Outsourcing Is In: Whether it’s to help their portfolio companies cut costs or as a place to invest, venture capitalists are turning to BPO’ more and more. –

Not long ago, the prospect of a venture capital firm based in India raising a $250 million fund seemed about as likely as a flying elephant. ChrysCapital however, did just that. The New Delhi-based firm, which has an office in Palo Alto, Calif., closed ChrysCapital III with $250 million. Its limited partners include Harvard Management Private Equity Corp. and an affiliate of the Stanford Management Company.

The firm doesn’t invest in medical devices or pharmaceutical companies, nor does it invest in companies that make nanotech devices or design software. ChrysCapital invests in India-based companies that provide business process outsourcing (BPO)-also known as “offshoring” services-to American industries.

ChrysCapital’s fund-raising success is but another sign that investor interest in the BPO sector has reached a fever pitch. Despite BPO’s political unpopularity at home, venture capital and private equity investors are eager to put dollars into outsourcing companies and eager to make sure their portfolio companies are outsourcing as much of their functions as possible in a race to stay cost competitive. While the industry consolidates and matures, companies are outsourcing new functions, new nations are rising to challenge India’s dominance in offshoring and new models of outsourcing are developing.

Meanwhile, VCs continue their torrid pace of investment in the space. They pumped $761 million into BPO startups in the first six months of this year, up from the $495 million they invested during the same period in 2003, according to market researcher Thomson Venture Economics (publisher of VCJ).

More than 400 venture firms and strategic investors have invested in the space in the past year-and-a-half. Thomson Venture Economics reports that the most active investors that have disclosed six BPO deals in the past year-and-a-half are 3i, BV-Cornerstone Ventures and Mellon Ventures.

The largest deal done so far this year has been the $50 million Series C funding invested in OfficeTiger by buyout specialist Francisco Partners.

“Outsourcing, at the end of the day, is the revenge of the Internet,” says John Halvey, a partner and head of Global IT and Outsourcing in the law firm of Milbank Tweed Hadley & McCloy. He expects to oversee about 50 outsourcing transactions this year. As a specialist in BPO transactions, Halvey has seen his outsourcing workload jump about 25% this year.

VCs are attracted by the strong growth in the space. Revenue from BPO companies are expected to reach $3 billion this year, more than twice the $1.3 billion they took in last year, according to research firm Gartner. (Offshore BPO companies represent 2.3% of that total.)

“What will happen in the next 12 to18 months is an acceleration in offshoring, and a lot of it is because a lot of companies that pioneered these practices were Indian companies,” says Brahmal Vasudevan, managing director at ChrysCapital. “U.S.-based companies will have to react to remain competitive.”

Venture capitalists are also attracted to BPO in part because of potential savings for their portfolio companies. “We’re working with a lot of firms to get their portfolio companies’ software development and other work offshore,” says Gordon Brooks, president and CEO of BPO provider Symphony Services Corp. “What they’re finding is that doing it yourself as a software company is unsuccessful. Even though we make a profit at what we do, we do it cheaper than they could do it themselves.”

In one case, Brooks says, Palo Alto, Calif.-based Symphony is helping a venture-backed client save $27 million a year, or two-thirds of its cost. Typical clients have their costs cut by half, Brooks says.

Brooks says that the venture capital industry has such faith and need for offshoring that there are now offshoring provisions written into term sheets. Accel Partners has been one of the more outwardly aggressive advocates of offshoring portfolio company functions. The firm plans to have 75% of its portfolio companies send work overseas by next year. And it’s made hiring in India and opening facilities in China conditional for funding.

Where’s the Exit?

VCs active in the space say that the exit signs are just starting to come into view and remain a ways off. “Exits are only in the infancy stage,” says ChrysCapital’s Vasudevan, who adds that the most significant exits so far in the space have been Spectramind’s sale to Wipro last year. Spectramind was a ChrysCapital portfolio company and the VC firm sold an approximate 40% stake in the company for $60 million.

