For venture capitalists these days investment options in the high-tech area are few and far between. One exception, though, as Knowledge at Wharton has observed before, is the field of cross-border business process outsourcing (BPO), which continues to attract both attention and funding. 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 in London, Mumbai and Pune, is one of India’s largest BPO providers.

What opportunities do private equity firms like Warburg Pincus see in the BPO business? What risks do venture capitalists weigh when making such investments? Wharton MBA student
Kiran Hebbar, who has been helping operations and information management professor Ravi Aron research trends in BPO, interviewed Mimi Wolfe Strouse, managing director of Warburg Pincus, for Knowledge at Wharton. Wolfe Strouse is based in
New York. She was a principal at General Atlantic Partners before she joined Warburg Pincus. Wolfe Strouse serves on the WNS Board of Directors.


(Note: Ravi Aron is conducting a research survey on companies considering cross-border BPO projects. To participate in the survey, click on the link at the end of this article. Knowledge at Wharton will share the results of this research with readers in a future article.)


Knowledge at Wharton: What is driving the flurry of private-equity activity in business process outsourcing today?


Wolfe Strouse: 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 IT services and enterprise software, like 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 a 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 they are complex. Technology started driving business instead of enabling it.


This complexity, combined with unattractive returns, meant that companies started looking for others to manage these systems for them. Initially companies thought that the people who implemented these systems were the logical ones to run them. But the problem is that operating a process and consulting to a client are different domains. Systems consultants do not necessarily have the mindset to generate operating efficiencies, even though they’re great at mapping processes and best practices.


Knowledge at Wharton: Gartner predicts that the BPO market will be $240 billion in 2005. What kinds of firms are best suited to capture this opportunity?


Wolfe Strouse: 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, 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 U.S. and 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 sunk 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 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.


Knowledge at Wharton: How do you see competition playing out between Indian BPO companies like  Daksh and Spectramind and traditional outsourcing vendors?


Wolfe Strouse: I think you will see traditional systems consulting and outsourcing companies such as EDS, ACS, and IBM start to manage entire processes of companies and move selected processes offshore. These incumbents have strong existing customer relationships and experience in selling large contracts. The biggest challenge for Indian vendors such as Daksh and Spectramind is the sales piece, i.e. how do you sell and deliver these large contracts?


Knowledge at Wharton: At Wharton we study the relation between outsourcing value creation and the knowledge continuum. At the low end of the knowledge continuum are labor-intensive processes such as medical transcription. At the other end are knowledge-intensive processes such as rules-based loan processing. Where do you think value is created for companies that outsource business processes?


Wolfe Strouse: Value is created at the knowledge-intensive end of the knowledge continuum. Some companies can drill down into the processes to understand where technology can provide efficiency and where better and cheaper labor can provide efficiency — and then marry both. Such companies can create a lot of value. For example, take the processing and administering of insurance policies. Most insurance companies have old, homegrown systems. A lot of new technologies have emerged around better policy administration. One can argue that to convert these systems to new technologies is expensive and time consuming – perhaps more expensive than retaining the existing systems. So perhaps vendors may want to keep such processes on legacy systems because they work. But if you can apply cheaper labor on top of that, you get extra efficiency.


We have seen this happen. In July 2002, WNS acquired a company in Britain called Town and Country, which provides claims processing services to the auto sector — largely to self-insured fleets — using an advanced technology platform. The company processes claims, but also it provides a preferred network of repair shops. We have moved some of the claims processing as well as the maintenance of the network to WNS operations in India. We have seen tremendous efficiencies from both the technology enablement and also from the highly skilled labor in India. Similarly, there may be processes that are not yet technology-enabled. One can technology-enable them and layer them with cheaper, better resources to get a doubly positive effect.


Knowledge at Wharton: In the future, will quality of service rather than cost become a compelling reason for outsourcing?


Wolfe Strouse: Yes, I think quality will become more important. When I spend time with large companies, I realize that one of their concerns is 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 not a lot of 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 because it costs less.


Knowledge at Wharton: 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?


Wolfe Strouse: 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 a view to migrating into more complex and knowledge-intensive processes.


Knowledge at Wharton: Various outsourcing models have emerged. Some companies, such as GE, have wholly-owned captive centers, while others work with independent third-party vendors. Which model will dominate in the future?


Wolfe Strouse: Most customers are worried about running captive centers due to the operational risk and time it takes to manage offshore operations. A lot of customers are saying, ’Yes, we can cut 20% or 30% off our costs, but is that worth all 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.


Knowledge at Wharton: 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?


Wolfe Strouse: 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.


Knowledge at Wharton: What is India’s competitive advantage in BPO?  Is it sustainable?


Wolfe Strouse: 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 U.S. 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 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%. In comparison, the rates in India are around 25%. This is important when there is a significant training and retraining element such as, for example, learning Dell’s servers.


Knowledge at Wharton: How does India compare with the Philippines?


Wolfe Strouse: 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.


Knowledge at Wharton: What are the risks of outsourcing to India?


Wolfe Strouse: Customers are concerned about stability related to issues surrounding India and Pakistan. We are less concerned about the geo-political 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, people taking contracts from which a lot of 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 under-pricing their business, not achieving high levels of customer satisfaction, and – as a result – not being able to make any profits.


Knowledge at Wharton: What kinds of processes do you see being outsourced? How will this evolve in the future?


Wolfe Strouse: 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 in the healthcare side may not move immediately because it is complex and people haven’t figured it out well here. 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 like 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.


Knowledge at Wharton: How do you evaluate a potential BPO investment?


Wolfe Strouse: 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’s 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 Asset 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.


Knowledge at Wharton: What kind of scale do you look for in your potential investments?


Wolfe Strouse: WNS will have more than 10,000 people in the next couple of years. That is a big company. I think for us WNS is probably the smallest size we would consider investing in. One of the reasons WNS was attractive was there are not many platforms of that size.


Knowledge at Wharton: What are the exit options for your BPO investments?


Wolfe Strouse: I think a company with scale will become an incredibly attractive asset to a lot of people. We will probably get acquisition interest. I think the Spectramind valuation was quite high and has put a high number in the heads of CEOs! The market will offer a premium for scale. An IPO, in India, the UK or the U.S. is also another option.


Knowledge at Wharton: While structuring investment deals, do you protect your investment through features such as liquidation preferences, participation, and dividends?


Wolfe Strouse: We have teamed 100% with management on WNS because it was an asset we purchased and we own a significant portion of it. It is not the type of situation where we are in a minority position and require all sorts of bells and whistles for our security. WNS had clean securities, and we are all aligned on building the business.


Knowledge at Wharton: While evaluating potential investments, do you apply different sets of criteria between IT-enabled services and BPO investments?


Wolfe Strouse: 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 catch-all 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. Outsourcing is an area that Warburg Pincus as a whole is excited about. For me it is rewarding because a lot of my colleagues are interested in looking at our portfolio and in looking into connections that we have to leverage into what we think is a pretty big macro trend.