Ensuring value for money is an essential part of negotiating an outsourcing tariff. But how do you know if you are getting a ‘fair deal’, without going through a lengthy and labour-intensive RFP process?
For fast-growing managers, there also is the risk of ‘growing pains’: a tariff may be genuinely competitive when initially negotiated, but as the business grows, the rate card may no longer be a good fit. With deals usually lasting for 5-7 years, it may be a considerable time before the rates can be revised through a competitive tender.
Many outsourcing contracts include a provision for benchmarking the tariff at least once during the lifetime of the deal. The approach to this can vary, and Alpha has refined its own methodologies over 10 years of benchmarking more than 70 clients, as well as extensive discussions with several leading TPAs.
Cost Per Unit Methodology
A common, though simplistic, benchmarking approach is to measure costs as bps of AUM. However, AUM is not a particularly relevant driver of effort at the TPA, and we believe that modelling the most significant drivers of effort provides a more accurate result. This could be transactions, or holdings, or portfolios, or many other factors, depending on the function in question.
For example, in Fund Accounting we find that ‘Cost Per NAV’ is the most accurate way to compare value for money with other deals in the marketplace.
However, this assessment alone will not prevent growing pains: we also need to consider the scale effect. That is, larger managers, for most outsourced functions, can expect a lower cost per unit than smaller managers.
The Scale Effect
In this example, if each of the tariffs related to the same book of business, with the same number of NAVs, then clearly Tariff C would represent the best value for money.
However, if A is a small manager, B is mid-sized and C is one of the largest players in the market, and we compare the ‘Cost Per NAV’ against each manager’s scale (number of NAVs), the picture looks a little different.
Based on our library of over 200 live Fund Accounting tariffs, for different fund types / domiciles and for managers of varying sizes, we can determine the expected cost for any given book of business, using a curve of best fit (scale curve).
Any points below the scale curve would represent better value (costing less than expected given their volume) than points sitting above the curve.
When taking scale into account, although Tariff A and B have the same cost per NAV, Tariff A costs less than expected given its size, whereas Tariff B sits above the ‘expected cost’ scale curve and so is more expensive than expected.
Similarly, although Tariff C has a much lower cost per NAV, this should be expected given their size. If this is taken into consideration, then the tariff is broadly aligned with the benchmark – slightly more than the expected cost, but still a very appropriate price level.
Overall, Tariff A seems to be the most cost-competitive of the three – but this may change given a period of rapid growth.
Benchmarking For Future Growth
Ideally, for both manager and TPA to be getting a fair deal, the tariff should be broadly aligned with the benchmark at all anticipated levels of growth.
Clearly, it is not ideal for a tariff to become overpriced as the business grows. But equally, negotiating an extremely under-priced tariff is not desirable either – the pain is simply passed to the provider instead and may cause avoidable friction in the relationship. Understanding how the tariff compares to the wider market, including future assumptions for growth, is an important part of the commercial negotiation process.
When negotiating a tariff, and during the lifetime of a deal, scale-based benchmarking can help to foresee growth-related problems and help to ensure that all parties get a fair deal for the long-term.