What the M&A practice can add to the sourcing practice
This blog shares part of its content with this older blog. I included this blog in my upcoming book but added more content. I hope you will find it useful.
Cost cutting is still one of the key reasons to outsource parts of the IT portfolio. There are many other sources of financial benefits hidden within these deals however. Deals which often involve large sums of money, a multiyear commitment and a considerable risk of failure. Properties which are not unlike a M&A deal.
At first sight may outsourcing and M&A not share many similarities, but at the core are both about one company buying assets from another company, with the aim to make a profit. M&A deals tend to be much larger in value however, which has resulted in developing best practices to both maximize and protect deal value.
One of the key differences between an outsourcing and M&A engagement is the stronger focus of the latter on the exit. If a private equity house buys (part of) a company, most value is created when the shares are sold again or the company is floated on a stock market. Consequently will considerable effort be directed to predict the expected future return. As Real Options can be used to value uncertainty (e.g. effect of economic slowdown) and flexibility (e.g. postpone part of an investment), are they a popular tool among M&A experts.
As dealing with uncertainty and flexibility are also important in outsourcing, can they also be a source of value here. When applying options and other M&A terminology to outsourcing, the value of an outsourcing contract can be described as follows:
Cost cutting is still one of the key reasons to outsource parts of the IT portfolio. There are many other sources of financial benefits hidden within these deals however. Deals which often involve large sums of money, a multiyear commitment and a considerable risk of failure. Properties which are not unlike a M&A deal.
At first sight may outsourcing and M&A not share many similarities, but at the core are both about one company buying assets from another company, with the aim to make a profit. M&A deals tend to be much larger in value however, which has resulted in developing best practices to both maximize and protect deal value.
One of the key differences between an outsourcing and M&A engagement is the stronger focus of the latter on the exit. If a private equity house buys (part of) a company, most value is created when the shares are sold again or the company is floated on a stock market. Consequently will considerable effort be directed to predict the expected future return. As Real Options can be used to value uncertainty (e.g. effect of economic slowdown) and flexibility (e.g. postpone part of an investment), are they a popular tool among M&A experts.
As dealing with uncertainty and flexibility are also important in outsourcing, can they also be a source of value here. When applying options and other M&A terminology to outsourcing, the value of an outsourcing contract can be described as follows:
- 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). Other sources of option value are better economies-of-scale by adding the volume of the new client and contract harvesting (e.g. additional projects).
- 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. Value can also be created if the vendor enables the creation of new products/services or improve forward/backward integration of the value chain. Furthermore is a vendor a source of volume, service and resource flexibility.
- Embedded value for vendor: the monthly revenue stream for the term of the contract (the value of an extension can be included as an option). Additional benefits are realized by assigning part of the transferred staff and assets to other contracts.
- Embedded value for client: the lower monthly cost achieved by better economies-of-scale for the same service. Other sources of potential benefits are better time-to-market and availability figures. Intangible benefits may include access to a larger and more diverse pool of workers and the effects of a more mature delivery organization.
- 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. Another source of negative value is spending more money on the exit-transition than the vendor can recover from the client.
- Exit costs for client: the client has to cover the cost of retransition the activities back inhouse or transfer the activities to another vendor.
In addition to the exit cost is there also the potential value destruction related to specific sourcing risks. These might be strategic of nature (e.g. costs due to opportunistic behavior 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). Depending on the upfront risk assessment and the value of the contract, more or less attention should be paid to one or more of these risks. Consequently can the important ones be included into the business case using options.
To show how a business case looks with and without using options a simplified example is used. The first business case follows a traditional structure outlining the investments and costs for both client and vendor for a period of five years. The second business case expands the base model by including several options to capture other sources of value. Both business cases are based on a fictional client company outsourcing some 70 IT staff, office automation for 3500 users, some 25 business applications and 400 servers to a local vendor. Both business cases are written from the perspective of the client company.
To show how a business case looks with and without using options a simplified example is used. The first business case follows a traditional structure outlining the investments and costs for both client and vendor for a period of five years. The second business case expands the base model by including several options to capture other sources of value. Both business cases are based on a fictional client company outsourcing some 70 IT staff, office automation for 3500 users, some 25 business applications and 400 servers to a local vendor. Both business cases are written from the perspective of the client company.
The cumulative net present value of the first business case becomes positive in the fourth year. In most cases this outsourcing would be a no-go.
