As General Atlantic’s point man overseeing the private equity firm’s numerous investments in this sector, Mark Dzialga chides the industry for past pricing sins, sees providers going soft in the marketplace, and thinks ‘offshoring’ is a dirty word. So why is he still looking for gems in the business services sector?
Greenwich, CT, with its pricey boutiques, neatly maintained circuitous roads, and multimillion-dollar houses, is home to blue bloods. In this northern suburb of New York City, you’ll find a historic town whose roots stretch back to 1642, lots of old money, and arguably the single most important investor in the BPO market—General Atlantic.
It’s no accident that General Atlantic, with $15 billion of assets under management, is mostly capitalized by wealthy families. After all, the median household income in this town of 61,000 is $122,000, or nearly 2.5 times the national average, according to the 2000 census. And Connecticut had the highest median family income in the country in 2006. But you might be surprised to learn that General Atlantic has more holdings in the HRO and FAO business than any other private equity firm, and is an influential behind-the-scenes player in the outsourcing industry. Among its portfolio companies are Hewitt Associates, Northgate Information Solutions, TriNet, Xchanging, Liberata, Genpact, Hexaware, and Patni. And it is credited by some as a founding investor of the industry when it helped launch Xchanging and Exult (later Hewitt) in the late 1990s. Today, it exerts considerable sway with some of the big names in BPO.
Front and center in guiding General Atlantic’s BPO strategy is 43-year-old Mark Dzialga, a managing director whose formative days at Goldman Sachs as a software industry specialist helped prepare him for General Atlantic’s long position in the BPO space. A contemplative graduate of Columbia University, the Ivy Leaguer joined the firm in 1998 and has served as a director at portfolio companies such as Hewitt and Genpact. Possessing keen insight and a historical perspective of the HRO and FAO segments, Dzialga recently shared his thoughts on the BPO industry at a particularly critical point in its development, a time when HRO seems to have plateaued in its biggest market while FAO is poised for a breakout year in 2008.
From the Ground Up
To understand why General Atlantic is such a significant player in the BPO market, step back in time to the halcyon days of the dot-com era. Around the mid- to late-1990s, private equity firms such as GA, as well as many other investors, flocked to the ultra-attractive tech sector, where the market seemed to be minting gold for any organization with a web page. Internet start-ups weren’t the only investment darlings—companies such as Cisco, 3COM, SAP, and many other tech firms were all fattening their market cap more quickly than farm-raised turkeys in the month of October.
Dzialga, who had joined Goldman Sachs shortly after graduating from business school, quickly earned a reputation for his wealth of knowledge of the software business after participating in a number of deals. He attributed his expertise to circumstance rather than design to learn the technology business.
“In 1991 and ’92, before any of these investment banks even had technology groups, I happened to get staffed on a few software business transactions. In those days, before these technology groups were formed, everyone was a generalist,” he recalled. “Once you worked on one of these tech companies, you would develop expertise few others in the firm had, so they’d always point to the one guy with prior experience and say, ‘You go work on this.’ That’s where I got a foundation for the technology services business.”
Through Goldman Sachs, Dzialga said he became familiar with the partners at General Atlantic, whose paths he would occasionally cross on mutual deals. In 1988, he joined the firm to help manage its investments in the tech sector. He said it was an ideal marriage because the firm needed his skills and knowledge, and he wanted to continue to work with the tech sector.
It was also around that time when General Atlantic helped to launch two marquis names in BPO, recalled Mark Hodges, executive director, corporate development, at sourcing advisory firm EquaTerra. Hodges, who as COO ran a firm called G2 Research in the mid-1990s before it was sold to the Gartner Group (he later joined Hewitt), credited the private equity firm for its role in helping to start Exult and Xchanging a decade ago. These seminal companies helped to point the spotlight toward what was then a fledgling HRO industry, which began to draw customers in meaningful numbers after the turn of the millennium.
“GA, in my opinion, did pioneer the concept in 1997,” said Hodges, who recalled the firm was the first investor to explore the idea of HR services outsourcing.
From those early investments, General Atlantic continued to expand its investments around the world in BPO. In 1999, it took a stake in Northgate, which started up as a software company. In 2002, General Atlantic invested in U.K.-based Liberata, followed by investments in India-based Patni (2002), Genpact (2004), TriNet (2005), and Hexaware (2006). This year, the firm invested in WuXi PharmaTech, a China-based provider of research services for the pharmaceutical industry. (Dzialga maintained that WuXi is similar to a traditional BPO service provider because it offers a noncore business service to the pharmaceutical industry.)
BPO: A Wise Investment?
