Outsourcing from an M&A perspective
January 19, 2010
There are various elements outsourcing can learn from the way mergers and acquisitions are handled. So is the attention given by Private Equity (PE) firms to the ‘value’ of the exit something outsource practitioners (both on client and vendor side) can learn from. A Private Equity company receives most of its return on the initial investments when it sells off its participation. For this reason have M&A practitioners gone to great lengths to calculate the expected exit price. Their approach cannot be applied 1-on-1 to outsourcing, but the section in the typical business case dealing with the exit can be greatly enhanced by applying a more sophisticated approach of calculating the value of an exit and its impact on the overall business case.
Where outsourcing practitioners typically distribute their attention more or less equally to Finance, HR, Processes, Governance and Legal, lies the focus within M&A primarily on the financial and legal perspective (and some strategy). So how would the business case look if an M&A practitioner sets it up?
Within M&A they use slightly different terms for the value captured within the deal. Value is created by both the client outsourcing and the vendor taking over the activities and assets. The value of an outsource deal described in M&A terms:
- 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). The second part of the option value is embedded with increased economies of scale by adding this new client to its portfolio.
- 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. The vendor can potentially help the client with forward or backward integration of its value chain and or the creation of new products/services. The vendor allows also for easier absorption of volume fluctuations due to changes in demand.
- Embedded value for vendor: the vendor gets access to new assets, people and knowledge which it can use to generate additional revenue in other areas. It furthermore obtains a revenue stream for the term of the contract (and likely even longer; this part could be seen as option value).
- Embedded value for client: the vendor can improve the quality of services by applying its best practises and reduce cost by economies of scale and may (if done well) reduce the level of delivery risk for the client organisation.
- 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. Additional negative value contribution can result from spending more money on the exit-transition than it can recover from the client organisation.
- Exit costs for client: the client has to cover the cost of retransition the activities back inhouse or transfer the activities to another vendor.
Other sources of negative value creation are related to various sources of sourcing risk. These might be strategic of nature (e.g. costs due to opportunistic behaviour of vendor), operational (e.g. vendor failing to deliver according to contractual requirements) or compliance (e.g. legal penalties due to vendor not protecting personal data).
Mitigating the risks related to negative value creation is done by among others legal clauses. Most of the items described below are already incorporated into current outsource practices, but some might still be new.
The legal terms used by M&A are slightly different compared to outsourcing, but the basic aim is the same.
- Earn-out. As said at the beginning of this post are PE firms very focussed on the exit of a deal. The money they expect at the end of the ‘contract term’ and how this influences the price of the deal is one of the key attention points. Translating this approach to outsourcing means for example linking the earnings of the vendor to the business volume of the client (e.g. client selling 20% more products, means for IT vendor 20% more application transactions x price $$$). Another often used mechanism is linking business performance to penalties/bonuses (e.g. client company failing to invoice due to BPO vendor screwing up means the vendor is penalises for the damage incurred by the client company)
- 3rd party arbitration: also within M&A situation both parties may agree on for example a fair transfer price. In those cases an independent party (e.g. audit firm) may be asked to provide an independent advise on the matter at hand. 3rd party arbitrage may also be used if there are other types of contract disputes or in case of personal of cultural clashes between parties.
- Representation warranty. This mitigating mechanism links the acquisition price to the original assumptions regarding the scope, assets and service levels. Even a due diligence cannot prevent situations where the vendor is confronted with cost drivers which were not in the original scope of the contract. To mitigate this risk parties agree to predetermined price reviews which might include benchmarking by an independent 3rd party.
- Change of control: during the term of the contract ownership of either the client or vendor may change and also within M&A engagements is it common to link the termination clauses to this type of event. Related to this topic are the clauses describing the procedures related to ‘key personnel’. In outsourcing contracts there is often a provision regarding the client and vendor changing employees on key (governance) positions.
Not too many people think that M&A and outsourcing are so closely related to each other, but looking especially from a financial perspectives at both types of engagements shows that the similarities are more prominent than the differences. More on the subject of managing the value of outsourcing here.