WandaVision season finale recap Stimulus check update Coming 2 America review Best Buy's 3-day sale Razer's Anzu audio glasses Space Jam 2's Lola Bunny Raya and the Last Dragon

The next high-tech hotbed?

High-tech investment options are yielding to cross-border business process outsourcing. Wharton discusses the pattern with Warburg Pincus managing director Mimi Wolfe Strouse.

Investment options in the high-tech area these days are few and far between. One exception, though, is the field of cross-border business process outsourcing, or BPO as it has come to be known.

Last year, Warburg Pincus, a global private equity fund that has $10 billion under management, acquired the majority equity stake in London-based World Network Services, which was earlier a subsidiary of British Airways. WNS, which has more than 1,500 employees collectively in London, Mumbai and Pune, India, is one of India's largest BPO providers.

What opportunities do private equity firms such as Warburg Pincus see in the BPO business? What risks do venture capitalists weigh when making such investments? Knowledge@Wharton interviewed Mimi Wolfe Strouse, managing director of Warburg Pincus. Wolfe Strouse, based in New York, was a principal at General Atlantic Partners before she joined Warburg Pincus. Wolfe Strouse serves on WNS' board of directors.

Q: What is driving the flurry of private equity activity in business process outsourcing today?
A: There are primarily two drivers--business and finance. On the business side, the trend is a need on the part of large companies to reduce costs. So, labor arbitrage is driving outsourcing, both onshore and offshore. Companies are also realizing that outsourcing to specialized vendors helps them reduce costs and get better service. On the financial side, outsourcing is made attractive by the recurring revenue that long-term outsourcing contracts make possible. The dot-com bust taught investors a hard lesson. The long-term nature of outsourcing contracts makes for an attractive business model.

Private equity investors with considerable experience in information technology services and enterprise software such as Warburg Pincus are increasingly focusing on IT-enabled services such as HR back-office, supply chain management, enterprise resource planning and customer relationship management. When I first began investing in BPO, I spent time talking to customers who would say that they had spent a couple of million dollars on licensing an SAP system and another significant chunk on implementation consultants, without seeing much return on their investment.

CEOs would say that they knew less about their key metrics after having bought these technologies than they did before the implementation. That is not to say that these systems are not good, but that they are complex. Technology started driving business instead of enabling it.

Gartner predicts that the BPO market will be $240 billion in 2005. What kinds of firms are best-suited to capturing this opportunity?
There has been lots of activity around customer and technical support. These firms are trying to move up to capture more of the enormous processing market. We are also seeing IT services firms moving into this marketplace. For example, Wipro acquired Spectramind and ICICI acquired CustomerAsset--and the list goes on.

However, these companies are used to selling into IT organizations, not into operations departments. So the leverage that these IT services firms get on the sales side is a bit tricky. Those best-suited to this business are vendors that know how to execute projects and cut costs.

There has been talk about Indian vendors acquiring U.S. firms. I have seen a lot of plans to acquire call centers in the United States and to move work offshore. I think that's a complicated model, because it assumes that the customer does not care where the delivery is done and will continue to pay onshore prices. There are also a lot of sinking costs and tax advantages that can't be easily recovered.

One of the unknowns right now is whether processes will move out broadly across entire functions or deep down vertically into certain niche areas. For example, will an entire loan process application move, or just data verification about someone's background? I think that we will probably see large outsourcing companies start to look for back-end capabilities. But right now, there's not much scale, so it's small potatoes for them.

In the future, will quality of service rather than cost become a compelling reason for outsourcing?
Yes, I think quality will become more important. When I spend time with large companies, I realize that they are not confident about the outsourcers' ability to deliver, because they are not big enough. You see a lot of customers doing 50-person pilots with different vendors, but few processes move out to one vendor. Companies that are looking to move huge processes look at both quality and cost. It's not just a matter of cost at any quality. They are going to want to see both, I think. They won't take worse service just because it costs less.

Do you see competition from providers in India, the Caribbean, the Philippines and newly developing regions such as Mauritius and Malaysia having an impact on the revenues of current providers? Do you expect to see this industry move to competitive pricing? If so, would it be better to invest in providers that can scale up to higher-end services that are more knowledge-intensive?
We see vendors emerging in several geographies. The Philippines in particular has made an aggressive effort to promote BPO. However, the number of seats relative to the potential size of the market for outsourced services is still small. Pricing may come down as vendors move aggressively to win brand-name customers, but will normalize around quality. Higher-end work should always demand a premium. Many vendors are taking on lower-end work with hopes of migrating into more complex and knowledge-intensive processes.

Higher-end work should always demand a premium.

Various outsourcing models have emerged. Some companies, such as General Electric, have wholly owned captive centers, while others work with independent third-party vendors. Which model will dominate in the future?
Most customers are worried about running captive centers due to the operational risk and time that it takes to manage offshore operations. A lot of customers are saying, "Yes, we can cut 20 percent or 30 percent off our costs, but is that worth all of the operational headaches that would result from doing this?"

Our view is that most companies will look to third-party vendors to provide outsourcing services. GE is unique because of its six-sigma process capability. That is core to the company and makes it necessary for GE to run its own operations.

Many C-level executives do not know how to quantify the risks surrounding the outsourcing of processes that could have strategic impact. Since they do not know what to measure and how to monitor the deliverables, they prefer to retain control of the outsourced processes and seem to opt for captive centers. Do you see them considering other options as a system of process metrics emerges and monitoring techniques get formulated?
That is a critical issue in the current market. Customers understand the benefits of outsourcing offshore, but they do not know how to outsource the work and how to monitor their vendors. Several intermediaries are emerging. Vendor management is an important factor in getting C-level customers comfortable.

