Structuring Sourcing Projects (Part 5)
Structuring Sourcing Projects (Part 5)
In most offshoring arrangements the shape of the deal is determined by how much control the customer wants to retain over the outsourced services, balanced against complexity and of course cost. The different models commonly used for offshoring are examined here, along with the pros and cons of each.
1.Captive Build
Captive build involves the customer incorporating (or acquiring) an entity as a wholly owned subsidiary in its offshore jurisdiction of choice, whereupon the outsourced operations are transferred to it. The subsidiary then becomes the supplier of the outsourced services to its parent and perhaps other members of the group.
Because the captive entity is part of the customer’s corporate family, the customer usually keeps control of all personnel, assets and systems. Working practices and the company’s ethos can also be preserved, and of course all the subsidiary’s profits are retained.
The customer will own any intellectual property developed during the project. It will also avoid the need to disclose confidential or commercially sensitive information to third parties. In fact the customer avoids dependence on third parties altogether (unless it chooses to engage consultants with local expertise) because there is often no need for third party consent to transfer licenses to a subsidiary, and no need for due diligence on any target company (unless the customer is acquring rather than incorporating the captive).
Assuming the captive is successful, the customer may even choose to diversify, to provide services to the local market via its group company.
Finally, there are potential tax advantages to a captive build arrangement, such as group relief (if the captive is incorporated in the EU) and sometimes government offered incentives in jurisdictions like India (subject to compliance with certain conditions). The captive entity will also be part of the customer’s group for VAT purposes.
Captive build does carry relatively high implementation and maintenance costs (capital investement can be significant), with the same on exit when the services must either be repatriated or transferred to another supplier. The customer will also be directly responsible for compliance with the laws of the local jurisdiction, which can be a significant risk (and cost) in its own right.
2.Joint Venture Company
A joint venture arrangement involves the customer forming a joint venture company (or JVC) with the supplier and transferring the outsourced operations to the JVC. (Another variant involves three or more entities, each of which is a shareholder and part owner of what is then a consortium company.)
Typically, the customer will choose a supplier with local expertise on whose reputation it can trade, thereby benefiting from external know-how and goodwill while retaining a high level of control over service delivery. In turn, shared risk and reward should incentivise commitment and performance from the supplier.
If successful, joint ventures can deliver rapid integration with the local market and, subsequently, opportunities to diversify to provide services locally.
There may be VAT savings available depending on the corporate structure adopted, and the customer will benefit from any capital appreciation of the JVC.
Of course a joint venture arrangement involves more than just setting up a JVC. The parties also have to implement a joint venture agreement, something which is often complex and expensive (ownership of intellectual property developed during the project must be worked out for example.)
It’s also in the nature of joint venture relationships that risk is only partially transferred to the supplier. Added to this, the customer will be taking on compliance risk in the offshore jurisdiction where the JVC operates. Finally, decoupling a joint venture relationship can be complicated and expensive, so the risks on exit may be considerable.
Generally, JVCs are more suitable for long-term transformation of the customer’s business rather than just short-term cost cutting.
3.Build, Own, Transfer
Build, own, transfer involves precisely what it says: the supplier builds, operates and manages a facility in the offshore location before transferring ownership to the customer.
The supplier has responsibility for setting up and implementing the services until such time as ownership transfers. This can provide the advantages of a joint venture arrangement - facilitating the customer’s integration into new offshore markets - while enabling it to postpone full integration until it feels ready (the transfer may be on an agreed date, or at one party’s option, or indeed the customer may elect for the supplier to continue providing the services for the life of the deal).
Inevitably of course this model gives the customer less control over the services, until the point at which they’re transferred to it. Implementation costs may also be higher (higher even than under a captive build structure), and the process of working out the detailed operational arrangements can be long drawn out and complicated (the provisions for transition of the services to the customer must be carefully considered, for example, along with ownership of intellectual property). Finally, the tax benefits touched on above may not be available under a build, operate, transfer structure.
4.Third Party Supplier Contract
This is the traditional outsourcing model whereby the customer contracts with a supplier to provide the outsourced services. The relationship may be with a single supplier, or with several (under what is now usually called a ‘multi-sourcing’ relationship).
The traditional model remains popular because responsibility for service delivery is transferred to the supplier wholesale, and because implementation and exit costs are relatively low (the supplier’s existing infrastructure will often reduce the level of capital expenditure for the customer, and also its HR costs). It is also relatively quick to set up (provided the supplier has the necessary infrastructure in place) and the customer should benefit from ongoing cost savings through economies of scale (assuming the supplier is providing similar services across the market). As far as possible, the supplier usually assumes responsibility for regulatory compliance.
Generally, the traditional model makes it easy for the customer to monitor and manage expenditure, and to benefit from the supplier’s local expertise and tax regimes. In a multi-sourcing relationship the customer can spread its risk by avoiding reliance on a single supplier.
On the other side of the ledger the traditional model does involve the customer ceding control of the services. It will have no control over the offshore entity, and its control over supplier personnel will be limited to whatever rights there may be in the governance and contract management provisions of the outsourcing agreement. In a multi-sourcing arrangement, while control over the services themselves is ceded to the suppliers, the customer will often have to assume responsibility for integrating them.
The supplier, for its part, will only be incentivised to deliver the services as economically as possible in order to maximise its margins. It has no motivation to invest in the customer’s business and will not be concerned with its growth.
Finally, the customer will usually have to disclose important proprietory trade secrets and confidential information and the parties must agree on who owns intellectual property developed during the project.
5.Indirect Outsourcing - the Hybrid Approach
The ‘hybrid’ approach usually involves the customer contracting with an onshore supplier who then subcontracts to another company within its group, based offshore.
