Principal-Agent Problems in Outsourcing Middle and Back Office Functions

All Investment Management firms see their key competitive purpose being to produce investment returns. The outsourcing of custody and investment administration functions to global providers has been seen as a positive step for both parties as administration tasks are viewed by the business as non-core and service providers are keen to exploit economies of scale.


The principal agent relationship between outsourcer and provider is outlined in the contract. The contract details the duties, authorities and liabilities of each party. In a lift out arrangement there may be an agreement not to re-enter the market and to enter into a long term contract to allow recovery of transition costs.

Generally with contracts over long periods and in all relationship issues I have been exposed to the cause has been a lack of attention to solving the principal agent problems of differing risk profiles, moral hazard and imperfect commitment when establishing the relationship. At its most severe this can resulted in attempts to break the contract and terminate the relationship with the outsource provider.

Differing risk profiles
Investors hand over their assets to an investment manager to manage. The investment manager then provides these assets to the service provider under the custody contract as its agent. As a result of its obligation to protect the interests of its unitholders as outlined in its Responsible Entity license the investment manager is risk-averse. This licence commonly imposes additional conditions upon the investment manager to monitor and supervise the service provider to ensure the assets are protected; essentially ensuring that the responsibility for the unitholders assets remains with the investment manager. The service provider as the custodian is risk-neutral as its obligation to protect the assets only exists under the custody contract. The custody contract will generally specify that the custodian will use reasonable care and diligence in carrying out these services and will at all times act in good faith, or similar wording. The differing risk profiles manifests in ongoing issues over the level of risk management that the investment manager requires of the service provider. The investment manager will promote a strong risk management culture as a result of its fiduciary responsibilities and as a source of difference in the market. This level of risk management is normally not reflected by the service provider and not addressed in the contract. Consequently, risks will not be managed to the level required by the investment manager.

Opportunism – Moral Hazard
Moral hazard results from the fact that it is impossible for a principal to observe the behaviour of the agent, without incurring prohibitive costs. Usually the investment manager cannot directly observe the level of effort deployed by the service provider it cannot easily tell whether a problem is due to negligence on the part of the service provider or due to an unforseen event. As the service provider knows the investment manager cannot tell, the service provider can always blame poor performance on circumstances beyond its control. A basic assumption of agency theory is that opportunism is an inherent characteristic of such a relationship. In order to gain more control over what the service provider does and remove the potential for moral hazard over the length contract generally the level of monitoring is increased; in some case removing some of the benefits of outsourcing initially proposed. Monitoring can extend to include annual surveillance visits, quarterly due diligence reviews, monthly liaison and steering committee meetings where SLA and KPI’s are measured and ongoing daily monitoring. The costs of this surveillance are not insignificant and despite the amount of effort expended by both principal and agent a lack of confidence in the service provider can still exist due to an absence of clearly documented expectations regarding the level of monitoring necessary.

Agency theory contends that the principal or agent will deviate from the behaviour prescribed by the contract whenever they benefit by doing so. The service provider will not always adopt opportunistic behaviour as moral codes, social norms, the risk of prosecution and the possible detrimental effects on reputation will tend to limit the extent of opportunism. The legal constraints on the investment manager do not allow it to rely on these limiting factors to ensure delivery of the service.

Issues can come to a head where Boards become involved and direct additional reviews of the service provider. Commonly outsourcing contracts include the ability of the outsourcer to audit the service provider however putting this into practice tends to be very difficult given the global operation. The concentration needs to be on resolving the differing views between the principal (investment manager) who requires full transparency and the agent (service provider) who believe their internal controls are sufficient and that they do not need to be monitored.

The industry regulators (ASIC and APRA) impose additional responsibilities on investment managers in outsourcing some of its functions (Unit Pricing Guide, 2005). The guide requires the principal to retain sufficient knowledge of the outsourced functions to effectively monitor both the performance of the service provider and the end-to-end performance of the unit pricing function, address any deficiencies in performance, and ensure continued compliance with all regulatory requirements. In order to satisfy these requirements the investment manager must have a monitoring program in place for the service provider.

