Two long years ago, when executives of any IT-related firm in the U.S. needed capital, they could as good as hold out their hands and expect wads of cash to plop into them. A tidal wave of venture capital was flooding Silicon Valley, Silicon Alley and other Silicon wannabes, and takers were in high demand. Analysts estimate that venture capitalists invested more than $100 billion in 2000, and firms ranging from dot-coms to telecom upstarts claimed a piece of the action. Today life is different, and dramatically so. Venture capitalists are busy “right-sizing” their funds, and VC investments in the first three quarters of 2002 have fallen to less than $20 billion, about the same level as 1997. Tech ventures have been hit particularly hard, thanks to the IT slump.


An exception to this trend does exist, though. Firms that provide back-office services such as customer-relationship management or document processing in developing countries such as India and the Philippines have been on a roll, signing up clients in the U.S., Britain and other high-cost countries. As more and more buzz grows around business process outsourcing (BPO), as the trend is called, venture capitalists are starting to take notice.


Consider just a few recent deals. On November 18, two VC funds, Oak Hill Capital Partners and Financial Technology Ventures, acquired Exlservice — a BPO service provider with three call centers in India — from insurance giant Conseco for an undisclosed amount. Exlservice’s clients include Conseco, Deloitte & Touche and 1-800-Flowers, among others. In addition, in November Westbridge Capital Partners, an India-focused VC fund floated by Goldman Sachs, announced that it would invest in two BPO firms in the next few weeks, according to a report in The Economic Times, an Indian business daily.


Two months earlier, in September, General Atlantic Partners, a private equity investment firm that focuses on IT ventures, invested $100 million in India-based Patni Computer Systems, a provider of BPO services. General Atlantic Partners also owns a stake in Daksh e-Services, another Indian BPO provider, but it is not interested in just Indian firms; last month it increased its stake by 50 million British pounds in Xchanging, a leading British BPO services provider, following a previous investment of 60 million pounds. More recently, General Atlantic Partners announced an investment in Liberata, the former outsourcing arm of Deloitte & Touche, which will result in a windfall of 100 million pounds for the accounting firm’s partners, according to an article in the Financial Times.  


Jitendra Singh, a management professor at Wharton who has been researching trends in BPO, points out that the increased interest of venture capitalists in BPO ventures is hardly surprising. “Silicon Valley and Bangalore (India’s high-tech capital) connected during the boom years of the late 1990s,” he says. “Now that the tech sector faces a meltdown, the nature of that connection has changed. The primary business proposition of BPO firms — providing high-quality service at a low cost — has become attractive to U.S. firms. This translates into more opportunities for BPO providers, and it also makes them attractive to venture capitalists.”


How do venture capitalists looking at BPO investments view their opportunities and risks in this sector? Knowledge at Wharton spoke with Eurindia, a VC firm headquartered in London, to find out. (Note: Singh is an advisor to Eurindia.) 


Eurindia is bullish about business process outsourcing to India – but it’s also picky. The firm has funded just two of nearly 30 BPO firms whose leaders it has interviewed. Last year was generally a slow funding year for Eurindia, admits CEO Vinod Ganjoor. But the choosy approach also stems from the scarcity of key ingredients to a successful BPO, such as top-flight managers, a compelling client list and operating effectiveness. Even so, Ganjoor and Eurindia are far from done with BPO. Ganjoor expects his next one or two investments to be with BPO firms, and plans to increase the BPO portion of his portfolio from about 30% to 50%. “It’s very exciting,” he says. “The whole BPO market to India has barely been opened.”


Eurindia is three years old, with a fund of about $20 million. The firm focuses on early-stage investments of about $2 million, and so far it has invested in seven companies: five information technology firms and BPO firms Allsec Technologies and Inaltus. Allsec is a Chennai, India-based call center outsourcer, while Inaltus is a London-based finance and accounting outsourcer with operations in Mumbai, India.


Ganjoor says the name “Eurindia” reflects his firm’s international strategy. “The aim was to take European capital and European know-how and bring Indian IT companies to market to Europe and beyond.” Although Eurindia started with strictly IT firms, it made its investments in Inaltus and Allsec this past year.


Eurindia’s roots are similar to the origins of back-office work in India. The company’s four professionals all were born in India but joined the international business world. Just as some Indian IT leaders familiar with the global business scene have helped jumpstart the BPO industry in India, so have Eurindia’s founders transformed their international finance expertise into a vehicle to bring capital to the country. Ganjoor, for example, had 11 years of experience as a bond analyst, corporate banker and credit analyst before launching Eurindia. The 38-year-old worked at both Bank of America and Deutsche Bank and has spent the last seven years in London.


With such banking experience under his belt, it’s not surprising that Ganjoor has developed standards for investing money in BPO outfits. One of the most crucial elements in a deal, he says, is the management team. Ganjoor looks for a group of people who have worked together in the past, and who have experience managing client relations. A consulting background is particularly attractive, he says, given the way business process outsourcing involves close interaction with corporate customers.