General Atlantic’s sizable investment in the BPO sector may surprise some industry observers for several reasons. By his own admission, Dzialga said many providers have struggled with margins and failed to
perform financially. In fact, a look at Hewitt bears this out. In its most recent quarter, the Lincolnshire, IL-based enterprise service provider took a $280 million write-off for its BPO operations; during the past two years, the company has lost nearly $1 billion on the outsourcing business, according to published reports.
Moreover, some question whether service providers can make any money at all in HRO because most of the large enterprise vendors early on in the industry’s development miscalculated the complexity, customization, and capital needed to provide such services. So firms such as Hewitt, ACS, and IBM all battled with poor margins from those deals. While market conditions have become more favorable to vendors as a result of capacity constraints, concerns remain about the economic sustainability of end-to-end HRO deals. Dzialga said he’s not surprised by some of the negative outlook.
“I think almost without exception, everyone who signed a number of big HRO contracts between the later 1990s through 2003 and 2004 really had a tough financial time with them,” he pointed out, adding that early in the market’s development, too many providers were desperate to land referenceable clients in hopes of establishing market credibility.
He noted that because many of these deals were money losers in the first few years of the contracts—one EquaTerra study showed that to win one large end-to-end, enterprise deal cost a provider an average of $10 million—vendors have struggled with profitability. In addition, in past deals, providers signed contracts in hopes of standardizing clients’ processes; in reality, many of those deals turned out to require customization and could not leverage the one-to-many models vendors had developed.
Dzialga noted that enterprise service providers who made pricing mistakes have since learned from them. This is best exemplified, he said, by a pullback in deal pursuit by providers, especially for large, end-to-end enterprise contracts. They have become selective in their engagement, choosing clients whose needs dovetail well with their own service delivery infrastructure.
“I think part of what’s happened is the outsourcing companies have gotten a lot less aggressive about the outsourcing business and have said, ‘Look, we still want to do this. We still see it as a great opportunity, but unless I feel like I can structure a repeat contract that I can make a reasonable return on, I don’t want to take it on in hopes that I can change a lot of fundamental processes and maybe I will make money,’” he added.
It’s this turnaround in thinking that has encouraged Dzialga about the BPO industry, but he said he believes providers still need to transform their business model from money loser to money maker. That means the industry needs to fundamentally shift client expectations and service delivery, he added, because the models that most providers grew up with are unsustainable. While he credited companies such as Hewitt for their standardization efforts in providing point solutions services such as benefits administration, he also faulted others for having naively waded into the enterprise, end-to-end market without realizing the complexities of standardizing clients on one platform. To achieve these lofty goals, he said providers will have to enlighten customers about the economics of outsourcing.
“You must do a better job of identifying process by process what can be standardized and get buy-in from the client early on as to what you’re going to standardize and on what platform you are going to standardize it,” he added.
For private equity firms that have invested in BPO—General Atlantic, Oak Hill Capital Partners, Trident Capital, Warburg Pincus, and others—the lackluster results turned in so far by BPO providers are not what they had envisioned. EquaTerra’s Hodges noted that providers who signed “anchor” clients a few years ago—Procter & Gamble, CIBC, AT&T, British Telecom, and Motorola, to name a few—have all failed to realize the kind of returns they had hoped for. Furthermore, he added, considering what he said was an abundance of talented executives working in the industry, it’s puzzling why the industry has not been able to ramp up profits more quickly.
“I do think Mark [Dzialga] has a point in that, for as much money as has been poured into these companies and as talented as the management teams have been, it’s disappointing that they have not been more profitable,” Hodges said.
Still, he’s quick to point out that early investors in the BPO sectors have made money, and critics of the industry forget that HRO is a long-term play. While many comparisons have been made with IT outsourcing, Hodges noted that it took many years for the IT sector to reach maturity and produce sound profits for the vendors involved. In addition, the fundamental nature of the BPO model requires a long investment of five to 10 years for private companies and maybe a little less for public organizations.
For Dzialga, remaining patient about BPO investments shouldn’t be a problem. Having held on to Hewitt since 1998 and Northgate since 1999, the firm has demonstrated a discipline for avoiding short-term gains. The company can do this, in part, because it operates under an evergreen capitalization structure in which capital partners provide staggered investments. Some of its more recent investments in companies such as Genpact, the fast-growing provider of outsourced F&A services, appears to be paying off. In its most recent quarter, the former GE captive services business reported a 27-percent spike in net income, while revenues were up 32 percent.
Dzialga said despite the industry’s initial struggles with profitability, BPO has a bright future ahead for several reasons. Global adoption of back-office service outsourcing is just starting to gain traction, so even though the North American market has slowed, the demand abroad has not. This trend complements General Atlantic’s own global aspirations, which have led the firm to establish offices in London, Düsseldorf, Hong Kong, São Paulo, and Mumbai.
