The Middle Market Case for Outsourcing
By enlisting third-party expertise, firms can efficiently respond to investor demands and streamline their operations to help support strategic planning.
For the past decade, the private equity industry viewed outsourcing with trepidation. When firms considered shifting operational functions to a third party, it was often labeled as a “leap of faith.”
That has changed as the regulatory landscape has become increasingly complex and this has fueled a growing list of investor expectations. Instead of seeing outsourcing as a risk, more general partners now rely on it for risk mitigation, particularly since areas such as technology, reporting requirements, and fund structures have become more complicated. By enlisting third-party expertise for fund administration, compliance, and management company services, firms can efficiently respond to investor demands and streamline their operations which help support strategic planning.
In the wake of the 2008 financial crisis, GPs have been compelled to rethink how they handle the burden of fund administration requirements. The priorities of limited partners have changed, and firms must address escalating demands for transparency. That means they must do more than deliver strong returns because today’s investor also cares deeply about reporting standards. That fact is particularly true if a fund wants to attract institutional investors. When it comes to cash control, independent oversight is a high priority for institutional investors and other LPs as well. Many investors even make outsourcing the role of fund administration a requirement.
Although firms care about responding to investor preferences, it’s not their only motivation for embracing outsourcing. GPs recognize they exist in an increasingly competitive landscape. With that in mind, they’re evaluating the best ways to create a competitive edge. Does that include spending time on something like handling performance fee calculations in-house? Probably not. They are looking for ways to excel at investing clients’ capital, and that’s not possible without effective use of time and resources.
By outsourcing key functions to increase efficiency, fund managers can focus on investors, deal sourcing, and portfolio management. Instead of handling fund administration, compliance, and the management company role in-house, firms can hire experts for those specific functions and use internal resources for oversight, not day-to-day execution. Fund administration professionals also benefit from a range of experiences with complex investments, which they can apply to GPs’ operational challenges. As a result, firms can devote more resources to improve business performance and drive long-term value creation.
Other dynamics that have accelerated adoption of outsourcing include regulatory and technology changes that affect firms’ scalability. As reporting complexity increases, so does the need for specialized knowledge. In addition, fund structures are more complex compared to a decade ago. That creates a heavy burden for in-house resources who must grapple with the volume of reporting requirements, as well as tax compliance headaches. Instead of taking on the expense of hiring a chief compliance officer who is fully engaged with constant regulatory changes, firms are outsourcing this function to service providers with a high level of expertise.
Beyond Excel’s Reach
Another area of rapid change is technology as firms recognize the need to move beyond the limitations of Excel spreadsheets. They want to reap the benefits of technologically sophisticated platforms that are constantly improving to support data-driven decisions and provide secure reporting. They need technology that enables the transparency investors demand. Increasingly, investors ranging from family offices to pension plans are requiring detailed data about prospective deals, cash flow, and portfolio benchmarks, and they want that information in real time.
Here’s the challenge: It is expensive to acquire or build the necessary IT infrastructure for secure communication, not to mention the cost of maintenance and upgrades. Technology can also create significant risks, as hackers find increasingly sophisticated ways to target vulnerabilities and access sensitive data stored in the cloud. That’s why GPs are turning to third-party providers who not only provide a more cost-effective approach to IT infrastructure, but also help ensure reliability and security. This allows GPs to concentrate on investment strategy and fundraising. In this way, outsourcing choices can enhance a firm’s agility and enable it to quickly add new funds in response to changing market dynamics.
When deciding where to put their money, LPs aren’t just looking at the investment rate of return or IRR. They now include operational efficiency as part of their due diligence process. Increasingly, investors want to partner with GPs that can concentrate on strategic investment decisions courtesy of delegating back-office operations to a team of experts.
What’s more, the pandemic has underscored the need for outsourcing to experienced professionals by highlighting the importance of business continuity and the role of online services. It has also emphasized the need for GPs to focus on core competencies and optimize their investment strategy, particularly in the midst of economic uncertainty. When they rely on third-party experts for functions such as accounting, reporting, and compliance, GPs can focus on deal sourcing and supporting portfolio company leadership. It provides an opportunity to streamline their operating model. Firms used to equate outsourcing with a lack of control. Now they recognize it can give them more control.
Stacey J. Relton is managing partner of STRAIT Fund Services, a middle market fund solutions firm that supports private equity, venture capital, hedge funds, and family offices based in Dallas, Texas.
