Outsourcing Captives is Not an Acquisition

About a year ago, I had written about why offshore IT captives don’t work [link]. Now I hear that the companies that had set up captives in India are rushing to get rid of them. Except that there is a curious twist. They want to be paid to rid themselves of their mismanaged captives.

The logic works this way. Let’s say Acme Inc. set up a captive for its IT work in Bangalore 4 years back. The experiment went sour. Attrition is high even though wages keep climbing. The costs and the rupee have together blown the business case to smithereens. So now Acme wants to get rid of this white elephant. They would have laid off everyone except that the 100 odd engineers in Bangalore, actually do good work (as long as they stick around, that is). Since they support some mission critical systems, Acme can’t just shut down operations. A reverse transition to US based employees will take time and will be hugely expensive. The other problem is that some of the Indian employees carry knowledge about Acme’s business and systems in their heads that Acme would like to retain. The CIO’s ideal scenario is to find a home for these employees in one of the IT majors who will then have to deal with the employees as well as transition and knowledge retention risks.

In the eighties this was called Outsourcing. EDS and IBM built huge services businesses doing exactly this in the US. Today, the same thing in India is called an acquisition. Acme expects the Indian outsourcer to ‘acquire’ Acme’s Indian subsidiary and pay them for transferring a “stream of cashflows”.

To me this seems like an unnatural act. I can’t see how the IT services company can justify this beyond paying for the acquisition of assets. But there is obviously a way this is being justified because it is happening.

How would the IT Services company justify this ‘acquisition’:

    – Growth is hard to come by. This deal will, from day one of the deal give me a revenue stream of $Xmillion.
    – A deal like this will not impact margins since the acquisition cost will be a balance sheet item. ROCE has never been a problem or a key metric for IT Services. Depending upon how the amortization is set up, impact to net margins may be minimal.
    – If my company doesn’t do this deal, my competitor will be happy to pay up.
    – The market keeps asking us about acquisitions. Acquisitions outside India are too hard to integrate. Instead, we’ll just acquire a few captives in India.
    – With this acquisition we will acquire some very important skills both technical and industry domain. This will give us a foothold in the Insurance industry or the German market or whatever.

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None of these justifications work for me. They are ways to rationalize what these companies feel compelled to do to meet short-term expectations from the market. By this logic, every client outsourcing work in the US should first form a subsidiary, transfer all employees into it and then 'sell' the subsidiary.

This new game is a dangerous one. It tells a story of an industry that doesn't know how to respond to the triple whammy of costs, exchange rates and a US recession.

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11 Responses to Outsourcing Captives is Not an Acquisition

  1. Anshuman says:

    Hi Basab,

    What are your views on solution for this problem?
    What should IT services company do to deal with this “Triple Whammy”? Seems that industry is confused and everyone is trying to do the same thing. What you would have done if you were CEO of an IT services company?

    Like

  2. Abhinav says:

    Hi Basab,

    ….But there is obviously a way this is being justified because it is happening…..

    Any recent examples where this kind of acquisition has happened?

    Like

  3. Tushar Jha says:

    Basab,
    While Captives not really ‘kicking on’ is evident, the Retail captives( Tesco,Target,Amazon and now Supervalu) all seem to be doing pretty well AFAIK.
    Any industry pattern here??

    Like

  4. Basab says:

    Anshuman, I would read my blog 🙂 I have written often in the recent past on this.

    Abhinav, talk to someone in the industry. there are a number of RFPs for captive buyouts out there.

    Tushar, I can’t think of any industry based reason. Good management can overcome hurdles that trip up most companies. These companies are well managed companies.

    Like

  5. Krishna says:

    Basab,

    I see your point but I am afraid, it satisfies all the conditions for the expression “acquisition”. In fact, it has some strategic advantages as well.

    From the seller’s side, it is hiving off its, say, IT services or ancillary services or back office division. If the cost allocations and revenue accruals are distinctly ascertainable, it certainly makes a good case for a transferable asset with a separate cashflow stream. Under the Indian tax laws, if the Bangalore arm is recognized as a “permanent establishment”, then it gets an Indian tax jurisdiction as well.

    Now if that comes with trained manpower capable of supervising migration to the T, the transaction is earnings accretive from day one and hence a juicy op for the buying IT outsourcing vendor. If the captive comes with some carried forward losses or unabsorbed depreciation (thanks to its mismanagement), a profitable buyer has an opportunity to save some taxes by setting off its profits against the book losses of the captive for eight years in future. If it is an acquisition, it has exemptions from stamp duty (on transfer of owned/leased premises) and capital gains tax.

    On top of it, it gets an assured customer, a dedicated, trained team and substantial cashflows. It only has to sanitise and morph the captive into its own low SG&A format while maintaining (or even improving) the gross margins it has on its other businesses due to expanded scale, centralized/shared services etc. If the buyer negotiates well playing his cards close to his chest, he might as well pay some salvage value (and wrap the deal up because he knows the captive seller is desperate) for such series of built-in gains that comes his way.

    So why can’t it have an acquisition tag?

    Like

  6. Basab says:

    Krishna,

    Calling it an acquisition makes a lot of sense for the seller. After all, they are the ones getting the check for selling what is not a stand-alone business but an internal services department that will continue to provide internal services.

    The real question is, does this make sense for the outsourcer? Should they pay for securing business from customers? The same expectation can easily be applied to say a US Fortune company that wants to outsource a part of its IT department. Till now this would have been a straight outsourcing deal, where money flows only one way. But now, the said company is incented to create a Delaware corporation, transfer the IT personnel into a separate company and then ‘sell’ the company.

    In fact, I would assert that this is a bad deal for the customer-seller as well. On paper the financials might look better than straight outsourcing. But the outsourcers are no fools. If they are paying upfront to ‘buy’ the captive, they will want guarantees on the revenue streams for long periods of time. During that period, if service levels are not as expected, there is little that the customer will be able to do.