The primary advantages for the customer are that it contracts under domestic law with a domestic supplier who understands its business needs and can meet these through its knowledge of the delivery capability of the offshore entity to which it subcontracts.
In some cases the customer may need to evidence direct contact with the offshore service provider to a regulator. There may also be some insolvency risk if the onshore entity is a shell company that would be wound up and unable to fulfil its contractual obligations.
...
In any decision to offshore, the key consideration is simple: look before you leap. Customers should always engage a strong advisory team with adequate resources and knowledge of local law to produce comprehensive due diligence on the offshore location and prospective suppliers. This might involve taking up references from suppliers’ other customers (to ascertain their service delivery capabilities) and conducting reference site visits in the region. This can be supplemented by consultation with local chambers of commerce, professional bodies and business groups to verify conclusions. Having completed this process, customers should ensure the offshoring agreement sets appropriate limits on subcontracting so as to guarantee that the entity providing the services is the same entity about whom due diligence was obtained.
Customers should conduct detailed risk and impact assessments when developing a strategy and business case for offshoring. Confidentiality or limitation of use provisions in the a customer’s existing contracts may present a hurdle to offshoring certain functions. Even where this is not the case customers should consider whether the law of confidence may preclude the disclosure of certain information to third party suppliers. In either case, customers would have to engage with all relevant contracting parties to obtain consent to the transfer of information. This is less likely to pose an obstacle for customers who elect to offshore by establishing an entity in the offshore location, because in this case the information will only be transferred within the corporate group.
There may be some functions of particular sensitivity which customers deem inappropriate to offshore. These may be retained in-house (although this will reduce the cost savings achievable through the offshoring) or spread between different offshore suppliers in a multi-sourcing arrangement to ensure that no single supplier gains a full picture of the sensitive function and to spread the risk of compromising it. Some customers elect to multi-source even where the functions to be outsourced are not sensitive, to avoid over-dependence on a single supplier. This is pertinent when offshoring to destinations which pose some geo-political risk. The multi-sourcing model also allows customers to seek out specialist service provision for different elements of the outsourced function.
Due diligence is not solely a matter for customers of course. Suppliers should make their own enquiries to etablish a solid understanding of their client’s business and the obligations and functions which will transfer under the outsourcing arrangement. Suppliers who are loath to rely on their due diligence alone may try to negotiate a period of post-contract verification. Customers will want to limit the number of changes permitted during any verification period to minimise the impact of associated delays and costs.
...
Geo-political risk
Business continuity and disaster recovery is fertile ground for negotiation in offshoring agreements because of the potential wide-reaching impact of political instability. The point becomes even more important when coupled with under-developed infrastructure in a region which is susceptible to natural disasters.
Any culture of corruption in the offshore location should worry customers who are concerned about data security and maintaining the confidentiality of information. While an obligation on the supplier to observe relevant standards will provide a means of redress, it’s rarely possible to rectify a breach of these obligations once information has been disclosed.
A further risk for the customer is that a new government in the offshore jurisdiction may adopt a different approach to offshoring and retract incentives offered by the previous incumbent.
To mitigate exposure to geo-political risk the customer may select a supplier who can offer a robust communications network encompassing several alternative channels, each with the capacity to carry the full range of the customer’s communications if necessary. An alternative approach is to select a dually located supplier with capacity at each of its locations which can be flexed to provide all of the services if necessary. The customer also has the option of retaining some capability in-house (in addition to the onshore function it retains to manage the offshoring), in order to reduce its reliance on outsourcing.
The customer will require assurances about how any geo-political risk (which can cause interruptions to the service and difficulties for the customer in conducting site visits) will be mitigated. This can be achieved through limiting force majeure relief to situations where the business continuity and disaster recovery plan cannot be implemented, and retaining the right to terminate in the event of continuing force majeure.
...
Running offshoring projects
As we’ve seen, offshoring gives customers the opportunity to consolidate their international operations through uniform business processes. This comes at the cost of managing local laws and regulations, all of which must be addressed in the suite of contract documents governing the relationship. These documents should also include the provisions of a domestic outsourcing contract.
A strong governance structure is essential to the success of an offshoring arrangement. This should include regular meetings and updates and a robust internal escalation procedure operating at the correct level, which can be especially challenging in multi-sourcing arrangements.
Clear reporting of performance monitoring information is vital to the success of an offshoring arrangement because of the physical distance between the customer and the supplier. The customer will not be able to visit a supplier located in Brazil as easily as one in a neighbouring city. Auditing an offshore supplier is an expensive and drawn out process which most customers like to keep to a minimum. Throughout the term, the customer and supplier should keep in regular telephone and email contact to discuss performance-related issues. Retaining audit rights to ensure compliance with the stringent reporting requirements of the Sarbanes Oxley Act 2002 is a particular concern for foreign entities with Securities Exchange Act or Securities Act registrations.
Setting the correct service levels will also be crucial to the success of the offshoring arrangement. The service level and service credit regime in an offshoring arrangement will be complicated where the supplier provides services to the customer across several jurisdictions. The parties should consider whether service levels should be set and service failures should be monitored at a regional or global level, and how service credits will accrue. It may not be appropriate to measure service failures at a global level since this could result in no service credits accruing for service failures which occur locally. Adopting a regional approach to service levels will also make it easier for the agreement to reflect any regional variances in the customer’s service requirements.
The offshoring agreement should clearly set out the payment terms including the currency and the location for remittance. The customer and the supplier should carefully consider the currency in which the charges are paid in light of the associated exchange rate implications. By pricing the services to be provided under the local services agreement in local currency, the currency risk borne by each of the parties can be minimised.
Structuring Sourcing Projects (Part 5) - Offshoring
30/11/2010
Offshoring service models
You might also like: