Carve-Outs as the Next Step for Shared Services

How British Airways reached for the skies by carving out back-office activities,
giving birth to the successful WNS Global Solutions

By: Jeremy Young and Steve Dunning

Managing Director
Warburg Pincus and WNS (UK) Ltd
(Issue Details: Volume 5, Issue 9, December/January 2004 2004).

In this period of turbulent economic and capital market conditions, corporates are
increasingly faced with the challenge of how to focus on their core businesses,
reduce costs, avoid unnecessary capital expenditure and enhance the balance
sheet wherever possible, whilst at the same time avoiding large-scale layoffs and
destroying morale. The back office has generally not been looked upon as the
answer to these problems. However, as the example of British Airways shows, a
carve-out approach is one option.

Although the back office has not generally been looked upon as a solution to the
balance sheet problem described above, a “carve-out” approach may provide a
way out by creating a new entity with a promising future. In talking to a number
of large corporates in the late 1990s, it became clear that by selectively carving
out certain back-office activities, including customer facing ones, we could solve
corporations’ most pressing needs and at the same time create exciting new
platforms from which to build bigger businesses. If these assets had already been
merged into SSCs, then so much the better.

Benefits

A major factor contributing to the current interest in carve-outs is that back-office

activities, including contact centers, are frequently seen as annoying and costly
distractions for senior management. Taking these “support” areas out of an
organization provides advantages not only to the parent company, but also to its
employees and shareholders. For the parent, benefits include:

o avoidance of future capital expenditure

o guaranteed lower costs through long term SLAs
o service level enhancements through culture change and IT
o the opportunity to receive cash capital gain through the carveout transaction
and close control through a combination of equity ownership and SLA
o easier access to offshore benefits via an independent vehicle
o the opportunity to benefit from incremental third-party volumes adding to
economies of scale.

Parent companies are also able to avoid difficult investor relations issues. Carve-
outs are often seen as a more attractive option than a redundancy program or
wholesale outsourcing operation. In some cases, the approach even serves as a
catalyst for culture change not otherwise imaginable.
Much has been said already concerning the morale-boosting effect of relaunching
a back-office support operation as a separate business. A carve-out takes this one
step further. By developing an independent growth-oriented company, solely
focused on providing excellent business services, employees are empowered,
benefiting from the cultural shift as well as the ability to own equity.

Corporate shareholders benefit from knowing that the new business begins with a
critical mass, and with already contracted revenue from the parent company. Add
to that the opportunity to develop best-of-breed processes and technologies
through capital infusions from an investor, and the ability to attract and retain the
best employees and management with equity incentives.

Carve-Outs in Practice

Carving out support services, whilst not widespread, is certainly not novel.
Successful examples include: Microsoft and Expedia, United Utilities and Vertex,
American Express and First Data, Cadbury Schweppes and ITNET, BP and Exult,
American Airlines and Sabre/Travel Network, and Lloyds TSB/Barclays and iPSL.
What is new, however, is that private equity firms are developing focused
programs and dedicated teams in this area, to act as both catalyst and driving
force.

Structural Models

Three core structural models exist for carve-outs.

In a joint venture scenario, the business is not really fully separated from the
parent, but a third party becomes a joint venture partner. Benefits include
transaction savings, third-party funding of investment costs, and shared risk and
reward. If the entity is ultimately carved out, there is an equity upside. This is the
model adopted by companies not really committed to separation. They tend to
retain more than 50 percent of the equity. However, the benefits of maintaining
more control are, in my opinion, largely negated by the fact that independence is
not achieved, so the full extent of the cost savings, positive culture change and
ability to grow through attracting other customers remains illusive.

The second model, at the other end of the spectrum, is when the assets are
sold outright. Benefits include total separation and an upfront payment, with the
acquiror taking on full responsibility and risk, under the terms of a tight SLA. This
model is often seen as “one step too far,” however, when the assets in question
still provide a critical service to the original owner. There is also no future equity
upside should the new entity become significantly more valuable in the future.
This model is common when traditional large IT outsourcers are the acquirors.
The result, however, tends to be that the carved-out assets are simply subsumed
and digested by the acquiror and the chance to create a new independent entity
are lost.

