What outsourcing can learn from M&A

There are various elements outsourcing can learn from the way mergers and acquisitions are handled. Especially the attention Private Equity (PE) firms pay to the exit when considering the acquisition of a company is something companies outsourcing can learn from. The last couple of years the situation has improved a lot (at least in the Netherlands) and much more attention is being paid to this topic. For those who are less familiar with the subject here the minimum exit to-do list:

1. define the exit requirements the vendor has to comply with,
2. include exit fees in the business case and contract and
3. make sure the vendor delivers an exit plan based on the requirements within 6 months or so.

But applying M&A to outsourcing has more to offer, even though quiet some elements are already common practise. The synergies and learning points I found are:

Approach of engagement
The activities undertaken during both types of engagement show substantial similarities as both incorporate elements like finding a suitable ‘target’ to either acquire or outsource too and include a (legal) transition of one party to another of assets. Comparing the phases of both types of projects:
One of the main differences between outsourcing and M&A is in my opinion the stronger focus on the non-financial part. Within M&A about 70% of the attention is put into the financial workstream while (in more complex) outsourcing engagements much more emphasis is put on the services/products that have to be delivered and setting up a governance structure. For the outsourcing deals I have been in it was typically 40% finance and the rest divided over requirements definition (e.g. describing the processes), HR, legal and governance.

Financial deal value
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). The last topic of the post discusses some ways the deal value is protected within M&A transactions.

Safeguarding the deal value
The 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. Another post on managing the value of outsourcing can be found here.