Asset Managers need to reduce their costs – SaaS will help

Why StatPro is evolving its business model

Time changes everything. What was once state of the art becomes a cumbersome nuisance at some point. The explosion of activity that occurred in the 90’s when hundreds of small software companies built applications to sell to asset managers allowed a big increase in efficiency. Processes that had taken weeks were reduced to hours or minutes. New processes that were impossible dreams became a reality. This was all possible because of windows and Visual Basic and the process was not unique to asset managers but affected every business sector. By comparison the Dot Com boom did not reach the business community but was aimed at the retail market and when it busted prematurely, development slowed.

So today the IT landscape of the Asset management industry is one where any company of any size has 10 to 20 important systems upon which they depend for a variety of essential services. The majority of these systems are all provided as software that is installed on the company’s own servers in their own IT centre. They will probably have many other applications of less importance that they run as well. The result is that they have large IT teams, complex processes and relatively high costs.

Some companies have tried to outsource the whole thing to a third party such as a custodian or IT services provider. However, there are many horror stories that warn this is not a simple solution. In fact the rule of thumb is that if your IT department works well and efficiently, you can outsource it, but if it is inefficient you can’t. The outsourcer cannot be expected to unravel your mess.

What has worked however is selective outsourcing. This typically means getting the supplier of your system to host their own application. This makes sense as the supplier ought to know how to support their own product and if they do this for all their clients, they can get economies of scale which a generalist outsourcer cannot hope to achieve.

The other factor is that Web 2.0 has unleashed a new revolution in IT making it possible for suppliers to provide “Software as a Service” (SaaS) solutions over the Internet and with relatively low cost. Incumbent suppliers are reluctant to adopt this new technology as they fear cannibalisation of their existing business and because they calculate that such is the complexity of the processes that surround their embedded systems, clients will be loathed to move anyway. That leaves the door open for start-ups, but this generation have a much bigger battle than the class of ’95 as the standards and functionality they have to match are significantly higher and the gains in efficiency are less about time and volume and more about money. Clients want the same for less rather than more for the same.

This is the thinking behind StatPro’s own strategy. We believe that eventually all our clients will want to access their services over the web just in the way that we all use email rather than a fax (or telex, or telegram). Indeed, email is fast being superseded by instant messaging. However, we also recognise that clients cannot simply throw everything out and start again, but rather need to evolve in a sensible direction according to a plan that has been tried and tested. The last thing anyone wants to do is jeopardise their business for the sake of saving a relatively small amount of money.

This means that we have focused on deploying new services and products that offer quick savings for clients whilst moving them towards the strategic objective of low-cost web-based applications.

StatPro has built a solid reputation as a supplier of Data for valuations and Analytics systems that cover Performance, Attribution, Risk, Compliance, GIPS and Reporting. Right now, most of StatPro’s clients deploy our software on their own servers. They feed the software with index data and market data from third parties and finally with their own data. The result is that the cost of the software we supply (on a subscription basis) amounts to less than 10% of their total annual cost of ownership in most cases. IT costs are about 10%, data supply will be about 30% and 50% employee costs although some of those employee costs relate to managing IT and data.

We are in a position to offer our clients the IT platform and the third party data and we believe that by doing so we can reduce the total cost of ownership to 70% or less of what it is despite charging additional fees for IT and data. This is because we can offer the IT platform together with the index and market data at a very low rate.

Apart from saving our clients money, we will also improve their service as we will have direct access to their system in the event there is a problem. We will also save our clients further money because we will not have to charge them to upgrade their software. The clients will receive upgrades when we are ready, not when their IT departments are ready. Overall, the complexity of process and the management time required to follow it all will be slashed so there will be other hidden savings and benefits. If a client buys more products from us to replace legacy software we will offer further discounts and savings.

It is also important to note that it will be easy for the clients to take this new service as it is a simple matter of us putting their existing system on to our platform. From there we will upgrade them progressively and, from their point of view, painlessly.

The second stage in our strategy is what we call SaaS2 which is a SaaS product built from scratch. This product takes full advantage of all the latest technology as well as our accumulated knowledge about our products. Once the platform is launched however, it will be relatively easy for us to migrate clients to it from the SaaS1 platform if they wish to use it. This new platform will be released in beta form during 2009 and go live in 2010.

Many asset managers must be thinking about SaaS as a way to reduce their costs, but the obstacle they will encounter is the complexity of getting there and doing so for a wide number of applications. We believe that our approach offers a strategic shift with clear and immediate savings whilst laying the groundwork for the final move to a pure SaaS platform which in turn will allow greater savings.

Justin Wheatley
Chief Executive StatPro Group plc

Mark to Model or Mark to Myth?

Why valuations of credit instruments based on Mark to Model might be a really good idea.

Asset managers and Custodians have a real problem valuing illiquid assets in their portfolios even though many of these assets are perfectly sound and the asset manager has no intention of selling them. Assets should be valued at mark to market prices as required by the Basle rules. However mark to market prices should not be used in isolation in my view, but rather compared to model prices to test their validity. Models should be improved to take into account the greater amount of market data available.

No less a person than Warren Buffet decried the traders of Wall Street for “Marking to Myth” their assets as they sold untold trillions of them to the ill-informed. The traders were using models to price these assets but miraculously the models always seemed to offer high valuations. This has given the process of Marking to Model a bad rap. What Warren Buffet was really criticising was the bubble in valuations caused by the systematic under-pricing of risk. In the same way that analysts during the Dot Com bubble extrapolated forecast profits into the multi-billions for companies that had not yet $1 of revenue and then sold over-priced junk stock to unwary investors, so too did Wall Street’s finest with credit instruments.

