Enrich your business case with M&A ingredients
August 10, 2012
This blog shares part of its content with this older blog. I included this blog in my upcoming book but added more content. I hope you will find it useful.
Cost cutting is still one of the key reasons to outsource parts of the IT portfolio. There are many other sources of financial benefits hidden within these deals however. Deals which often involve large sums of money, a multiyear commitment and a considerable risk of failure. Properties which are not unlike a M&A deal.
At first sight may outsourcing and M&A not share many similarities, but at the core are both about one company buying assets from another company, with the aim to make a profit. M&A deals tend to be much larger in value however, which has resulted in developing best practices to both maximize and protect deal value.
One of the key differences between an outsourcing and M&A engagement is the stronger focus of the latter on the exit. If a private equity house buys (part of) a company, most value is created when the shares are sold again or the company is floated on a stock market. Consequently will considerable effort be directed to predict the expected future return. As Real Options can be used to value uncertainty (e.g. effect of economic slowdown) and flexibility (e.g. postpone part of an investment), are they a popular tool among M&A experts.
As dealing with uncertainty and flexibility are also important in outsourcing, can they also be a source of value here. When applying options and other M&A terminology to outsourcing, the value of an outsourcing contract can be described as follows:
- Option value for vendor: By taking over the assets and people of the client the vendor might be able to get into new markets and/or clients (e.g. get more clients in the media vertical after signing a contract with a newspaper publisher). Other sources of option value are better economies-of-scale by adding the volume of the new client and contract harvesting (e.g. additional projects).
- Option value for client: The money the client receives from the vendor for the asset transfer can be used to enter new markets, innovation or to other means. Value can also be created if the vendor enables the creation of new products/services or improve forward/backward integration of the value chain. Furthermore is a vendor a source of volume, service and resource flexibility.
- Embedded value for vendor: the monthly revenue stream for the term of the contract (the value of an extension can be included as an option). Additional benefits are realized by assigning part of the transferred staff and assets to other contracts.
- Embedded value for client: the lower monthly cost achieved by better economies-of-scale for the same service. Other sources of potential benefits are better time-to-market and availability figures. Intangible benefits may include access to a larger and more diverse pool of workers and the effects of a more mature delivery organization.
- Exit costs for vendor: the exit cost is related to the risk (option of the client) to switch to another supply source at the end of the contract term. Another source of negative value is spending more money on the exit-transition than the vendor can recover from the client.
- Exit costs for client: the client has to cover the cost of retransition the activities back inhouse or transfer the activities to another vendor.
The cumulative net present value of the first business case becomes positive in the fourth year. In most cases this outsourcing would be a no-go.
- 0,5 times NPV (migrate one country at $50 with business decline of 50%) + 0,5 times NPV (migrate one country at $50 with business growth of 50%) = 0,5 x $34 + 0,5 x $19 = $26,5
- 0,5 times NPV (migrate all countries at $150 with business decline of 50%) + 0,5 times NPV (migrate all countries at $150 with business growth of 50%) = 0,5 x 42 + 0,5 x 5 = $ 23,5
Sources and recommended articles for further reading:
- D. Craig en P. Willmott ,Outsourcing grows up, McKinsey Quarterly, februari 2005.
- T. Blommaert, S. van den Broek, E. Curfs, Methodiek voor betere besluitvorming van (strategische) IT investeringen, Informatie, 2009 (Dutch).
- T. Copeland, P. Keeman, Making Real Options Real, McKinsey Quarterly 1998 no 3.
- T. Luehrman, Strategy as a portfolio of real options, Harvard Business Review, September-October 1993.