Move Over Software, Here Comes BPO –

Milestone Venture Partners had no intention of investing heavily in business process outsourcing (BPO) companies. Nonetheless, they dominate the portfolio of the New York-based firm’s latest fund.

“We really set out to invest more in software companies,” says Todd Pietri, a founding partner with Milestone. “We launched our fund in the middle of 2001 and, as we started to evaluate our deal flow, the companies that seemed to have the most traction and momentum were in the business process outsourcing space.”

Of the five deals in Milestone’s latest fund portfolio, four out of the five are BPO deals. One was an investment in an information services company, while another was an electronic publishing play. Venture capital investors are increasingly finding value in companies that provide comprehensive services that sometimes can take over entire functions on behalf of a client company. These services range from customer service to human resources and beyond.

North American venture capitalists pumped more than $2.9 billion into BPO companies in 2002 and another $783 million into the space as of June 30, according to Thomson Venture Economics (publisher of VCJ). Research firm Gartner estimates that 85% of U.S. companies will outsource their human resources functions in the near future, and revenue generated from this will reach $46 billion in 2003, an 18% increase from 2002 spending. The firm’s study also estimates such BPO services will generate $51 billion and that that human resources services provided by BPO companies will comprise 39% of all BPO revenue.

Larger pools of data on the BPO space may be harder to come by. Spread over several horizontal and vertical sectors, BPO companies may be classified as software companies or part of the respective sector they serve. “It’s a vague term and a bit of a buzz word, so it’s not very well tracked,” admits Pietri. “It includes a lot of things, such as data processing and more niche-outsourced services models that you wouldn’t normally consider in the BPO space. It blurs into services and pure body shops and blurs into pure software.”

Old Is New

Mark Dzialga, a partner with General Atlantic Partners, says that the market isn’t really new despite its recent bout of conversational popularity. “The concept of outsourcing business processes has been around a long time,” he says. “I think what is new about it is that companies are a lot more interested in outsourcing things they never considered outsourcing before.”

Observers and participants alike are bullish on the prospects of further BPO investment. “I lived through the last irrational period,” says John Halvey, an attorney with Milbank Tweed who speaks frequently on the topic of BPO. “I’m an advocate [of BPO investment],” he says. “Because of my genetic coding as a lawyer, I’m a cautious advocate. I think it’s trendy, but I don’t think the full scope of it has ever been really explored.”

Halvey is not alone in tempered enthusiasm. “I think it’s going to be a large area of investment and I think it’s still rather early,” says Mimi Strouse, a partner at Warburg Pincus. “When you look at the number of contracts relative to the number of customers, it’s still in its early days.”

In particular, Strouse says she has seen more interest by enterprises in commercializing back office functions, and that often requires investment. She cites, for example, an investment by Warburg and General Atlantic in Rebus Group, which operates in more than 40 countries and employ in excess of 1,800 people in areas including human resources and payroll software and processing services. Rebus Group raised more than $32 million in four rounds of venture funding, according to Thomson VE.

And the technology boom of the late 1990s and early 2000 is helping set the stage for a healthy BPO market. “One of the most important things that has happened over the last couple of years is that almost every large company has undertaken a very significant investment in the next generation of technology,” says General Atlantic’s Dzialga. “What a lot of CEOs and CIOs were told the technology was supposed to do isn’t really happening. [Next-generation technology is] very expensive to maintain. Even though they’ve re-engineered their organization, it hasn’t solved a lot of day-to-day operating issues. The tech vendors would have you believe it’s all about technology. Increasingly executives are skeptical about that and know it’s … really that process of people, process and technology.”

Broken Promises

As more companies that ramped up their IT in the technology boom of a few years ago start to feel the pinch of increased maintenance expenses of large software programs and in-house processing costs, the market for BPO deals grows larger. It is on the software front that investors see large opportunities. “Part of the reason some VCs are focused on it is because there’s somewhat of a disillusionment with enterprise software,” says Pietri. “Not just because the economy is bad, but because of the feelings of the model. These companies hire a lot of people and pay for a lot of services; and nine times out of 10 the installation doesn’t meet expectations. They don’t use half the software and it’s hard to keep people trained on the software. It’s easier to have people take over that business process.”

