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Insourcing, outsourcing and co-sourcing: Which is right for you?

Weighing the benefits and drawbacks: What to consider and why

February 01, 2024
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Financial management Private equity

There’s no question that funds are being scrutinized more than ever in today’s challenging fundraising environment. Investment advisors 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 Securities and Exchange Commission (SEC) requiring more detailed limited partner (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.

As a fund chief financial officer (CFO), chief operating officer or managing partner, you likely face a barrage of questions from LPs regarding middle- and back-office functions. When you can show that those operations are running at peak performance, it instills peace of mind for investors both at the time of initial investment and as part of their ongoing operational due diligence.

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 your fund administrator can log in and utilize your firm’s instance of fund administration technology.

Private fund chief financial officers (CFOs) too often are putting out fires or bogged down in their daily work to consider strategic changes to their operating model. The goal of this article is to provide you with an unbiased primer on co-sourcing, including some pros, cons and questions to consider when deciding the right model for your firm.

Unfortunately, there is no universally correct answer to the question: “Should I insource, co-source or outsource?” Each organization is distinctive and has unique growth trajectories; with differing strategic priorities, you will need to weigh the pros and cons of each model to determine what is right for your firm today and tomorrow.

Co-sourcing vs. insourcing

Advantages of co-sourcing vs. insourcing

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.

Cost to 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. When combined with the desire of limited partners (LPs) to have a level of independent oversight, it can be a win-win for both general partners (GPs) and LPs.

Scalability

Is trying to run a lean back office amid fear of your staff leaving keeping you up at night? While turnover happens at every organization, it can be more effectively absorbed and the disruption minimized at a larger fund administration organization.

Disadvantages of co-sourcing vs. insourcing

Perceived quality of resources

As a self-administered firm, you thoughtfully hand picked each engagement team member based on experience, education and intangibles (i.e., cultural fit). By outsourcing the people aspect of the team, you are relying on your administrator to hire and allocate the right team to your engagement.

Administrator dependency

Any time you gain independence by outsourcing (see above), you end up lessening your control over processes and timing and increasing your reliance on that independent provider. While LPs and regulators find comfort in this, you as the CFO may find the need to amend how you manage your own expectations.

Process transparency

Just as you have added reliance on your administrator, with co-sourcing you also lessen the visibility you have into detailed processes.

Co-sourcing vs. outsourcing

Advantages of co-sourcing vs. outsourcing

Transparency to information and activity

Co-sourcing ensures you have 24/7 access to your data for reporting and/or review. It also allows for greater ability to monitor your administrator’s work. This is even more important with the proposed new Security and Exchange Commission rules, including but not limited to the requirement to regularly assess the performance of material service providers.

Your choice of technology

When co-sourcing, you can make sure that your administrator is utilizing the technology you feel is the right fit for your organization.  

Impact on administrators

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

Disadvantages of co-sourcing vs. outsourcing

Technology cost

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.

Need for internal IT resources

Administrators have retained staff who are responsible for ensuring all their technology products are working as efficiently as possible. With your own instance, the cost of that resource falls to you.

Technology disruption

Administrators are 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 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.

Takeaway

There is no universally correct answer to which operating model you should choose, but some questions you should consider when deciding include:

  • Growth: Is your firm growing in complexity?  
  • Resources: Do you have sufficient resources to meet this growth?
  • Regulations: Do you have the right resources to keep up with the role regulators are asking CFOs to play?
  • Key person risk: Will even slight turnover cause major disruption?
  • Cost: Do your fund documents allow you to allocate co-source and outsourced administration as a fund expense? Is your firm large enough to rationalize the additional cost of a direct technology license?
  • LPs: How would your LPs feel about back-office independence?
  • Scalability: Would your firm benefit from having unrestricted access to the functionality of a fund administration platform?
  • Technology integration: 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?
  • Transition: Do you want to ensure the most efficient migration from one third-party fund administrator to another, in the event you are not happy with the performance of a provider?

With the proper awareness, due diligence and resources there will certainly be a right path for your firm. Knowing your firm and your options are the first steps in making that right decision.

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

In today’s challenging fundraising environment, your ability to meet increasing investor and regulator demands and execute without distraction is the competitive edge that will help you succeed.

RSM contributors

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