Globalization is pivotal to the industry’s efforts to improve profits. Why? As the FAO sector has already shown, labor arbitrage is a crucial driver for adoption of outsourcing, and Dzialga said providers must take advantage of available talent wherever they are located, whether that means centralizing in low-cost areas or strategically near customers. By tapping into the best available pool and at the lowest costs, BPO providers are able to achieve something that their customers can’t: they can leverage resources across multiple organizations while taking advantage of labor arbitrage. He said the globalization movement is no longer about offshoring.
“We are striving to eliminate this word ‘offshoring’ from outsourcing. It’s not about offshoring; its about putting the right processes in the right place at the right time. And that may mean India, it may mean Mexico, it may mean Eastern Europe, or it may mean Greenwich, CT,” he said. “It is going to be about developing these centers of operational excellence where, as the sun goes, you’re going to move the process along with it and you’re going to have a technology workflow-processing platform that allows you to migrate the processes to different processing centers.”
Offhsoring for All?
While an offshore strategy has proven effective in FAO, it’s unclear whether HRO will embrace globalization with the same zest. HR leaders are often uncomfortable with the “O” word—offshoring—so does Dzialga think HRO providers will emphasize their global capabilities? He said there is no universal answer.
“I think, ultimately, you have to look at it process by process. The answer to that question is if you were to list out the 18 or 20 major processes that sit under the HR function, I think there will be a number of those that are only conducive to being done much more locally,” he commented, adding that many others can and should be delivered from a low-cost region.
So even as BPO providers improve on their own costs, they will likely restructure customers’ costs as well, allowing themselves more generous profits and a “buffer” for unforeseen problems in deal implementation and service delivery. Dzialga said in the past, HRO vendors often failed to account for contingencies in their pricing, so when delivery failed to go according to plans, providers often absorbed cost overruns. They have since changed their pricing strategy.
“The outsourcing companies are going to be tougher about structuring financial proposals, economic proposals, and pricing, if you will, in a way that does allow them to make a fair margin and gives them a buffer for error to recognize that there will be some uncertainty in any contract they take on,” he added.
As providers adjust their business models, Dzialga said market growth will likely remain robust because buyers have grown comfortable with the McKinseyan view of focusing on core competencies. The days of boasting broad, horizontal competencies have given way to strategically outsourcing noncore services.
As part of that trend, buyers will increasingly look to providers with vertical expertise because generalists can’t adequately address their needs. Offering generic BPO services several years ago might have been enough to attract customers because most companies didn’t develop industry-specific skills, but today, HRO and FAO providers must demonstrate a proven track record in the client’s space.
“Increasingly we’re pushing companies to develop substantive expertise in retail banking, property and casualty insurance, reinsurance, and the pharmaceutical industry. When we can go to those clients and say, ‘We have a large group of people who are experts in the retail business in these parts of your supply chain or we can manage these F&A functions because we know how and why they are different for a retailer because we do work for five other retailers,’ it’s tremendously powerful,” he said. “I think that’s the next evolution of the great outsourcing companies—they are going to have to develop much more distinctive vertical competency in providing these services for potential clients.”
Relying on market changes to improve returns may be a risky proposition for investors such as General Atlantic, but having already made such a huge bet in the sector, Dzialga might not have a choice. Besides, recent trends indicate brighter days ahead. For instance, Hodges pointed out, the break-even point for an enterprise contract is now 24 months after engagement, down from 36 months in the early days of the industry. In addition, average per-employee costs of enterprise deals actually rose last year, following several years of falling prices. All these indicate that the market may have reached equilibrium.
Nevertheless, he conceded that great investments in BPO may be harder to come by these days. Instead of looking to enterprise service providers, opportunities may lie with point-solution vendors such as recruitment process outsourcing (RPO) companies or multi-jurisdictional payroll providers in Europe, he added. And General Atlantic may explore other nontraditional service companies such as WuXi Pharmatech.
“That’s a perfect example of an outsourcing opportunity that has moved up the knowledge chain, the knowledge process outsourcing concept where providing a very high value-added service that’s very differentiated, very difficult to replicate, and doing it for the best companies in the world. This is very illustrative of the direction we’re likely to go and things we’re thinking about in trying to find those kinds of companies that have deep domain expertise, very deep process expertise, and have applied that to some of the leading companies in the world.”
|Having watched the BPO industry grow up, Mark Dzialga has witnessed the evolution of the market and its key players. In a verbal equivalent of the Rorschach exercise, HRO Today asked Dzialga to describe a select group of service providers in one word or phrase. Here are his impressions of each company:|
| Northgate (a General Atlantic holding): Consolidator
Accenture: Broad offerings
IBM: Great competitor
Genpact (a General Atlantic holding): Global impact
Xchanging (a General Atlantic holding): Partnership approach
TriNet (a General Atlantic holding): Total HR
Hexaware (a General Atlantic holding): Best of breed