For the second business case the break-even occurs a years earlier, as more sources of value have been quantified. However, these additional sources of value are surrounded by uncertainty, hence the use of Real Options. Only with the progression of time the client company will know for sure whether the benefit and risk assumptions are correct. By for example tying the realized benefits from co-creation and improved quality in year 3 to the decision to increase the scope of the outsourcing contract, a more objective decision can be made regarding this ‘call option’.
This flexibility to change the course of action during the term of the contract, is a major source of value. In a traditional NPV-based business case is no room to adjust the number of countries or processes that will be outsourced. The decision has to be made upfront, regardless of the level of uncertainty and quality of information. As options introduce the ability to postpone decisions, will their use become more valuable with increasing levels of uncertainty. Consider the example.
A large multinational company considers to outsourcng several business processes within three countries. The implementation can either be executed ‘big bang’ or sequential, starting in the United States with Brazil and Mexico following over a three year period. From the ROV perspective is outsourcing out an ‘call option’: the right, but not the obligation to outsource within a specific country. The value of this option changes during the duration of the contract, due to for example the project running into difficulties, changing economic circumstances, the company engaging in M&A activities or deciding to (des)invest in certain markets and products. At the moment the decision has to be made whether or not to outsource the processes in the next country, the value of the option is recalculated, incorporating the changes in the economic situation and so on. Only if the value of the option to outsource in a specific country is still equal or higher than the initial NPV, the project gets a go.
Imagine the company has to invest $50 for the transition per country, but the NPV will only yield a positive return if there is a substantial growth in revenue. The company knows however only in two years time whether the revenue has shrunk or increased by 50%. The illustration depicts part of the decision three required to model the outsourcing project. The two basic scenarios are parallel outsourcing in all three countries (invest $150) or start with one country (invest $50).Assuming that there is a 50% percent chance of either 50% growth or decline in revenue the expected NPV for both scenario’s can be calculated.
This flexibility to change the course of action during the term of the contract, is a major source of value. In a traditional NPV-based business case is no room to adjust the number of countries or processes that will be outsourced. The decision has to be made upfront, regardless of the level of uncertainty and quality of information. As options introduce the ability to postpone decisions, will their use become more valuable with increasing levels of uncertainty. Consider the example.
A large multinational company considers to outsourcng several business processes within three countries. The implementation can either be executed ‘big bang’ or sequential, starting in the United States with Brazil and Mexico following over a three year period. From the ROV perspective is outsourcing out an ‘call option’: the right, but not the obligation to outsource within a specific country. The value of this option changes during the duration of the contract, due to for example the project running into difficulties, changing economic circumstances, the company engaging in M&A activities or deciding to (des)invest in certain markets and products. At the moment the decision has to be made whether or not to outsource the processes in the next country, the value of the option is recalculated, incorporating the changes in the economic situation and so on. Only if the value of the option to outsource in a specific country is still equal or higher than the initial NPV, the project gets a go.
Imagine the company has to invest $50 for the transition per country, but the NPV will only yield a positive return if there is a substantial growth in revenue. The company knows however only in two years time whether the revenue has shrunk or increased by 50%. The illustration depicts part of the decision three required to model the outsourcing project. The two basic scenarios are parallel outsourcing in all three countries (invest $150) or start with one country (invest $50).Assuming that there is a 50% percent chance of either 50% growth or decline in revenue the expected NPV for both scenario’s can be calculated.
- 0,5 times NPV (migrate one country at $50 with business decline of 50%) + 0,5 times NPV (migrate one country at $50 with business growth of 50%) = 0,5 x $34 + 0,5 x $19 = $26,5
- 0,5 times NPV (migrate all countries at $150 with business decline of 50%) + 0,5 times NPV (migrate all countries at $150 with business growth of 50%) = 0,5 x 42 + 0,5 x 5 = $ 23,5
To keep it simple, relevant information is left out, including the WACC used to discount the cash flows. For further reading I can recommend the following two articles: T. Copeland, P. Keeman, Making Real Options Real, McKinsey Quarterly 1998 no 3 and T. Luehrman, Strategy as a portfolio of real options, Harvard Business Review, September-October 1993.
Sources and recommended articles for further reading:
- D. Craig en P. Willmott ,Outsourcing grows up, McKinsey Quarterly, februari 2005.
- T. Blommaert, S. van den Broek, E. Curfs, Methodiek voor betere besluitvorming van (strategische) IT investeringen, Informatie, 2009 (Dutch).
- T. Copeland, P. Keeman, Making Real Options Real, McKinsey Quarterly 1998 no 3.
- T. Luehrman, Strategy as a portfolio of real options, Harvard Business Review, September-October 1993.
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