These are challenging and difficult times. The UK economy has officially experienced the worst economic slump in 50 years. The early optimism of the ‘green shoots’ of recovery has given way to a solemn stoicism that a return to the good times will, at best, be a long and protracted haul and, at worst, a double economic dip (the so called ‘W-curve’). For many companies this has meant waves of restructuring in order to survive. In the public sector, massive budget cuts are anticipated next financial year as the government seeks to rein in expenditure. Things will never quite be the same again as the international economy emerges from a recession the likes of which have not been experienced since the 1930s.
The global outsourcing sector, despite spectacular growth over the last 10 years, is hardly immune from these challenging and difficult times. At the start of the crunch, TPI reported a 40% drop in the value of financial services outsourcing and Forrester that 40% of large businesses were cutting budgets. Of course, organisations will still look to outsource to lower their cost base, yet even this area is not entirely counter cyclical. According to Nasscom, the Indian software and services industry is heading for around a 16% growth this year which is massively down from the 30% annual growth prior to the onset of the recession. Many outsourcing companies (eg Satyam Computer Services) are themselves going through a significant period of turmoil and re-adaption, in turn causing a good deal of angst for customers.
Suppliers are attempting to respond to the recession by re-stressing IT and BPO services as the essential strategic ingredient to cut costs, re-shape the business and position for the long-term upswing. On the other hand, customers are eager to re-negotiate existing contracts, display reluctance to enter new transactions (particularly longer term deals given the major uncertainty in business planning most companies face) and some mission critical deals are being brought back in-house. While deals driven by cost efficiency are on the table, those with investment driven transformational outsourcing are less commonly seen.
In these circumstances, many customers are reviewing their existing outsourcing arrangements as they re-assess their business prospects or are reluctant to enter into new ones reflecting economic uncertainties. This article provides some key practical considerations for both situations.
If you already have an outsourcing arrangement
Those companies that entered into outsourcing contracts before the fourth quarter of 2008 could not have readily anticipated the market conditions we are experiencing today. Although certain legal protections would normally be included, such contracts are likely to involve long-term commitments with narrow scope for reduction in business. For these customers, the scope for seeking major cost reductions is significantly less than for those organisations entering into an outsourcing contract today.
All too frequently, organisations do not consider the strategic issues before entering into detailed and sometimes protracted negotiations. The following points should be key considerations.
· Do the services still meet a real underlying user need? During the recession business priorities may have shifted dramatically. The organisation may now be prepared to delay or postpone major projects or accept dramatically simplified service expectations in return for substantial cost savings. This may mean foregoing new or updated systems or accepting lower service quality for non-critical applications. At the extreme, do the services provided still meet an urgent business need at all or would it better to calculate the risk and cost of terminating the contract early to pursue an alternative course of action?
· Is there a strategic outsourcing strategy and plan? Piecemeal outsourcing arrangements entered into on a case-by-case basis over the last few years may now seem inflexible and inappropriate in today’s environment. Periodically aligning the portfolio of outsourcing arrangements with organisational goals, internal capability, business processes and the benefits case has proved to be a difficult challenge for many organisations. Creating and updating the strategy and plan is an essential step before entering into any new arrangements. It can result in significant rationalisation and cost reduction and is a frequent driver in fields such as telecoms and application support outsourcing.
· Are the charges calculated and managed on an appropriate metric? During the recession many organisations will shrink in terms of their size and capacity (eg workstations, employees, licences, storage space, transactions) and this should lead to a proportionate reduction in charges when it is most needed, probably limited to a minimum baseline. The contract should specify an appropriate metric and charges should fall accordingly on a month-by-month basis. If such metrics are inadequate it should form an urgent item for renegotiation. Suppliers may prefer to stick to lucrative contracts, but they are not immune to corrective pressure given that long-term relationships are often at stake and down scaling is often feasible within certain parameters.
· Is the supplier’s performance being actively managed? The procedures designed to control performance in the contract must be up to date and actively managed. Sadly this is not always the case. For example, are major delivery projects on track and key service levels being achieved? Poor performance may be an early indication of systemic supplier failure and should lead to early reporting, rectification and (if continuing) to the triggering of an increasing range of customer remedies. In particular, are governance procedures working adequately and are major performance problems receiving sufficient senior management time? A sudden deterioration in performance, particularly if accompanied by the sudden attrition of the supplier’s key personnel, can often be a sign of a deeper underlying problem.
· Is supplier risk being actively managed? The recession and other internal failures have adversely impacted the ability of a growing number of suppliers to perform. This has forced many customers to think through how they would deal with a supplier in trauma, where there is no quick effective mechanism for enforcing rights and obligations. One of the starting points here is for the customer to have up-to-date copies of all key documentation, applications and data (eg contact details, key subcontractors, key personnel, technical documentation). In particular, the exit plan must be up to date, deal with the eventuality of a complete supplier failure and be lodged with the customer. Best practice is to monitor the risk of the supplier (including its group), its key subcontractors and also look across the portfolio of outsourcing arrangements to identify common risks. When suppliers are in financial distress, customers can and do take steps well before exit becomes a certainty to ensure business continuity.
If you are planning to enter an outsourcing arrangement
Despite these troubled times, now might be the right time for some organisations to evaluate new outsourcing opportunities. This is because suppliers are quicker and more eager to respond, and prices are falling, especially in those territories with over capacity, increased political risk and regulatory failure. For new outsourcing contracts, Gartner has estimated that prices are falling by 5% to 20%, despite the fact that in the past outsourcing as a sector has held up well in a recession as customers typically cut costs, streamline and downsize.
As ever, there are still many outsourcing deals currently in progress although perhaps smaller and more tactical in nature than at the start of 2008. Additionally, these deals are reflecting greater customer awareness of the unfolding events of the last 12 months. The following should be key considerations.
· Contingency considerations The customer must decide if this is a type of commodity outsourcing deal whereby the services can, with a manageable amount of effort, be switched to a new supplier or back in-house. In which case, there should be an enforceable, detailed plan to execute it. In its pure form, dual sourcing with hot stand-by offers full resilience in the event of a supplier failure but can often be expensive to implement and maintain, damaging the attraction of the business case. It is attractive in sectors such as call centres and application maintenance where distinct processes can be diverted to different suppliers and, arguably, scale becomes a management disadvantage over certain thresholds. Alternatively, the customer must decide if this is a mission critical outsourcing arrangement whereby key processes and knowledge are outsourced with no easily available contingency measures. In this event, the business case must be compelling and the customer’s main protection is undertaking supplier due diligence and thorough ongoing management of performance and risk procedures as well as the supplier management issues identified above.
· Deep and extended supplier due diligence The recession has taught some the very harsh lesson that the customer cannot always rely on information from credit rating agencies, published or management accounts or government regulators. Many failures have been monumental and well documented. Practically, there is no substitute for engaging in-depth with the supplier’s existing customers, user groups and key personnel. For larger outsourcing transactions, customers are employing private investigating companies to dig much deeper, investing in an equity stake and even demanding a seat on the board. These steps are much more likely to yield early intelligence but come at a significant price.
· Evaluate setting up a special purpose vehicle (SPV) for large deals It is entirely feasible to set up a Supplier SPV, a build-own-transfer (BOT) or a joint venture model, ring fencing assets, people, IPR and contracts and thus allowing for a wholesale transfer of operations on a supplier failure. This can be attractive on large or very high risk deals but is also a factor where the customer has a long-term intention to in-source once operations are stable.
· Sector specific regulation Customers must also consider any specific sector regulations governing outsourcing arrangements. Outsourcing news bulletins and watch lists figured heavily in the first quarter of 2009. For UK regulated businesses (eg insurers and banks), this means regulations imposed by the Financial Services Authority (particularly, the Markets in Financial Instruments Directive (2004/39/EC) and the general requirements for outsourcing set out in Chapter 8 of its Senior Management Arrangements, Systems and Controls sourcebook (SYSC 8)). Although these obligations are now reasonably well understood, the turmoil since the onset of the recession has added additional emphasis, and rigour to the implementation of such regulations.
Conclusion
This article has attempted to provide some key areas for consideration for those customers who have existing outsourcing arrangements in place or who are considering new ones. In practice, we have seen a wide variety of solutions to the issues raised. There is no substitute for detailed investigation and analysis and this article can only pull out some of the major issues.
In these challenging and difficult times the only sure thing is that there will be more turbulence and no immediate return to the good times. The immediate customer-side focus since the onset of the recession has been on survival and cost reduction. However, from the fourth quarter 2008, the number of customers with the ‘desire’ to undertake new outsourcing arrangements has probably been growing faster than the amount of business actually completed. This has been caused by uncertain conditions and certain well documented failures. This situation may be about to be reversed.
With supplier-side competition more intense, improved offerings and prices falling, now might be the very time to consider the long-term viability of further outsourcing. This will require careful planning, senior management commitment, precise execution and a consideration of at least some of the issues identified in this article.
Andrew Withers is a Senior Associate with Field Fisher Waterhouse.
