Beating the credit crunch

One prevailing theme in a global market slowdown is always going to be how to cut costs but maintain quality, and that is a key consideration in outsourcing.

Can you use outsourcing to beat the credit crunch, or at least to manage it?

The outsourcing industry started 2008 in a positive frame of mind, particularly in IT, where its potential to slash overheads and minimise bottom line balance sheet impact was being lauded. In September TPI reported that the first six months of 2008 had seen £28bn of outsourcing deals – the highest number of contracts in the past decade. By TPI’s third quarter review, there were signs of a slowdown, particularly in relation to the financial services sector. It is fair to say, though, that the third quarter in any given year tends to be the weakest and so the key measurement is likely to be the fourth quarter of the year, which is traditionally strong. If it is not, that will be a sign of credit crunch impact.

Cost cutting is a major consideration in any plan to outsource services. Deloitte published a survey at the beginning of 2008 stating that 64% of executives surveyed said that cost reduction was the main attraction of outsourcing. In the IT sector, having started the year forecasting a 6% rise in IT budgets, Forrester is now reporting that 43% of companies have cut their IT budgets. IT is now such an intrinsic part of business that making cuts is not necessarily the answer, since this could decrease overall efficiencies. Rather, it appears that businesses are putting discretionary projects on hold, so as to focus on their main business.

Some current hot issues in outsourcing are:

the continued growth of offshoring;

multi-sourcing – will the credit crunch increase or decrease it?

Offshoring

Offshoring is always a hot topic. Some predict that offshore spending in 2008 will grow by 60% in Europe and 40% in the US. However, how much is understood about offshoring? Statistics suggest that many businesses do not understand how to get good value from it. Financial services continue to dominate offshoring, with 14% of deals done in the first quarter of 2008 being in that sector. We are also seeing new destinations emerge. India is still the dominant player, but countries such as Thailand, El Salvador, Paraguay, Uruguay and the Dominican Republic are becoming viable options.

A particular credit crunch issue relevant to offshoring is the extent to which the service providers are exposed to the financial services sector. India’s top five service providers rely on the financial service sector for 45% of their business. Long-term contracts with major financial institutions were previously the holy grail, representing guaranteed long-term income, but these institutions are no longer the safe bets. Both domestic and offshore service providers are looking carefully at their own exposure and pricing for long-term contracts in this sector. Many are trying to diversify into safer sectors, such as public sector.

Multi-sourcing

Multi-sourcing has begun to emerge as a trend in the last two years.

This is where the customer buys the package of services it requires from a group of service providers, rather than awarding the entire package to one service provider. The main advantage is that the customer can choose “best in class” providers for each aspect of the services, rather than taking the risk that a service provider who is expert in one area is less proficient in another.

Multi-sourcing arguably increases the flexibility for the customer, who can reverse out of the contracts for the individual services if they are not working, without having to change the entire contract. Customers also value the fact that multi-sourcing develops a relationship with a wider group of service providers, which increases the market knowledge and contacts within the customer group.

The main downside of multi-sourcing is the extra work involved in reproducing the “end to end service” that a single service provider will offer. The contracts with each individual provider in the multi-sourcing model need to be carefully planned to make sure that all aspects are covered. Someone has to be in charge of service integration and management (SIAM). If that is the customer then time and resource costs are going to be involved. The customer needs to be convinced that this is outweighed by the service benefits multi-sourcing will deliver. An alternative could be to give responsibility for SIAM to one of the service providers: the likely trade-off is that that service provider will want to be awarded a critical mass of the services on offer, to make it worth their while.

It is possible that new services will emerge to help offset the perceived additional management cost for customers involved in running a multi-sourced relationship, for example outsourcing of contract governance. Suppliers offer customers who have already outsourced services a contract management and governance service, covering management of contract change and monitoring service provider performance against service levels.

The jury is out on multi-sourcing in the credit crunch. Those who say that its popularity will reduce, point to the higher management costs for customers. Businesses may view single-sourcing as a way to leverage more “bang for their buck”. Those who believe multi-sourcing will grow, point to the decline in megadeals, with companies instead looking to several providers and spreading the risk of supplier failure. The number of outsourcing contracts worth more than $1bn fell from 12 in 2006 to 10 in 2007.

What should in-house lawyers do?

So what are the key issues in outsourcing contracts that in-house lawyers need to be aware of during the credit crunch? Our key recommendations are:

Actively manage your current outsourcing contracts, and engage your internal client in discussions as to how they might save money under the contract, rather than waiting for them to make demands. Is it possible to sponsor shared services among different clients within the business?

Check contract compliance by the service provider and make sure that your own paperwork is in order, in case you are looking for ways to get out of a contract.

Check how you stand on termination of the contract. This can be:

• for convenience, i.e. on notice, and what the implications would be, such as termination charges;

• for change of control: the credit crunch is causing unprecedented consolidation in the industry, and if you have been able to negotiate an opportunity to terminate for change of control the chances are that you will have a limited window to exercise it. Understanding that window is important;

• for credit ratings: some contracts will contain provisions allowing the customer to exit if the service provider’s credit rating drops below a certain level. Whether by general economic downturn or by consolidation, this is happening to a number of service providers. The big decision for customers is whether to pull the trigger: often the loss of a contract could then set off a chain which ends with an insolvent service provider.

Update (or draft!) an exit plan for how the business could minimise the impact of an outsourcing contract being terminated early.

Look at benchmarking clauses, which all long-term outsourcing arrangements should have. These may allow you to drive lower prices based on an adjustment within the market generally.

If any of this is leading to renegotiation rather than termination, bear in mind that renegotiation can also offer an opportunity for the service provider. By the time renegotiation comes along they will know the customer’s business better, and rather than relying on the tender documentation prepared by the customer on which they based their original proposal, they will now know far more about the matters the customer would consider to be key dependencies. Therefore the service provider may be looking to increase charges in some areas, if they can get away with it.

It is clear that we live in interesting times, not least because the pace of change in businesses on both sides of outsourcing relationships is fast. The statistics suggest that outsourcing is continuing to grow, and trends around single or multi-sourcing are not settled at the moment.

Changing business pressures demand that legal teams carefully reassess both the implications of existing outsourcing contracts and their overall outsourcing strategy.

Yvonne Dunn is a partner in Pinsent Masons, an international law firm with offices in Glasgow and Edinburghn