Thursday, June 7, 2007

Strategic Rationale for M&A in IT & BPO Service Providers

Mergers & Acquisitions (M&A) are the flavor of the season in IT & BPO industry. Right from small startups to well established big firms, the inorganic route has become one of the growth strategy. Will they be successful and create value? What are the strategic rationales for the M&A in IT & BPO industry? Are these rationales similar to rationales in other industries- economics of scale, economics of scope, synergies, capability augmentation, time to build or do we need to look them in a different way?

The understanding of these strategic rationales will have implication on valuation and due diligence process. Most of M&A’s don’t create estimated value. While much of the reason of failure is improper post merger integration but many of the expectation can be made realistic at strategic rationale itself.

IT & BPO is different from other industries. To understand what could be strategic rationale for M&A first we need to understand how growth happens in IT & BPO industry and then see what M&A drivers can help in this growth. Growth happens when company gets new projects – sounds simple. Company can get new projects either from new clients or additional work from existing clients.

In these growth scenarios the most important strategic rationales are economics of credentials and economics of relationships.

Economics of Credentials & Economics of Relationships as M&A rationale

Economics of credentials – When combining credentials of two firms, the probability to get new client increases versus the individual probabilities of getting client based on independent credential by each firm separately; we can describe this as economics of credentials.

Economics of relationships – When combining two firms, the probability of getting additional work leveraging combined client relationships increases versus the individual probabilities based on leveraging individual relationships of getting additional work by each firm separately; we can describe this as economics of relationships.

To see the relevance of economics of credentials and economics of relationships, we should look at how a company selects IT & BPO service provider? If the work is new then company typically follow through proper bid process. Information is collected from suppliers in form of RFI (Request for Information) which can sometimes run in hundreds and thousands. Based on credentials of suppliers, few of them are short listed for RFP (Request for Proposal) stage. Based on RFP response, final supplier or suppliers are selected. Here along with price and solution approach, the credentials are deeply evaluated to arrive at final selection.

Some of the credentials on which IT and BPO service providers can be evaluated or eliminated are

Financial Credentials – Revenue, Revenue in a particular industry vertical (BFSI) or a horizontal (HRO)
Capability Credentials – Number of people, skill sets (number of years of experience) in technology, process, packages etc, number of people in different industry verticals or horizontals
Client Credentials – Number of Clients, Number of clients in different industry verticals or horizontals, Number of clients in particular geography
Geography Credentials – Number of delivery locations in different geographies, number of people in different geographies

If M&A helps in improving these credentials for the combined organization then organizations can leverage economics of credentials.

Sometimes companies can look for their existing suppliers for additional work. Here leveraging economics of relationships companies can win additional work. However, one caveat that relationships are starting point only. If credentials are not there, then relationships cannot be translated easily into projects. As it happened initially with many IT firms when they ventured into BPO. Company’s IT relationships didn’t automatically give them BPO clients, but once they have started getting credentials in place their relationships started fructify into client wins and their growth is much faster than their peers.

In M&A for estimating economics of relationships it will be prudent to estimate
1.How many active client relationships does that company have?
2.Which of these relationships one has potential to tap and grow the accounts with other services?
3.Does combined firm have credentials in other services so that the opportunity can be tapped?

Some M&A examples

Companies should identify their growth areas and then look for acquisition candidates who can augment their economics of credentials and relationships in the growth area. The growth area can be a vertical, a horizontal, client geography, a delivery location. Some randomly picked recent M&A examples illustrate these points

When MNC acquires offshore company, typically increasing their geography and capability credentials in offshore presence. - EDS acquiring Mphasis, Capgemini acquiring Kanbay, CSC acquiring Covansys, IBM acquiring Daksh

When service providers acquire niche companies in India– Wipro acquiring Spectramind, WNS acquiring Marketics, EXL acquiring Inductis are examples of companies increasing their capability and client credentials in new services.

When service provider acquire niche companies abroad – Infosys acquiring Expert in Australia, Wipro acquiring Nervewire in US, Satyam acquiring Citisoft in Europe are examples of establishing client, geography and capability credentials and hope to leverage some of the economics of relationships

Why traditional rationales are not right measure of value?

Having looked at economics of relationships and economics of credentials it will be a good idea to see quickly why traditional rationales might not be the right measure

Economics of Scale – Does the combined average unit cost decrease by combining two firms? It generally happens in high capital intensive industry where fixed cost can be leveraged over much larger production units. In IT & BPO industry not much advantage except some advantages due to location, infrastructure, software and hardware.

Economics of Scope – Does the combined support cost like sales force can decrease by combining two firms? Not much unlike FMCG where huge sales force which can be combined and rationalized.

Time required to built and ramp up– Many of the IT and BPO firms are recruiting greater than 10000 employees in a year so this is hardly a compelling rationale for acquisition.

Talent Acquisition - There is high attrition and talent can be recruited by giving premium from market, the way many MNC’s did, so it can hardly be a compelling strategic rationale for an acquisition.

New Growth Avenue – That can happen in a saturated industry where a major growth can happen only by acquiring another major player. The IT and BPO are still sunrise industry and far from getting mature.

Lesson for Acquirers and Targets

Companies need to understand the true leverage they can get in economics of credentials and economics of relationships by acquiring. This mind set need to be in place for searching targets, due diligence, valuation and negotiation. Similarly tragets who want to get acquired should make their economics of credentials and economics of relationships proposition clear when they are selling them

But the question will always remain about the transaction value. Does the value justifies the economics company can get of credentials and relationships? If future is known, isn’t the business becomes a child play. Companies who are close to estimating real economics of credentials and relationships are more likely to be successful than others.

I will like to end this with a true conversation with an investment banker recently. He asked me “How much advantage of economics of scale will we get if we combine the two BPO firms? My answer was you can’t beyond few licenses, and infrastructure. He asked then how to estimate the synergies in merger? I said for true value you need to look economics of credentials and economics of relationships. After listening to all my explanation he asked a simple question, how will he get all this information? Well my friend, for that you are paid hefty transaction fees, isn’t it?