Vasudevan says that the majority of exits will be through the M&A market. He says that only a few of the hundreds of companies in the BPO space have scaled to the point of bringing in more than $15 million a year in revenue, whereas those few companies that have gone public have had upwards of $30 million a year in sales.

This past June, publicly traded Hewitt Associates acquired Exult for $691 million. Exult had been backed with more than $31 million from DB Capital Partners, General Atlantic Partners, Goldman Sachs, Hillman Ventures and Mellon Ventures before launching a $51 million IPO in 2000.

Also, IBM acquired Daksh eServices, India’s second largest outsourcing provider, this past April. IBM reportedly paid between $150 million and $160 million for the company, about 2.5x its earnings. Daksh had received about $28 million from Actis, Citibank Venture Capital India and General Atlantic Partners. Prior to the acquisition, IBM already had 9,000 employees in facilities in Bangalore through a subsidiary company.

Stomp of Approval

“We’re seeing an increased presence by the jumbo players,” says Mimi Strouse, a partner with Warburg Pincus. She cites IBM’s acquisition of Daksh as a significant development in conferring stability and viability, if not maturity, on the space. “You’re seeing validation of the opportunity as larger vendors focus on BPO,” she says.

“We’re going to continue to see consolidation,” says Ramanan Raghavendran, a senior partner with TH Lee Putnam. “There are a number of small outsourcing companies that are for sale.” Increasing consolidation will mean that competition will be tougher and VCs will be more likely to be pressured into paying top dollar. But that will also mean that VCs who were earlier to the game, we’ll see a return through a merger or acquisition.

Vasudevan of ChrysCapital says that the biggest change he has seen in the BPO market to date is the sector’s expansion to more industries and into more complex services. BPO providers are no longer doing just simple customer service work; they now have complex design capabilities. “In the early day it was all about cost saving,” he says. “What we’re starting to see is people creating services that before were not economically viable.”

Specialty Shops

While outsourced jobs have predominantly been in customer service and technical support, offshored jobs have been getting specialized and more professional. Investors are looking to have functions such as accounting, financial analysis and enterprise technical support based overseas. Health care information and insurance processing are the next sectors where investors have shown interest. What marks outsourcing today, besides increased demand and volume, is the degree to which work done by offshore companies is increasingly complex.

“Traditionally a lot of the outsourcing had been back-end work or testing work, and a lot of the low-end work had been repetitive in nature. But that’s changing,” says Sujit Banerjee, a principal with Nokia Venture Partners. “The traditional back-end and outsourcing of testing is going to remain, but I see more innovative outsourcing going there also,” says Banerjee, who opened a new Nokia office in New Delhi this summer.

“We’re seeing interesting opportunities emerging now,” says Warburg’s Strouse. “What we saw four or five years ago was tangential functions like payroll. It’s moving more into industry functions. We’re seeing it more in health care and claims processing. A year ago it was more general. People were talking more about BPO. Now customers are demanding more expertise. It’s a sign of the industry maturing a little bit. But I would not by any means call it mature.”

While India has not lost favor with the venture capital community, VCs are also aware of emerging offshoring opportunities in other countries. VCs mention regions like the Philippines, Costa Rica and Eastern Europe as potential hot stops. While the market is creating opportunities that have spiked competition among BPO providers and BPO providing nations, no nation is poised to eclipse India. VC firms continue to open offices in India at breakneck speeds.

Beyond India

Rishi Navani, a principal with BPO investor WestBridge Capital Partners, says that while India has a big, first-mover advantage and perhaps nearly 80% of the offshoring market, other countries are beginning to effectively compete against India. The Philippines is becoming a player, and China is in a position to compete, as well, but the communist country will likely attract more manufacturing businesses than technical service BPO companies.

Ash Lilani, head of global sales and marketing for Silicon Valley Bank, identifies the four key offshore markets as the United Kingdom, India, China and Israel.

India, of course, is No. 1 as it continues to be the dominant market and promises to stay that way for the foreseeable future, particularly in sectors that hold investor interest. But Silicon Valley Bank estimates that India is 10 to 20 years from oversupply.

