Carve-Outs as the Next Step for Shared Services

In this period of turbulent economic and capital market conditions, corporates are increasingly faced with the challenge of how to focus on their core businesses, reduce costs, avoid unnecessary capital expenditure and enhance the balance sheet wherever possible, whilst at the same time avoiding large-scale layoffs and destroying morale. The back office has generally not been looked upon as the answer to these problems. However, as the example of British Airways shows, a carve-out approach is one option.

Although the back office has not generally been looked upon as a solution to the balance sheet problem described above, a "carve-out" approach may provide a way out by creating a new entity with a promising future. In talking to a number of large corporates in the late 1990s, it became clear that by selectively carving out certain back-office activities, including customer facing ones, we could solve corporations’ most pressing needs and at the same time create exciting new platforms from which to build bigger businesses. If these assets had already been merged into SSCs, then so much the better.

Benefits

A major factor contributing to the current interest in carve-outs is that back-office activities, including contact centers, are frequently seen as annoying and costly distractions for senior management. Taking these "support" areas out of an organization provides advantages not only to the parent company, but also to its employees and shareholders. For the parent, benefits include:

• avoidance of future capital expenditure
• guaranteed lower costs through long term SLAs
• service level enhancements through culture change and IT
• the opportunity to receive cash capital gain through the carveout transaction and close control through a combination of equity ownership and SLA
• easier access to offshore benefits via an independent vehicle
• the opportunity to benefit from incremental third-party volumes adding to economies of scale.

Parent companies are also able to avoid difficult investor relations issues. Carve-outs are often seen as a more attractive option than a redundancy program or wholesale outsourcing operation. In some cases, the approach even serves as a catalyst for culture change not otherwise imaginable.

Much has been said already concerning the morale-boosting effect of relaunching a back-office support operation as a separate business. A carve-out takes this one step further. By developing an independent growth-oriented company, solely focused on providing excellent business services, employees are empowered, benefiting from the cultural shift as well as the ability to own equity.

Corporate shareholders benefit from knowing that the new business begins with a critical mass, and with already contracted revenue from the parent company. Add to that the opportunity to develop best-of-breed processes and technologies through capital infusions from an investor, and the ability to attract and retain the best employees and management with equity incentives.

Carve-Outs in Practice

Carving out support services, whilst not widespread, is certainly not novel. Successful examples include: Microsoft and Expedia, United Utilities and Vertex, American Express and First Data, Cadbury Schweppes and ITNET, BP and Exult, American Airlines and Sabre/Travel Network, and Lloyds TSB/Barclays and iPSL. What is new, however, is that private equity firms are developing focused programs and dedicated teams in this area, to act as both catalyst and driving force.

Structural Models

Three core structural models exist for carve-outs.

In a joint venture scenario, the business is not really fully separated from the parent, but a third party becomes a joint venture partner. Benefits include transaction savings, third-party funding of investment costs, and shared risk and reward. If the entity is ultimately carved out, there is an equity upside. This is the model adopted by companies not really committed to separation. They tend to retain more than 50 percent of the equity. However, the benefits of maintaining more control are, in my opinion, largely negated by the fact that independence is not achieved, so the full extent of the cost savings, positive culture change and ability to grow through attracting other customers remains illusive.

The second model, at the other end of the spectrum, is when the assets are sold outright. Benefits include total separation and an upfront payment, with the acquiror taking on full responsibility and risk, under the terms of a tight SLA. This model is often seen as "one step too far," however, when the assets in question still provide a critical service to the original owner. There is also no future equity upside should the new entity become significantly more valuable in the future. This model is common when traditional large IT outsourcers are the acquirors. The result, however, tends to be that the carved-out assets are simply subsumed and digested by the acquiror and the chance to create a new independent entity are lost.

The middle ground is represented by "the outsourcing carve-out partnership". Under this scenario, a third party takes a majority equity position in a new company (comprised of the carve-out’s assets). A SLA transfers all risk while still offering some control. Again, the partner can be a financial one, e.g., private equity firm, or a strategic one, e.g., an IT outsourcer. The strategic partner would usually argue that it can bring technology to the partnership, and perhaps customers. The drawback is that the ultimate prevailing strategy tends to be that of the partner, so independence is never really granted. Furthermore, there is rarely the commitment to create a liquidity event for the shareholders: the better the asset performs, the more likely the strategic partner will want to continue to own it. A private equity partner will want to exit at some stage, to return profits to their investors, and are by definition value-creation oriented. Also, the strategy will only be dictated by what is right for the carve-out. The original parent should benefit from this.

Are You Ready For a Carve-Out?

A carve-out will not deal with deep operational problems: poor quality should be sorted out first. An overview check should include:

• are the operations of a sufficient scale to be at critical mass if independent?
• are operating cost savings to be gained if the operations were independent?
• are the systems within the operations a potential source of competitve advantage, or do they need complete replacing?
• what is the quality of management? how will they react to being in an independent, growth-oriented entity?
• is the industry such that competitors are likely to be willing to outsource to the new vehicle if sufficiently independent?
• is the opportunity to create value of enough substance to attract experienced and talented senior management?
• what does the parent really want out of this?
• is there an internal champion of enough seniority to see the transaction through?
• what is a realistic estimation of future capital needs?
• can a viable growth strategy be mapped out?
• will confidentiality of data and processes will be maintained?
• what is the time frame?
• what is the earnings impact if the parent is public: is there a good story for shareholders?
• does the partner have a track record of engaging in such transactions? Does it have the financial capability to complete the transaction as well as support the new business going forward?

WNS Global Solutions

British Airways’ SSC operation in India went through almost one year of carve-out negotiations before it emerged as what is now known as WNS Global Solutions.

BA’s operations were hidden within the airline and were underutilized when we first began talking at the end of 2000. With 1,400 people, the unit had a critical mass, however, and high credibility based on the quality and range of processes already being performed for BA.

While BA knew they had done a good job of creating some real competence in the center, they recognised that they had neither the capital nor the management focus to take it forward themselves.

Today, WNS Global Solutions has made two acquisitions, is up to 3,000 people, is growing at over 100 people per month and is the dominant, UK-headquartered offshore BPO company. Additionally, the new organization gained an independence that allowed it to attract both new senior management and new customers.

Trust – A Major Factor

Corporations frequently take a tremendous amount of persuading to believe that they have found the right partner. Even when a mutually acceptable transaction structure and SLA has been constructed, many good opportunities falter due to internal corporate politics. If I had to pick one issue that really matters, it is the confidence the corporate needs to feel in their prospective partner. They may have experienced prior disappointments with outsourcers, or consultants over-promising and under-delivering, leaving behind institutional scar tissue.

Forming a partnership with a firm with a large balance sheet and a long-term outlook provides a certain amount of flexibility on transaction structure and SLAs, which a corporate outsourcer, given quarterly earnings constraints, cannot accommodate.

About the Authors

Jeremy S. Young is MD of Warburg Pincus, a global private equity firm. He led the firm's investment in WNS and is actively working to identify other BPO opportunities leveraging the firm's extensive experience in India, where Warburg Pincus is the largest nondomestic private equity investor, China and other parts of Asia. jyoung@warburgpincus.com

Steve Dunning is Managing Director of WNS (UK) Ltd. He leads WNS' Global Airline practice and is Managing Director responsible for WNS' UK operations. Prior to joining WNS, Steve served as Managing Director at Speedwing (the British Airways subsidiary that owned WNS).