The difficulty is to determine the level of monitoring required by the investment manager and ensure this is implemented by the service provider. The regulatory environment clearly states that in an outsource relationship the risk of non-performance does not transfer to the service provider (Corporations Act, 2001). The risk of non-compliance with the regulations is the cancellation of the investment manager’s financial services license and as a result a loss of all its revenue. Consequently the investment manager will continue to raise the level of monitoring of the service provider.

A solution is to fundamentally change the nature of the contractual relationship with the service provider. The investment manager’s objective is to have a provider relationship that is an extension of the business delivering the service through a collaborative working relationship that is performance based and has the flexibility to adapt to changing business strategies through creative and innovative solutions. A number of relationship principles should be identified with the intention to ensure these outcomes are embedded in the relationship through the contract or the relationship structure. This is intended to overcome the coordination and motivation issues inherent in the relationship.

Shirking
There is the additional problem of the monitoring of the investment manager and service provider employees to ensure they are acting properly (that is that they are carrying out their role subject to contractual terms which includes compliance with the investment manager’s policies and procedures). As direct monitoring of both the investment manager and service provider employees is not always possible, shirking may also be prevented by placing some of the remuneration of both at risk. For investment manager employees, their bonus is dependent on them not only achieving specified goals, but also on them behaving in accordance with the investment manager’s values and in accordance with their contract (which includes policies and procedures). Performance against these goals and values should be assessed at least twice a year. This ensures (in theory) that employees don’t simply try to achieve their goals by whatever means possible. Service provider employees should have a similar remuneration structure. Some authors argue that other incentives besides monetary reward can be more effective in assuring the provision of effort (Deci, 1975).

Investment managers in the main rely on their reputation in order to gain further business. This reputation acts as a “signal” about the quality of the investment manager’s service. To protect its reputation and guard against employees engaging in opportunism, the investment manager should have a self-monitoring system where employees must complete reports each month reporting any risk issues (including breaches of policies and procedures) and each quarter, Risk & Compliance would conducts reviews of each business unit to test compliance. These reports and reviews effectively monitor employee behaviour. The service provider ideally would have a similar process in place using an in-house system to measure client-driven performance standards.

Service providers are normally renumerated based on a fee for service with no incentive for on time delivery and no penalties for non-delivery in the contract. As in the traditional sharecropper example, the outsourcer is always concerned that the service provider may engage in shirking because even if it makes no effort to deliver the service it will still receive the fee. In order to avoid shirking and provide the motivation to deliver the contract needs to include a risk and reward framework that is underpinned by a robust performance management system with KPI’s to measure performance.

Opportunism: imperfect commitment
Imperfect commitment is the imperfect capacity of both the principal and agent to commit themselves. To ensure outsourcer and service provider will not be tempted to renege on their promises and commitments a service level agreement (SLA) should be in place detailing all services which is monitored daily. The development and monitoring of the SLA is clearly a cost of the principal agent relationship.

Sometimes during outsource negotiations the investment manager will attempt to construct a contract where revenue is based on a fee for service and the contract does not allow a fee increase above a market level. Therefore to increase profits the service provider will seek to minimise its costs. This could result in the service provider shirking through non delivery or under delivery through poor quality. The investment manager, on the other hand, is seeking to continually improve its business. These divergent interests need to be resolved in the contract by outlining the expectations and providing incentives for each party. In this context where many of the product/service attributes are unobservable and when quality is important an incentive contact that is based on output may be inappropriate. The contract needs to provide incentives for both delivery and for quality along with a method of ensuring continual improvement is a goal for both parties.

Conclusion
Many long term outsourcing contracts degenerate over time and result in alternate providers being appointed at the end of the contract. However utilising agency theory to analyse the relationship highlights that fact that it was unlikely to succeed due to the issues of differing risk profiles and post contractual opportunism not being adequately dealt with at the commencement of the contract. The regulatory environment and investment manager’s risk averse nature results in the requirement to monitor an outsource provider closely. The contract needs to clearly outline the monitoring required and provide the motivation for both the investment manager and service provider to commit the necessary level of resources.

References
Corporations Act 2001, s601FB and 769B
Shirking and Motivations in Firms: Survey Evidence on Worker Attitudes, L. Minkler, University of Connecticut, September 2002
Unit Pricing Guide to Good Practice, Joint APRA and ASIC Guide, November 2005