The benefits and risks of co-sourcing fund administration

Co-sourcing, also known as hybrid fund administration, combines some elements of outsourcing and keeping fund administration and technology in-house. Co-sourcing is often touted as a service that combines the best of both traditional solutions in that co-sourcing provides the fund manager with the flexibility and control that come with managing administration in-house, while also providing third-party back-office resources and specialised expertise.

In certain situations, co-sourcing can indeed be the optimal solution. But the reality is that the decision to outsource, co-source or keep fund administration in house is often difficult and complex.

In short, there are benefits and risks associated with each option, and the benefits and risks of co-sourcing — which is a relatively new solution — are not widely known. This article describes what co-sourcing is and why it’s an increasingly popular alternative for fund managers. It also summarises co-sourcing’s primary benefits and risks.

Co-sourcing: Background and reasons for its popularity

Fund managers seek help with back- and middle-office fund administration for a variety of reasons. Outsourcing fund administration has become popular with both established and emerging funds, though outsourcing typically becomes more attractive as funds grow and expand into new markets. As funds grow, fulfilling the compliance obligations of all relevant jurisdictions with resource-stretched in-house teams becomes riskier and more costly.

Outsourcing in the traditional sense carries other benefits. Fund managers get access to cutting edge platforms that are paid for and managed by the provider, and they get access to the provider’s operational expertise, all of which can create efficiencies and free the fund manager and others to perform their core functions.

This kind of full or traditional outsourcing can have drawbacks for some firms, particularly large, established funds that want complete control and instant access to their own data and want the ability to switch fund administration providers more easily in the event of unsatisfactory service or for other reasons.

Under a co-sourcing fund administration model, the fund manager implements and maintains its own accounting and other back-office platforms and engages the fund administrator to perform accounting and other functions on those platforms. This model allows the fund manager to manage and control its data and get instant access to it. It also allows the fund manager to switch fund administration providers without migrating data from one or more third-party platforms.

As we’ll see in the next section, there are other benefits — and risks — associated with co-sourcing. It’s worth noting here that co-sourcing is often considered by larger private equity and real estate firms that have traditionally performed  all their fund administration in-house and are expanding into new markets. These firms may transition to co-sourcing as a long-term solution or as an interim measure before gradually moving to a full outsourcing model.

The benefits and risks of co-sourcing

We’ve touched on some of the benefits of co-sourcing, but it’s worth outlining them in more detail, and listing some of co-sourcing’s risks, to get a better understanding of what fund managers should consider when performing due diligence on fund administration options and providers. We’ll start by expanding on co-sourcing’s benefits.

Benefits

• Improved data access and control. This is perhaps the primary driver of co-sourcing’s rise, and there are several reasons firms want to control their data. Today’s investors often demand unique or specialised reports with quick turnaround times, and eliminating the need to request and obtain these reports from a third-party administrator may improve response times. The same holds true when internal or external auditors request fund data and in other situations, such as when conducting a fund analysis. Furthermore, fund managers maintain control over who is using the data and how.
• No need to perform shadow accounting. Fund managers who outsource typically maintain shadow or duplicate records of the data they send to their fund administrator(s). Shadow accounting is not ideal in that there can be discrepancies and, even if carried out without errors, the administrative burdens of shadow accounting are significant. Co-sourcing allows the fund manager to keep one set of records that is the single source of truth.
• Increased efficiency. Because data is retained in-house and there’s a single source of data, co-sourcing tends to promote efficiencies — from eliminating many cross-organisational transactions to reducing reporting turnaround times. Increasing efficiency is critical to meeting the needs of today’s investors, who may demand ad hoc reports under tight deadlines.
• Improved data security. When managing fund data in-house, the firm retains control over data security. Eliminating the need to send data back and forth between the firm and the fund administrator decreases the possibility of a data breach. Maintaining data in-house, however, comes with its own risks, as noted below in the “Risks” section.
• Flexibility. As we mentioned, co-sourcing can be an attractive option for established, growing firms that have traditionally performed fund administration in-house. For these firms (and others), co-sourcing can be an effective model when expanding into new markets, as it eliminates the need to find and hire talent and to manage new, sometimes large teams. Co-sourcing also promotes flexibility around provider choice. Maintaining data in-house makes switching co-sourcing providers relatively easy, since there’s no need to migrate data from one or more platforms, either to another provider or providers or to in-house platforms. This is a particularly important benefit to larger firms that have funds in multiple countries.
• Access to third-party operational and technical expertise. One of the benefits of co-sourcing that may not be fully appreciated is gaining access to a fund administrator’s expertise. It’s understood that the fund administrator will provide back-office services on the client’s platform in this model. But a proven fund administrator that maintains and uses its own platforms can also provide invaluable advice on how to efficiently implement and maintain platforms and processes, properly conduct fund accounting on various platforms, maintain compliance with all relevant regulations and jurisdictions, and more. In some cases, the fund administrator can work with software providers and the fund manager to ensure the platform is optimised for the fund manager’s needs. In short, using an experienced fund administrator in a co-sourcing relationship can reduce operational and compliance risks (including risks related to cybersecurity) and promote operational efficiencies.

