be linked to financial reports, broker estimates, pricing, and more. As the space evolves, investors will need to maintain the flexibility to adjust their ESG strategy and, in turn, the ESG data they use while maintaining seamless connectivity to all data sources supporting the investment process.”

Far from the front

According to a number of industry reports, private equity could see the outsourcing of front-office functions, like portfolio management or even the act of trading itself. These functions “could now start to go to the asset servicers. This allows lean asset management firms to focus on investment decisions and using technology to research and analyse securities and the markets,” continues Eley at GoldenSource.

However, according to BCG, firms have not made enough efforts to streamline their organisation in preparation for this move. The consulting firm outlines: “Many principal investors have embraced lean teams but have not adopted new ways of working or made the right organisational changes to harvest their new-found flexibility… many routine processes feature multiple handoffs that require manual intervention. Such handoffs are exacerbated by fragmented technology and software solutions that hinder coordination and interoperability — such as the typical trade-booking cycle, which requires users to log on to several different systems to input data.”

Although service providers have created scalable capabilities to help the front office with marketing strategy and support services, other industry experts also think GPs still have a way to go for this to come to fruition.

Andy Welch, director, ACA Group, comments: “Considering the make-up of private market teams, the industry is never going to get away from needing someone in-house as a registered compliance officer and anti-money laundering officer. These are two very important functions that I can’t see being outsourced.”

Welch does not think the industry will get to a point where the regulated PE business is only made up of capital raising and investment decisions functions: “There are too many other necessary roles internally. In addition, some of these roles need to be a sounding board or hold the other two areas of the business accountable.”

Outsourcing in the hedge fund space and in liquid markets has made the transition into the front office where a large portion of portfolio analytics and trading can be outsourced. Due to the legal and slower nature of private transactions, this could be hard to replicate.

“One of the success factors of the private markets is the diligence and targeted nature of the investment team, followed by that team’s ability to analyse and promote growth in those businesses. This takes an enormous human effort, which I can’t see being replicated by technology in any way.”