The Growing Trend towards Multi-Sourcing

by Hilary Weatherstone, Director of Technology in Lloyds TSB Coporate Markets’ Corporate Asset Finance division

The trend more recently has been for corporates to move torward multiple specialist service providers.

Fuelled by two key developments in the past decade, the outsourcing industry has passed the point of critical mass. Firstly, customers have become increasingly educated about the best way to go about outsourcing their non-core functions. And secondly, this has given them the ability to choose the most appropriate outsourcing partner with much more success, as publicly available and anecdotal experience on outsourcing becomes more accessible.

Indeed, the market has witnessed successes in outsourcing and learnt from the disappointments of others. And as this market has matured, companies have increasingly moved to a model using multiple outsourcing partners who provide specialist services, rather than larger corporates who act as prime contractors. This shift has brought advantages and challenges - one of which is to ensure that the future investment necessary to fund the on-going technology requirements will be available and appropriately structured from both the outsourcer and its customer’s perspective.

Fragmentation and differentiation

Look at any recent predictions in relation to technology outsourcing, and you will see a healthy continued projected growth rate, with Gartner recently forecasting 2008 growth rates to be 8% or higher in the global market. However, looking across the industry, in addition to declining margins and continued pressure to lower the overall costs of any technology outsource, the market seems to have agreed that the age of the mega-deal has stalled, and may be in decline. The main reasons cited for the growth of multi-sourcing are positive, highlighting specialist expertise for certain services in areas such as the outsource of your desktop, BPO of certain defined functions, or transformational outsourcing.

The table in Figure 1 summarises some of the operating models which have historically been used.

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Although mega deals still exist (recently announced examples include; Computer Science Corporation’s $540mn deal with NASA, EDS Corporation’s $715mn contract with Bristol Myers Squibb, and Fujitsu Services’ global infrastructure contract with Reuters), the trend more recently has been for corporates to move toward multiple specialist service providers (including those providers involved in mega deals), where the deal sizes awarded may be less than $100mn, but with multiple smaller contracts across the enterprise.

So why are corporates looking at doing this? Some of the perceived benefits for corporates are summarised below:

• The reduction of risk across the portfolio of services (through diversification of supply);

• Innovation through competition;

• Potential lower cost of supply (multiple service providers potentially creates price reductions);

• Potentially more portable service provision - as individual services can be transferred to another provider with limited disruption; and

• Allowing specialist providers to concentrate on their true core competencies to deliver efficiencies

However, with these benefits come a number of challenges, including the need for good customer governance regarding the interplay between individual providers, and the time investment in managing each relationship.

Talking to specialist financies allows the corporate to focus on the important decisions.

A less well publicised challenge is the ongoing investment necessary to ensure that the appropriate level of underlying investment is guaranteed over the term of the contract, which could be for up to ten years. In the past many outsource providers swallowed the cost of this investment, as the margins earned overall on the contracts gave enough leeway to meet the carry cost. As margins are squeezed and outsourcing becomes increasingly commoditised, questions about funding for ongoing investment in technology have become more common when discussing the dynamics of the deal.

Figure 2 illustrates the revenue and expense cash flows in relation to this type of arrangement, highlighting the challenge in recovering the expenditure incurred early in the contract term from the ongoing related service payments. Traditionally the outsourcer has absorbed the cost of the investment made. However, depending on the outsourcer’s own financial position, his internal cost of capital can skew the deal economics to the extent where the decision to outsource is adversely affected.

One way of managing this situation is to look to an external financier who can fund the ongoing expenditure, looking through to the risks in the underlying contract, and based on the corporate’s covenant. This should provide a lower cost in relation to the ongoing investment, while guaranteeing that the funds will be available to pay for the future expenditure.

Leading financiers should work closely with service providers and corporates to finance the expenditure through a number of routes such as a structured loan or receivables based product. Lloyds TSB look at the underlying payment streams generated over time (under the outsourcing contract) and from this create a pool of cash which can be used to fund capital expenditure now and in the future. Assets such as hardware and software and even delivered services (such as consultancy) can be purchased today for use in the outsourcing contract by raising finance against future committed payment streams from the end customer. [[[PAGE]]]

These structured financing solutions are most suitable when the outsourcing provider and the corporate need flexibility both in choosing the assets being used (and replaced) over a period of years, and in choosing countries where those assets might be located. The structured solution is matched to ensure that the term, profile and frequency closely match the benefits accruing from the underlying outsourcing contract. This allows the business to have an efficient tailored solution.

This solution has been used in many different scenarios; however its relevance in the new world of multiple outsourcing contracts should not be under-estimated. Talking to specialist financiers allows the corporate to focus on the important decisions - such as which outsourcer is best placed to provide the service and how will this be managed over the life - rather than being concerned about where the cash will come to finance business critical assets.

In addition the solutions provided can be structured to ensure that the following elements are taken into account:

• Accounting treatment - the construction of the finance solution is fine-tuned to best suit the outsourcing company and its customer’s business accounting practices and (with the relevant auditor’s approval) potentially treat the assets as being off-balance sheet.

• Asset flexibility - most types of business assets can be financed, with the ability to substitute assets over the life of the agreement.

• Operational benefits and geography - we have the ability to locate assets globally without potential restrictions on geographical location.

• Tax neutrality - the parties can structure the transaction to allow any potential tax allowances to sit with the party who can take most benefit.

• Constraint free at the end of financing - the corporate or the outsourcing company remains in control of the assets throughout the financing period, with no constraints placed at the end of this period on using the assets.

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Case Study - Meeting the investment challenge

The business need:

A well-known media company wanted to finance new technology infrastructure.

Outsourcing non-core functions allows a business to focus on delivering its chosen products and services.

The management of these assets was going to be undertaken by an outsourced service provider who would have an on-going managed services contract.

The assets were going to be bought over time as the project reached certain milestones, and as each milestone was reached then these assets would need to be funded.

The solution:

Lloyds TSB Corporate Markets entered into a receivables agreement with the service provider where it gave its commitment to fund the project over the roll-out period.

The underlying agreement between the customer and the service provider was structured so that the payment stream within the agreement was sufficient to cover the upfront cost of the assets.

Once the milestones were reached, Lloyds TSB paid the cash across to the service provider for the underlying assets, and the payment profile was sold to Lloyds TSB.

At the end of the financing period, the customer and its service provider have complete flexibility in the continued use (or disposal) of the underlying assets.

Conclusion

Outsourcing non-core functions allows a business to focus on delivering its chosen products and services. This is now a well accepted method of trading where the end-user company can create a strategic advantage over its competition by establishing efficiencies through outsourcing secondary functions. While the model continues to be refined through the rise of multi-sourcing and opportunities are materialising through greater efficiencies, the challenges of managing a diversified base of suppliers with the corresponding investment needs of the client in mind requires careful consideration.

Our experience of working with both clients and the outsourcing providers has ensured that the investment needs can be met so that the client and the outsourcer can get on with the real reason for the agreement - seamless customer service delivery.