Risks

• The time and costs of implementing and maintaining platforms. Co-sourcing gives fund managers improved control over and access to data, but this comes at a cost. One benefit of traditional outsourcing with an experienced provider is that the provider itself must make the considerable initial investments (including time and money) in their accounting and other platforms, and make ongoing investments related to platform updates, testing, disaster-recovery plans, obtaining reliable IT support in locations where they operate and more. Fund administration service providers perform their tasks at scale, and offer cost-savings to their clients, precisely because they’ve made significant investments in robust, secure technologies. An investment firm must accurately weigh in-house platform costs against the benefits of co-sourcing when considering their options.
• Data security costs. We noted this as a benefit of co-sourcing because the firm maintains control over data security and eliminates the need to send data to and from an external provider or providers. However, managing fund data in-house comes with risks. Implementing and maintaining secure platforms is costly, and data breaches can cause reputational damage and lead to fines and penalties. These costs and risks can be minimised by using the platforms of a vetted, proven fund administrator that can provide evidence of its controls.
• The high costs of tailored services. Co-sourcing is a highly appealing fund administration solution due to the benefits mentioned, but benefits come with a price. Given the considerable costs of implementing and maintaining technology, as well as hiring and retaining accountants, consultants and other experts, fund administrators can offer their services most efficiently when those services are performed on their own systems and with their own people. Co-sourcing removes one element of that model and involves increased training on and familiarity with client systems and processes, often resulting in increased costs. Moreover, these costs — including training on new and updated systems — are ongoing rather than one-time expenses. Finally, it’s important to understand that vetting, hiring and managing ongoing IT support in new markets can be especially costly and burdensome.
• Fewer experienced providers. Many fund administration providers do not want to get into the business of co-sourcing for the reasons mentioned: They have invested in people, systems and processes, and some providers have determined that offering tailored co-sourcing services is not worth their effort. Furthermore, co-sourcing is a relatively new service for some fund administrators, and this lack of experience can lead to inefficiencies, delays, errors and other service delivery problems. As a result, fund managers conducting due diligence may find that the pool of experienced co-sourcing providers is smaller than they’d anticipated.
• The potential for increased management burdens. Fund managers who choose a co-sourcing model must not only implement and maintain platforms and cyber-security controls, they may also find themselves managing more of the ad hoc investor requests that must be carried out quickly on in-house platforms. A fund manager should expect the co-sourcing provider to effectively work with them to meet these kinds of requests, but a traditional outsourcing arrangement often reduces these kinds of burdens for the fund manager and places them more squarely on the fund administrator, who typically can more easily fulfil the requests on their own systems.

Additional considerations

Achieving and maintaining compliance with regulations in all relevant jurisdictions is a primary concern for fund managers. Keeping compliant is challenging in part because reporting requirements promoting transparency, sustainability and investor protections are evolving in virtually all jurisdictions. A fund administration provider with a global footprint can help a fund manager keep abreast of and fulfil current and future obligations in all relevant countries.

The decision to keep data and administration in-house, to co-source or to outsource can affect a firm’s ability to comply with regulations, no matter what jurisdiction or jurisdictions are involved. One proposed US SEC regulation demonstrates this. The proposed rule, called Outsourcing by Investment Advisers, would require investment advisors “to conduct due diligence before outsourcing and to periodically monitor service providers’ performance and reassess whether to retain them.”

Perhaps most significant here is that the investment advisor must periodically reassess the relationship with the fund administrator and switch providers (or bring the services in-house) if the relationship is deemed unsatisfactory. As we’ve discussed, switching providers under a co-sourcing model is more easily accomplished than switching providers under a traditional outsourcing model, since there’s no need to migrate the data when co-sourcing. If the SEC proposal becomes effective, it will likely increase the chances that a fund will have to change fund administration providers, making co-sourcing even more attractive. It should be emphasised that the SEC rule is in the proposal stage, and it’s unclear how heavily a fund manager should weigh this consideration, even assuming the proposal becomes effective.

Finally, because co-sourcing is relatively new, there remains some flexibility (and uncertainty) around how much of the fees from a co-sourcing engagement can be apportioned to a fund. As a result, fund managers have some flexibility when negotiating fund administration fees under a co-sourcing model.

A fund manager considering changing fund administration models, or starting a new fund, should almost certainly consider co-sourcing along with more traditional outsourcing. As we’ve seen, there are risks and benefits to co-sourcing. Generally speaking, co-sourcing will appeal to the largest funds, which are typically in a better financial position (relative to smaller firms) to take on developing and maintaining their own platforms. That said, smaller firms will also want to consider co-sourcing, not just as a long-term solution but as a potential interim measure before moving to a more traditional outsourcing model.