What is India's competitive advantage in BPO? Is it sustainable?
The number of graduates and their educational level, a strong work ethic and the size of the English-speaking population make India an interesting environment. Nevertheless, India's low-cost advantage is not sustainable. In the end, success in this area will be driven by quality, not by cost. If you take the call-center industry in the U.S., we now see excess capacity as a result of the telecom bust. Pricing at U.S. call centers used to be $25 an hour, whereas vendors in India or the Philippines would offer services of comparable quality at $5 an hour.

But recently, I met a vendor in the United States whose prices were $8 an hour. The offshore component becomes less of an issue when the cost difference is only $3 an hour. Just look at what it's fallen from! Excess capacity has created tremendous price pressures.

Certain customers are very sophisticated. In particular, Dell Computer and American Express are great sourcers of voice capability; they play vendors against one another. For the vendors, this competition is positive, because they get to have Dell or AmEx as a customer. Dell and Amex will hardly be willing to pay $25 an hour for work that can be done in India at $4 an hour and let the vendor keep the difference. But if the vendors offer better quality, they are willing to listen.

Another area of strength for India is employee-turnover rates. In customer care, the U.S. experiences turnover rates well in excess of 100 percent. In comparison, the rates in India are around 25 percent. This is important when there is a significant training and retraining element such as, for example, learning Dell's servers.

How does India compare with the Philippines?
I was in the Philippines last October, and I think that the market and the government there are incredibly enthusiastic about customer care outsourcing and BPO. They would suggest that they are a little bit behind India, because they didn't have the experience of the IT services wave. There are probably 5,000 to 6,000 outsourcing seats in the Philippines compared with 50,000 seats in India. But the government has set up all kinds of initiatives to encourage people to go there. I have seen a number of Indian vendors looking there for redundancy. Both countries have good environments, but India is probably ahead at this stage.

What are the risks of outsourcing to India?
Customers are concerned about stability-related issues surrounding India and Pakistan. We are less concerned about the geopolitical risks. Warburg Pincus is the largest non-Indian private-equity investor in India. We believe strongly in the country. The Philippines would criticize India about its telecom capability, but we have not had any problems.

Another risk is that some contracts do not work, because some vendors bite off more than they can chew. In that case, customer satisfaction is low, and you get negative stories in the marketplace, which is bad for the entire sector and the country.

It makes me nervous when I see, particularly as a result of pricing pressure, vendors taking contracts from which many vendors would walk away, because they know they can't make any money. Right now the venture community is excited about investing in IT-enabled services, but if the business models don't work out, that money will go away. I worry about people underpricing their business, not achieving high levels of customer satisfaction and, as a result, not being able to make any profits.

What kinds of processes do you see being outsourced? How will this evolve in the future?
Most contracts tend to lead with voice capability or include some voice capability. That is interesting, because outside the technical support help desk area, I don't think voice is the logical thing to move. For technical support or areas that have a large technical community it makes sense, but some of the customer service stuff doesn't make a lot of sense. I think there are easier processes to focus on.

In the future, data-intensive tasks such as mortgage processing and claims processing will move offshore. Claims processing on the health care side may not move immediately, because it is complex and people haven't figured it out well. Other insurance back-office functions such as subrogation or recovery will also move out over time. We have one customer at WNS for whom we are running their entire SAP financial systems out of India: accounts payable, treasury functions, etc. It's as if their whole finance department is in India. I think you will see more such arrangements, where control and strategic level remains with the customer, but the processing piece moves offshore.

How do you evaluate a potential BPO investment?
We are looking for deals that have a sizeable platform with brand-name customers. WNS was particularly attractive because of the British Airways relationship. They started with core customers; a core set of assets and scale. That is very difficult to build from nothing.

We also look for strong management, because at the end of the day, we don't run the company or sell the contracts. In the case of WNS, we hired David Tibble, who ran the whole BPO business for Hays, a leading U.K.-based outsourcer. He brought some people from Hays' operational side who built their Indian and Sri Lankan capabilities. So they've run big operations. The president of WNS, Neeraj Bhargava, was with McKinsey and eVentures. He was responsible for building McKinsey's document and research capabilities in India. When he was in eVentures, he invested in customer assets and a couple of other outsourcing businesses. Neeraj spent about a year looking for a platform as part of a team supported by Warburg Pincus. He was involved from the Warburg Pincus side in the WNS investment. He has the investment experience and brings the consulting angle to it as well.

We are also looking for selling skills. We're looking for people who can go out and sell the vision as well as deliver on it. That's a big issue in the market, and people are learning on the job, because the market is new. Also, outsourcing contracts are very complicated. Knowing how to structure contracts correctly and tapping into the right knowledgeable resources in the market is a rare skill that we value highly.

BPO is an overused term. It has become so commonplace that sometimes I want to look for the next big thing!

What kind of scale do you look for in your potential investments?
WNS will have more than 10,000 people in the next couple of years. That is a big company. I think that, for us, WNS is probably the smallest size we would consider investing in. One of the reasons that WNS was attractive was that there are not many platforms of that size.

While evaluating potential investments, do you apply different sets of criteria between IT-enabled services and BPO investments?
BPO is an overused term. It has become so commonplace that sometimes I want to look for the next big thing! It smacks of some of the characteristics of the Internet bubble. "IT-enabled services" also has become a catchall phrase. People use these terms interchangeably. I tend to think of BPO as taking large functions over for customers and IT-enabled services as applying technology to a service.