Dump a captive - necessity or smart strategy?

Companies set up captives – wholly owned subsidiaries set up to pro­vide services only to the parent company – when they feel a need to isolate non-core, back office services (like primary research, data analytics, product research, IT Maintenance and support, after sales service etc.) to focus on their core revenue earning activities. Besides there are a host of other reasons too –

a) Lack of mature service providers;
b) Desire for direct control / concern over IP protection;
c) Regulatory restrictions (especially in financial services);
d) Risk mitigation;
e) Service delivery cost;
f) Scale of operations;
g) Corporate culture.

Of late, the parent companies are realizing that the captive models are cracking. Rampant inflation in emerging markets drive up wages in offshore destinations, high attrition, lack of talented manpower, poaching by mainstream service providers that makes it impossible for running a stable captive operation. So they want to get rid of them. There are several mainstream outsourcing vendors that are interested in buying these struggling captives as they help build their book. But when more and more parents divest captive outfits, there is also a speculation whether it is a pre-planned strategy – outsourcing by another name, in the process the parent making some money as well!

I think the speculation is well founded. In the normal outsourcing scenario, the parent company comes in as a client of the service provider. In this case, the parent company is the “seller” and the outsourcing vendor is a “buyer”. It’s like *buying* an order (for a price), not taking it.

But on second thoughts, it’s not so simple as it seems.

It takes a lot of time, effort and cost to set up a captive. Recruitment, training and maintaining a bench is hell as outsourcing vendors acknowledge. Finally when the operations go on stream, people leave, processes come unstuck, projects get delayed and blame game starts - when the regular fire fighting begins. The very purpose for setting up captives, to have an in-house, efficient service provider that frees up a lot of quality time for management to focus on core operations of the parent company remains an illusion because now they also have to manage the captive from a distance. Being a wholly owned sub, their financials are to be integrated into the parent company balance sheet as well - its losses tarnish the parent company performance as well.

So in the end parent company has more trouble to deal with. That makes it divest the captive to a mainstream service provider if not the captive desires to go out on its own. Who will compensate the parent for developing a functional business model and transferring it out of its inventory? It bore the pain for so long. Imagine the level of information they carry. SLA compliance headaches will be fewer since the parent knows what to expect from a former captive. In fact, it can be trusted better because there is a quid pro quo between the parent and the captive for long term associations. Then make other benefits by way of tax savings from carried forward losses of captives available for set offs against the profits of buyer count as well.

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I think it’s a good strategy for both buyer to buy and seller to divest a captive than to outsource directly, where the outsourcing vendor will have to outbid the competition by squeezing its own margins. In a sellout, the seller deals with a known devil, the buyer gets the benefit of "a bunch of former buddies" that call the decision makers of the client by first names. Then if the buyer is smart enough, it can soon morph the captive into its mainstream (low) SG&A format and flog it at will.

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Now isn't that a viable proposition...? I guess so.

Hat Tip : Basab Pradhan’s post. Read my comments under that.

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