He adds that Milestone favors BPO companies that are coupled with unique software. “We like to invest in BPOs that have their own software and their own tech whereas some of the public companies in the space don’t have that view. If you can do both things, you’re going to ultimately be in the best position. … It’s all about constant process improvement. If you make your own software you can fill your own process gaps more effectively.”

But higher costs make BPO investment in some ways more difficult for venture investing than software, due to some scalability issues. BPO companies are more people-intensive than software companies and require more capital right off the bat. However, the stability and more regular revenue streams make BPO companies more attractive, and investors have shown that a little stability goes a long way and that a certain level of scalability can be sacrificed for the likelihood of stability and regular returns.

“Selling high-gross margin software with large up-front fees is very different than selling a pay-as-you-go service,” explains Sam Jadallah, a general partner with Mohr Davidow Ventures (MDV) and a former VP of Worldwide Enterprise Sales for Microsoft. “With the BPO you generally have a large capital expense, whereas with software very little or none. What’s nicer about the BPO sector, on the other side, is that they tend to have long-term contracts and a recurring revenue stream, and if you do it right they should be cash-flow positive sooner.”

But the BPO space also presents some unique challenges for venture investors. BPO companies, being people- and capital-intensive and centered on smooth operations, require a different breed of manager. Instead of producing a technologically advanced product to sell to knowledgeable technology professionals, the BPO company has to live up to a contract where smooth service is provided to anxious companies.

“The biggest challenge is finding management that knows how to sell and operational-ize against these kinds of contracts,” says General Atlantic’s Dzialga. “These are incredibly operating-intensive contracts in business. This is about knowing how to run a factory, if you will, and knowing how to drive productivity in an operationally intensive environment.”

“There are certain challenges on how you contract for this type of work,” says Warburg’s Strouse. “It takes a fair amount of understanding what services you want in scope and the ability to structure an appropriate service-level agreement. It’s not something investors are particularly experienced in, particularly in earlier investment in the BPO space. You do need a unique leadership in the companies that knows how to operate and operate effectively but also understands how to utilize technology. For example, Warburg helped land David Tibble, former Group Finance Director of Hays PLC, to be chairman of portfolio company WNS Group. WNS, which provides outsourcing services to British Airways, has raised $37.8 million in two rounds of venture funding from Warburg and others, according to Thomson VE.

BPOs Here, BPOs Everywhere

Another key to venture investing in the BPO space is the ability to do business overseas, particularly in South Asia and East Asia. BPO companies have tiers of locality expressed oftentimes as “onshore” (in the United States), “nearshore” (territories like Puerto Rico) and “offshore” (usually India).

“Bain owns Domino’s Pizza. If you’re in London and order a Domino’s pizza, that call gets routed to India,” says Warren Haber, a partner with Mellon Ventures, as an illustration of the pervasiveness of offshore investment and BPO positioning. “What’s really interesting is that the person [on the other end of the line] has the updated football scores.”

Milbank Tweed is opening offices in India and China to address the need for people on the ground there. The Philippine Islands are also a center of BPO investment, with close ties to the United States and a population that speaks English.

While there certainly are cost benefits to locating companies in places like India and the Philippines, there also are issues that arise with sending so much capital overseas. First, basic services and general stability are not as taken for granted overseas as they are in the United States, and it can take longer to fix major technical problems due, in part, to a shortage of resources. Also, being caught in a price war and a race to the bottom of cutting costs and expenses can have an adverse effect. “Companies continue to keep lowering rates and cannibalize their own opportunities,” says John Halvey of Milbank Tweed. He refers to the phenomenon as the Donner Party problem.

The VC Role

Investors see more opportunities to invest in BPO companies as the market for the space matures and other business relationships in the technology sector become more complex. With companies across sectors looking for more ways to keep costs down and outsource more of their functions, VCs are getting ready to step up and make sure they have a hand in what develops. Venture capitalists have eyes on several target industries. “We tend to look for inefficiencies. I think in the vertical space the financial services industry and payment processing is fairly mature,” says Warburg’s Strouse. “When I look at something like health-care services, there are so many complexities that there are still lots of opportunities. Complexity brings opportunity for BPO investing.”

“Two things are happening,” says MDV’s Jadallah. “The economics are becoming a lot more attractive and the processes of interacting with the BPO are becoming more defined. It’s easier and becoming more understood how to hire a BPO and how to manage a BPO. It’s a growing trend for sure.”