The credit crunch is now 19 months old and the fundamental reason why we had one in the first place is due to the mis-pricing of risk and therefore of assets. With cheap and plentiful supplies of money, competition drove down the prices at which banks would do deals and drove up the prices that investors were willing to pay. A lethal combination of faulty models and bonus-driven salesmen did the rest. When at last people started calling into question the values of these accumulated assets (not just ones based on falling property prices but also on optimistic future profits and continuing economic fair weather) the giant game of financial musical chairs began as everyone searched desperately for any remaining buyers in the market to off-load their “investments”.

With the new Basle rules about marking to market this has had a domino effect on a prodigious scale. Assets that otherwise would have been held to term have had to be dumped as prices have been marked down to the most recent market prices. As corporations and banks have been unable to get any credit, the lack of liquidity has turned to potential (and actual) insolvency and that in turn has triggered a mass of downgrades of credit ratings. This once again has caused many investors to sell off downgraded assets as their investment mandates forbid them to hold any bonds with less than AA ratings.

It stands to reason that on the way up prices that were marked to market were affected by over supply of buyers and on the way down the mark to market prices are affected by a massive under supply of buyers. However, just because there are no buyers for your asset doesn’t mean that the asset is worthless if (and this is a BIG if) you are not a forced seller. The core issue is whether you need to sell your asset to raise cash. If you are not in a rush, over time the market price will recover. Many fixed income assets are bought and held to term (with no leverage). Provided the issuer does not default on interest or capital, the asset has the value of its cash flows and principle. So if you have such assets and a long term investment horizon and no liquidity issues, how should you value these assets? What happens if you are put into the perverse position where you have to mark the value of your assets down to a level where your terms of reference force you to sell them? Mark to market is good for transparency, but where there is no liquidity does this approach still work?

Look at value another way, if you wanted to sell your house that you bought for £1.0 million 18 months ago, you would probably go to an agent and get them to estimate what the going rate was for similar houses. Let’s say they gave a range of £650K to £750K you would then “model” your house price on this and put it on the market for £790K hoping to get £750K. If someone offers you £50K for the house you would be unlikely to sell it to them, however their offer would represent the only “market” price for the specific asset: your house. For better or worse, you would stay put and wait for better market conditions and in the meantime you would probably make a mental note that your house was probably worth £650K despite it only being a model valuation rather than £50K (the last real offer).

In other words there is a problem with mark to market when there is no liquidity. By definition a liquid market is where consenting parties agree on a price at which they will deal with each other freely. It is not surprising that rather graphic terms are used for buyers in the current illiquid markets such as sharks, rapists, bottom feeders and vultures as they are only interested in buying from the truly desperate. In the housing market the forced sellers are the people who have defaulted on their mortgages, are divorcing or have inherited a property and want to get cash quickly. These are the asset sales that at the margin define the market price. Until this overhang of supply works its way through the system there will be no motivation for buyers to pay more.

I am not arguing that one should ignore the market but rather that blind faith in it does not make sense and that the law of unintended consequences can play havoc as a result. Rules that enforce one approach can have perverse results. An example is with Index Funds. When a new stock enters an Index, they all buy it, propelling the price of the stock higher. When a stock exits the index, they all dump it, causing the price to fall further. What is needed is a circuit breaker or alternative way of thinking to validate the orthodox approach. Indeed the accountants that set the rules for the International Accounting Standards Board are also concerned about “Fair Value” over a market price. To them Fair Value is the amount at which an asset could be exchanged in a current arm’s length transaction between willing parties where each acted knowledgeably, prudently and without compulsion. If that cannot be obtained from quoted prices, then they look to proxies and finally to model prices.

When Warren Buffet buys an asset, he uses his own model for determining whether the asset is good value or not. Sometimes he will pay more than others for a given asset. He works out the price he will pay and then he sticks to it. This is a good example of making the market come to the model price. Buffet’s model is based on a fundamental approach to valuations that stays consistent irrespective of “Mr Market” (as he likes to call it) and he maintains the discipline of sticking to his model for valuation even if he has to wait several years to buy.

The problem faced by asset managers and the custodians of their assets is what approach to take vis-à-vis valuing so many illiquid assets where there are seldom any trades? There are some 4 million or so bonds in issue not counting CDOs, CDSs and other derivative assets and 95% have no regular market made in them. Even where a broker price can be obtained these are often skewed and reflect the trading book of the broker. It makes sense then for custodians and asset mangers to use multiple sources to gauge more accurate valuations of their assets including model prices. Market prices in any case are based on the models used by the investment banks so it is good to have an alternative model to validate them.

However, not all model prices are equal and custodians and asset managers should look for more sophisticated models. For example, historically, credit ratings provided the only means of gauging the risk of default, but now the CDS market for a given issuer is a much more up-to-the-minute guide on the likelihood of default. Further one can build up the price of an asset by looking at the various spreads over LIBOR including the sector spread by using highly liquid indices like iBoxx and iTraxx. Thus the price of an asset can be modelled from LIBOR, its credit spread, its CDS spread and its sector spread and whatever other factor based on its term sheet. Such a price will be very robust and a sound basis to challenge the “market” price from an investment bank.

In summary, a valuation is not the same as a transaction and at times of stress dogged application of rules can cause more harm than good. There is no harm in challenging “market” prices if they seem skewed and the best way to do that is to have alternative opinions in the form of independent model prices. New methods and new data are available to help improve models and these should be used. In the end all prices start off from a model.

Justin Wheatley is Chief Executive of StatPro Group a leading supplier of portfolio data, pricing and analytics.