Nonetheless, the lion’s share of venture capital investment that goes to companies with offshore facilities go to companies with facilities in India. India’s low labor costs, large educated population proficient in English and technology literacy make it the preferred offshoring location. The English-language sensibilities of India cannot be overstated.

Venetia Kontogouris, a managing director at Trident Capital, says that VCs will fund more hybrid and U.S.-based operations as outsourcing becomes more specialized. But, she cautions, it’s important to learn about the culture before jumping in. “We have learned the lessons of what works and what doesn’t work,” she says. “It’s not only about cost; it’s about service. Telesales doesn’t work in India. A lot of major corporations are bringing their telephone sales back to the United States.”

TH Lee’s Raghavendran says that in the Philippines, the advantage there is primarily the familiarity with the American culture, style and approach to doing business. The Philippines were an American colony for 50 years, and the citizens there have English-language skills and share some commonality of culture with the United State. That makes the Philippines the No. 1 competitor with India for American call center and customer service businesses. India still has an advantage with its increased size and larger educational infrastructure. “The labor pool is one-twentieth the size of India’s and that’s also an issue,” Raghavendran says.

Baby Dragon

China is also catching the eyes of venture capitalists. Its large pool of inexpensive labor, as well as its enormous potential market, makes China an intriguing prospect. While VCs agree that China has a way to go to rival India’s high tech service capabilities, that hasn’t stopped investors from starting to build ties to the country. Silicon Valley Bank’s Lilani led a group of VCs to China this year. Based on the enthusiasm for the market, the bank plans to open an office in Shanghai in the first half of 2005. It plans to open an office Bangalore, India, this month.

The United Kingdom is a preferred market for BPO investment for its access to European markets. The United Kingdom has other venture capital and private equity firms that are more similar in culture and scope to American investors. The United Kingdom is a logical choice for VCs and entrepreneurs looking to tap into the British Isles market and springboard onto continental Europe, say BPO advocates.

No Bubble In Sight

With rapidly increases in VC investment and public skepticism about the real savings of outsourcing, might the enthusiasm for outsourcing deals be a bubble in the making?

“This market doesn’t bear any resemblance to the bubble aspect of the Internet market,” says Halvey. “Most of the people who are investing are survivors one way or another of the Internet bubble. If anything, this sector is more cautious than anything you saw during the Internet bubble.”

STI Knowledge Chief Strategy Officer Chemain Sanan says that the BPO industry has not skyrocketed like the trendy dot-coms sector, but has risen steadily over the past three years. “This isn’t the dot-com era where things are measured in eyeballs or clicks. These are companies with revenue,” she says.

Larry Bohn, managing director of General Catalyst Partners, says that while he has seen an increase in funding of companies based overseas, he doubts it will become a significant enough trend to alter the industry. All of General Catalyst’s portfolio companies have a central headquarters component that is in the United States, a trait shared with the overwhelming majority of outsourcing companies. Also, venture capitalists are hesitant to invest in companies without a significant U.S. component, since foreign companies are harder to bring onto the U.S. public markets.

While there may not be an investment bubble, the BPO sector’s popularity is making it tougher to manage, says Nokia’s Banerjee. “There are a lot of companies entering the India market for outsourcing. There’s been a lot of hype. It’s been creating a resource shortage in India,” Banerjee says. As a result, some of the call centers have 80% attrition rates. Companies from the United States or Europe go to India and hike up the salaries 100%, but it’s still cheaper than back home, Banerjee says. “The benefits of outsourcing still holds, but it’s getting to be more expensive and it’s getting harder to manage.”

And with the encomiums they heap upon the industry, outsourcing and offshoring players are sure to sound a caveat. After all, outsourcing is not easy. Operating in different time zones, cultures and with different language skills is not easy. “But in the last five years, customers and third-party members have gotten a lot better at it. There’s a realization that this can be done and it can be done well,” says Raghavendran.

Email: matthew.sheahan@thomson.com