Another part of the management puzzle, Ganjoor believes, is hiring and personnel prowess. That’s because BPO firms depend on expanding a workforce quickly and coaxing high performance out of employees. “It’s a people and scalability issue rather than a tech product,” he says. “Hiring people is extremely important. The managers have to be willing to hire people and pay them well for performance.”


A BPO provider’s particular niche market also weighs heavily in Ganjoor’s investment calculations. If a BPO provider has targeted a growing industry or domain, it can be small and yet have a promising future, he believes: “In this game, it’s not that big is necessarily beautiful.” Even small BPO firms, though, should have a presence in Europe or the U.S. Ganjoor would ding a company that was based solely in India without offices in the West. “Clients are looking for that kind of comfort and the kind of hand-holding which can only be provided by a local operation,” he adds.  


Also vital is a BPO firm’s client list. Ganjoor expects even start-ups to come to his door with letters of intent from clients. Without customer commitments, a BPO provider can burn through too much cash. “The ability to lock in one or two clients is critical,” he says. “We have turned down deals because we did not see a client deal for six to nine months.”


Demonstrating a lean, smoothly running operation also earns points with Ganjoor. The labor-intensive BPO industry has thin profit margins, at best, in the start-up phase. So firms that can cut waste and achieve profits quickly stand out.


Operational effectiveness was one of the chief selling points of Allsec, Ganjoor says. The company hit the break-even mark 18 months after launching in November 2000. While other BPO providers don’t reach profitability until they take in $10 million in revenues or more, Allsec stopped bleeding red ink with less than $3 million in revenue, Ganjoor says.


Allsec, which expects to have 1,000 employees by March, also caught Ganjoor’s attention with its client list. Ford Motor Company, Lexis-Nexis, Dun & Bradstreet, a major computer company and a major software firm all have signed up for Allsec’s call center services.


Inaltus, on the other hand, won Ganjoor over with its U.K. headquarters and management team. The company’s leaders came mostly from consulting giants Accenture and PricewaterhouseCoopers. Inaltus’ Chairman, John Barnsley, had been the leader of PwC’s global BPO practice, and CEO Shashank Tripathi spent five years as a manager in Accenture’s finance and accounting outsourcing business.


Inaltus’s managers will have their work cut out for them on the hiring front in the coming year: the firm expects to ramp up its Indian workforce from about 110 to 600 by the end of 2003. But Ganjoor trusts his investment is in good hands. “These are guys that have ’been-there, done-that,’” Ganjoor says.


Of course, measuring up would-be BPO firms is only part of the venture capital dance. Eurindia also must woo entrepreneurs to see the best business plans. One feature of Eurindia, Ganjoor says, is its international connections. Along with the London headquarters, the firm has a presence in Asia. Eurindia partner Rajeev Ahuja worked as an investment banker for BT Alex. Brown/Deutsche Bank in Hong Kong and Singapore, and still is based in Singapore. Eurindia’s global business ties already are benefiting Allsec and Inaltus: the venture capital firm has helped hire sales people in England for both companies. Ganjoor also boasts of the ability to connect BPO service providers directly to clients.


Another Eurindia feature that may lure entrepreneurs is its philosophy on structuring deals. While some investment firms want 60% to 80% ownership of a firm, Eurindia prefers taking just 20% to 40%. That leaves founders and managers with bigger equity chunks – and therefore a stronger incentive to stick with the start-up. “We want everyone to have more skin in the game,” Ganjoor says. “We want ownership to be fairly widely dispersed.”


The life of a BPO venture capitalist includes other challenges. For example, BPO VCs are wise to keep an eye on company compensation and stock incentive plans, Ganjoor says. That’s because BPOs require many managers whose pay and equity levels could be vital to the firm’s success.


What’s more, BPOs force VCs to think about exit strategies different from those at typical technology start-ups. A rule of thumb for tech investments is that seven of ten fledgling firms die quickly, two limp along or do okay, and one hits it big. With an initial public stock offering or acquisition, the successful start-up can pay the VC back 30 times the original investment. In the BPO arena, though, VCs are likely to find themselves behind a company without the prospect of a blow-out IPO or buy-out, Ganjoor says. On the other hand, the BPO firm may well bring in a steady cash flow. The dilemma, Ganjoor says, is to structure a deal that allows a VC to reap five or six times the original investment. One tactic is to treat the investment as debt, which must be paid back out of the firm’s revenues.


Despite the difficulties, Ganjoor remains enthusiastic about BPO firms in India. He scoffs at the notion that the BPO market is already too crowded with players driving profit margins into the ground. Call center business from the United Kingdom is one fertile market, he says, and another is the finance, accounting and human resource divisions of major companies. Already, Ganjoor says, British corporations have “in-sourced” some of those operations – keeping them within the company but relocating the work to lower-cost areas of England. “The next leap of faith is you send it to Bombay,” he says.


Indian BPO firms can learn something from the global consulting giants and from call centers in Western countries. But Ganjoor sees the field as a fresh frontier, where standards have yet to be set and his investment choices are defining a new way of doing business. “I don’t believe the model exists,” he says. “We are seeing a new sub-industry (develop).”