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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Lifeline for smaller BPO outfits

Almost 3 out of every 4 IT startups in India have some or other offshoring / outsourcing focus. Especially after the recent trend of imploding captives, this trend is increasingly becoming widespread and the lineup is only getting longer. Forrester believes that more than 60% of Captive centers set up (by large businesses) in places like India fail to meet expectations. Common reasons for failure: a poor delivery track record, operational problems, a lack of scale, poor morale, rampant attrition, and high costs.

There are more than 3,000 smaller companies in India focused on BPO, call centers and software development. These smaller firms are ripe for acquisition as their margins suffer from the combined effects of rising wages, difficulty attracting talent and now, rupee appreciation versus the dollar. Consequently the expectation is that a lot of smaller 'mom and pop' IT shops in India will be forced to sell to survive. The small shops lack the scale and customer base to weather 18% annual wage inflation on the back of rupee appreciation.

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'Captive' IT companies, serving dedicated western clients will have to consolidate to drive scale and increase attractiveness to talented prospective employees. The attraction for larger players to buy them out is on account of their highly trained staff and acquiring a marquee western client (or a few clients) in the process. Captive units of large global businesses providing offshoring services may also find the going unattractive and may opt for buy v. build.

Third-party service providers generally outperform captive offshore facilities because of their expertise, familiarity with local employee psyche and specialization. But the fragmentation in the industry is getting way too much and is almost getting commoditized. It is in this context that Deloitte’s initiative in Private Equity needs to be seen – to enable smaller IT service providers to grow inorganically by consolidation, leaning on private equity support if necessary. If it works well, it’s quite a lifeline for the smaller players.

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Sadagopan has a few interesting posts on the subject here, here and here. Vinnie has a different view and his argument is that the 40% margins enjoyed by offshore IT companies is the main driver (aside of IP protection, data security) for clients to bring deals back in, which he articulated so well thro his reply to Sud’s comment under his post – “it's like saying home cooking has failed because restaurants are doing well” – I loved the comment…but captive implosion argument is not entirely devoid of merits.

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Will the small Indian BPO players choose to consolidate...Frankly I don't think they've got too many choices.

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