The middle ground is represented by “the outsourcing carve-out

partnership”. Under this scenario, a third party takes a majority equity position
in a new company (comprised of the carve-out’s assets). A SLA transfers all risk
while still offering some control. Again, the partner can be a financial one, e.g.,
private equity firm, or a strategic one, e.g., an IT outsourcer. The strategic
partner would usually argue that it can bring technology to the partnership, and
perhaps customers. The drawback is that the ultimate prevailing strategy tends to
be that of the partner, so independence is never really granted. Furthermore,
there is rarely the commitment to create a liquidity event for the shareholders:
the better the asset performs, the more likely the strategic partner will want to
continue to own it. A private equity partner will want to exit at some stage, to
return profits to their investors, and are by definition value-creation oriented.
Also, the strategy will only be dictated by what is right for the carve-out. The
original parent should benefit from this.

Are You Ready For a Carve-Out?

A carve-out will not deal with deep operational problems: poor quality should be
sorted out first. An overview check should include:

o are the operations of a sufficient scale to be at critical mass if independent?

o are operating cost savings to be gained if the operations were independent?
o are the systems within the operations a potential source of competitve
advantage, or do they need complete replacing?
o what is the quality of management? how will they react to being in an
independent, growth-oriented entity?
o is the industry such that competitors are likely to be willing to outsource to
the new vehicle if sufficiently independent?
o is the opportunity to create value of enough substance to attract experienced
and talented senior management?
o what does the parent really want out of this?
o is there an internal champion of enough seniority to see the transaction
through?
o what is a realistic estimation of future capital needs?
o can a viable growth strategy be mapped out?
o will confidentiality of data and processes will be maintained?
o what is the time frame?
o what is the earnings impact if the parent is public: is there a good story for
shareholders?
o does the partner have a track record of engaging in such transactions? Does it
have the financial capability to complete the transaction as well as support the
new business going forward?

WNS Global Solutions

British Airways’ SSC operation in India went through almost one year of carve-out
negotiations before it emerged as what is now known as WNS Global Solutions.

BA’s operations were hidden within the airline and were underutilized when we
first began talking at the end of 2000. With 1,400 people, the unit had a critical
mass, however, and high credibility based on the quality and range of processes
already being performed for BA.

While BA knew they had done a good job of creating some real competence in the
center, they recognised that they had neither the capital nor the management
focus to take it forward themselves.

Today, WNS Global Solutions has made two acquisitions, is up to 3,000 people, is
growing at over 100 people per month and is the dominant, UK-headquartered
offshore BPO company. Additionally, the new organization gained an
independence that allowed it to attract both new senior management and new
customers.

Trust – A Major Factor

Corporations frequently take a tremendous amount of persuading to believe that

they have found the right partner. Even when a mutually acceptable transaction
structure and SLA has been constructed, many good opportunities falter due to
internal corporate politics. If I had to pick one issue that really matters, it is the
confidence the corporate needs to feel in their prospective partner. They may
have experienced prior disappointments with outsourcers, or consultants over-
promising and under-delivering, leaving behind institutional scar tissue.

Forming a partnership with a firm with a large balance sheet and a long-term
outlook provides a certain amount of flexibility on transaction structure and SLAs,
which a corporate outsourcer, given quarterly earnings constraints, cannot
accommodate.

About the Authors

Jeremy S. Young is MD of Warburg Pincus, a global private equity firm. He led

the firm's investment in WNS and is actively working to identify other BPO
opportunities leveraging the firm's extensive experience in India, where Warburg
Pincus is the largest nondomestic private equity investor, China and other parts
of Asia. jyoung@warburgpincus.com

Steve Dunning is Managing Director of WNS (UK) Ltd. He leads WNS' Global
Airline practice and is Managing Director responsible for WNS' UK operations.
Prior to joining WNS, Steve served as Managing Director at Speedwing (the
British Airways subsidiary that owned WNS).

Copyright © 2008 SSON. All Rights Reserved.

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