Wednesday, 3 May 2017

Strategic Analysis: Old Mutual changes its replatforming partner

The most interesting story of the week in UK financial services must be Old Mutual Wealth's (OMW) decision to switch its replatforming exercise from IFDS to FNZ.

Strategically, I think it is interesting on a number of levels:

1. Sunk costs really are irrelevant

Every finance and decision making text will tell you that sunk costs should not influence a decision. However, behavioural economists have ample data to illustrate how difficult most people find it to apply this simple logic, and how seldom they do so.

OMW's decision is a masterclass on the subject. It successfully disregarded £330m of sunk costs in making this decision. (Although, I am sure that not all of that investment was thrown away and presumably OMW will have build up a significant library of requirements analysis and other IP that it can carry forward into its implementation of FNZ.)

In OMW's case, not all the costs are financial, and they would also have had to factor in any potential loss of investor confidence as they approach the break-up of their parent group (Old Mutual plc).

2. Financial cost is a secondary criterion

Even after setting aside these sunk costs, the advertised cost of implementing FNZ (£120m-£160m) is still greater than advertised costs of completing the IFDS implementation (£110m). The decision does not make sense based on those costs alone.

There are two other factors which would have swung this deal:
  1. Benefits: that is the benefits promised by FNZ outweighed the those promised by IFDS.
    AND/OR
  2. Risks: that is the perceived risks of IFDS exceeding budget, over-running schedule, or failing to deliver benefits exceed those perceived risks for FNZ.
All of which only reinforces the view that if the negotiation hinges on costs, then you've already lost.

3. Doing is the best form of marketing

I don't know what either FNZ or IFDS spend on sales and marketing, but I suspect that the impact of this one press release outweighed the impact of all of their other sales and marketing activity combined.

FNZ must be grinning like a Cheshire cat right now. In contrast, I suspect there are a lot of difficult questions being asked at IFDS.

Of course, this story isn't finished, and all eyes will be on OMW and FNZ over the next 18 months to see if FNZ can get on any better with OMW than IFDS did.

4. Systemic risk in the sector is shifting

This is perhaps not 'new' news, but this story brings it back to the fore. To put this in perspective, figures from Platforum show that 84 per cent of platform assets are expected to be held on platforms backed by just four technology firms by the end of 2018.

This level of market concentration inevitably attracts regulatory scrutiny, and ultimately intervention.

In the 2008 financial crisis, it was the banks that were considered 'too big to fail'. In the next financial crisis (isn't it inevitable?) it may be the technology providers supplying the financial institutions which take this role.

5. Technology is eating their lunch

According to the Financial Times Global 500 rankings, 5 of the top 10 companies by market capitalisation as of 31 March 2017 are now technology companies (Apple, Alphabet, Microsoft, Amazon and Facebook), as the industrial and financial conglomerates that dominated until recently slowly slip down the rankings.

As the financial services value chain fragments and the number of vertically integrated financial services companies (like Hargreaves Lansdown) declines, it becomes ever more important to understand to where in the value chain the value will flow.

The key motivation for disaggregating your value chain and buying core systems from a third party are that you believe a third party can do the job better and more cheaply than you can. A write-off of £330m is a big negative in that evaluation.

Given the combination of concentration and market cap factors outlined above, it seems likely that value will flow away from financial services providers and towards their technology suppliers, leaving the financial services providers increasingly commoditised, whilst still bearing the capital burden.

As the old adage goes: in a gold rush, it's the shovel-maker who gets rich.