    I can see how the accumulated losses in the sub might provide a tax benefit which might justify the sale. But will it be more than a rounding error? The relationship between a sub in India and the company outside, must be arms-length (now confirmed by the Courts). The services are provided at a significant ‘markup’ to costs. Assuming that costs include all apportioned infrastructure costs as well, can the sub accumulate enough losses to justify doing the transaction as an acquisition by itself?

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  7. Krishna says:

    Basab,

    Appreciate your view. From an angle, it could look like the seller making-a-virtue-out-of-necessity and then going to monetize it as well. They just said the world is flat, not fair!

    But recognize that people at either end of the transaction will be shrewd entrepreneurs. One can’t con the other as easily as floating a shell, throw in a few IT workers (“the team”), mark up premium and then push it down the outsourcing vendor’s throat. Valuation and business due diligence exercises will be elaborate and if anything it’s the seller that is not just desperate to let go but equally keen to make sure the mission critical processes are run by seasoned pros. The buyer will have a fairly good idea about the cost that seller might have incurred to build the department, recruit and train people, bear overheads, devote significant management energy for outlining the business process and its eventual integration into LOB. If an outside vendor bagged this as a separate contract initially, it will have to apply similar resources and incur similar costs as well. In fact, being an external service provider, the initial launch costs would be significantly more for an outside vendor owing to stringent and uncompromising SLA specs demanded by the enterprise client with severe built-in penalties. Remember all this would have been unknown quantities then.

    In an acquisition, a buyer knows what to expect because it has absorbed “the team” on its side and hence has a benchmark expectation of SLA compliance standards. Clients cannot act up and impose unrealistically high SLA watermarks because the team has done it before and can vouch for what is and what is not. And yes, the buyer will certainly insist for a minimum guaranteed business from the seller, but the seller as well has the comfort that it is dealing with a known devil.

    Every outsourcing vendor spends a lot on initial customer acquisition. It incurs overheads piece meal on every new customer pitch; here as a buyer, it pays for the shares in lumpsum. And the seller can hope to exploit “the buddy buddy effect”, because the team has been a slice of the customer itself. Minor lapses need not lead to major disputes and can certainly be ironed out by prevailing camaraderie (at least in the short term), that often can’t be bought for a price. Then several other merits like predictable cashflow, scope for future contracts, access to inside information all count as vital for the buyer in the long run besides getting its feet wet in a new vertical.

    I think a buyer has a lot going for it here.

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  8. Basab,

    A very timely piece. This has started happening some 4/5 months before.

    When I talk to their managers, they are confused and do not know what to do. “It is the top management which is handling” – which they normally say. More confused are the employees who are automatically getting pushed/pulled into newer ones and they are in panic.

    Satya

    Like

  9. C Krishna says:

    Basab,

    These are the three common problems I have seen in MNC captives.

    1. The India team “augments” the HQ staff with the hope that some day they would “come up to speed” and “own something”. But that “something” is never defined; the end goals of having a team in India are never thought in advance. End result – the India team perpetually “augments” HQ staff, till the HQ staff either leave for greener pastures or get laid off.

    2. Lack of an effective delivery structure in India. The teams are matrixed or verticalised with the local management chain having little or no influence over deliverables or processes. Add this to #1 and you get teams that are disconnected from the strategy, feel disenfranchised and are confused.

    3. Extension of point #1 and 2 – completely divesting the first and second line managers of any authority over the India teams. This is most evident in the case of hiring. Even hiring of rookie engineers has to be vetted by HQ. Ditto for work allocation and promotion recommendations.

    Typically – after the first two years most of the employees are left wondering if they made a smart career move by joining this company.

    Like

  10. Sunita says:

    I agree 100% to your views here. When GE outsourced to GECIS (Now GENPACT), salaries were high, perks were all time high…all because GE was justfying a cost savings that the India arm brought against US operations…a very high saving!!!!

    After 3-4 years operations, the benchmarks changed!!!! The benchmark was no longer US costs… but cost savings against what GE-india was doing the previous year….And that’s when the problem started-compensation rationalization, reduction in employee engagement budgets etc!!!

    I believe Microsoft and Oracle will also go through this issue unless they really bring in strong leadership in their Indian arm and also start engaging their offshore arms in doing some path breaking research and product development-to justify retaining the talent pool at offshore.

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  11. Basab

    while I agree with most of your observations (incl those made in your previous post that deals with why captives are broken), I must point out that some smart captives have been successful in hauling themselves up the value curve. imho, here’s some elements that brings that about

    1. Partner the business: Most captives fall in the trap of defining “business” and “customer” as folks at the HQ who outsource to them. It takes a while to change this mindset but once done, the business sees the captive as a partner and engagements deepen. Better still, they broaden to areas that were unplanned before
    2. Valor upfront: People setting up captives should invest a part in “back-to-the-future” activities that may (will) not pay off immediately. Example, while setting up an offshored development center, the visionary may choose to invest in product managers too. It’s kind of a delayed-yet-potent-release candidate that can accelerate growth later on.

    A lot of “IP protection” argument is given for captives. I don’t think that holds water. Most captives don’t do anything that some other company would want to adopt.

    I’d really like to get your views on “the great captive steel ceiling” – the bite-the-hand-that-feeds phenomena, which establishes a very rigid restriction on growth of employees (and hence the captive capability). I cannot think of any other “business” that imposes this. Does that then mean captives as a business model is fundamentally flawed (no matter how much tactical tinkering is done)?

    Regards
    Subrata
    PS: Liked your gridstone platform a lot. Are you content agnostic or tied to a factset or thomsonreuters or the likes?

    Like

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