Although it offers many potential benefits, outsourcing is a risky business solution. Unfortunately, many enterprises approach outsourcing with little or no understanding as to how outsourcing works or of its inherent risks. As a consequence, buyers are increasingly adopting two particular outsourcing models in today’s marketplace: (1) equity stake, and (2) shared-services spinouts. Both are notorious for being at the root of some spectacular outsourcing failures.
While both models appear at the outset to align the buyer’s and provider’s interests, both models have major potential conflicts of interest–a clear indicator interests will become unaligned over time.
A 2004 Outsourcing Center survey asked buyers and providers to indicate which of eight factors is the leading cause of outsourcing failures. Several respondents commented that two of the options often go together: (a) interests become unaligned over time, and (b) the outsourcing arrangement is not mutually beneficial. Together, as shown in the figure below, these two factors represent nearly 50 percent of the odds of failure, according to responses in the survey. Both factors are prominent in the equity stake and shared-services spinout outsourcing models.
The Equity Stake Model
In this model, a component of the pricing arrangement for the outsourced services is the buyer’s receipt of stock (ownership investment) in the service provider company. Frequently, start-ups and even established outsourcing companies grow their business by being carried on the backs of the first few customers in an industry or business process in which the provider seeks to gain knowledge and experience.
This model also is frequently the basis for providers quickly acquiring references and expertise in complex industries (such as US healthcare). Despite the significant risks to buyers, partial ownership of a highly promising provider organization sometimes motivates buyers to enter into this type of arrangement.
Nevertheless, efforts to ensure adequate margin and increase revenue through this model will often conflict with and eventually lower the quality of a provider’s performance for its first customers. The value of those customers’ equity stake will then diminish if the buyer holds the provider accountable to agreed-upon levels of service when such accountability causes a financial burden for the provider.
The dilemma of having diminished value of the equity stake versus having an outsourcer not providing a high level of services in support of the buyer’s business objectives will invariably cause dissatisfaction, conflict, or even eventual termination of the arrangement. In addition to the equity stake dilemmas that can cause outsourcing failure in any industry, US hospitals face two additional risks with this approach:
- Stewardship/fiduciary responsibility. Hospital boards evaluate their executive teams partly on the effective operation of the health system; a significant component of operations these days is selecting quality providers whose services produce value that exceeds the cost. Moreover, if service delivery is less than stellar, stakeholders (board, employees, and physicians) will balk, perceiving their interests were not considered when the outsourcing decision was made.
- Exposure to insolvency. If one of the hospital/health systems with an equity stake in the provider becomes insolvent (not an unlikely event in the US hospital arena), the outsourcing company will experience a loss of investment that potentially could imperil service delivery. In a bankruptcy, the equity held by the defaulting hospital would likely go to its creditors, creating a very unfavorable business dynamic for the other equity owners in the outsourcing company.
The Shared-Services Spinout Model
Another visionary–but problematic–model is to create a new company (spinout) from an internal shared-services unit, with the intent that the new company become an outsourcer with multiple clients over time. Unfortunately, studies reveal that a complex set of consequences occurring at the time of transition and again when new clients are brought on board often quickly destroys the benefits the buyer hopes to achieve through this model.
William Beaumont Hospital is a highly successful example of the visionary shared-services spinout model; but such successes are rare. In the case of the equity stake model, Bank of America was Exult’s second customer, and the outsourcing arrangement included the bank’s equity stake in the start-up services provider. Benefits of outsourcing can be achieved by companies that deploy effective risk management techniques along with best practices in structuring and governing these types of outsourcing models. Otherwise, buyers should view these models as major potential for pitfalls.
Lessons from the Outsourcing Journal:
- Using the equity stake model or the shared-services spinout model in outsourcing intensifies the prerequisite for a buyer being able to assess and manage risks.
- While the equity stake model and the shared-services spinout model appear at the outset to align buyer/provider interests, both models have major potential conflicts of interest–a clear indicator interests will become unaligned over time. Unaligned interests are a leading cause of outsourcing failures.