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IT Outsourcing in the Small and Medium Businesses

One of the most important factors determining pricing, incentive alignment, and other dynamics of the outsourcing engagement is the ownership of the IT assets. There are three options of asset ownership arrangement. Buyers can:

1. Transfer ownership of IT assets along with operational responsibility to the supplier of the service
2. Retain the assets while the supplier assumes the operational responsibility
3. Transfer the asset ownership to the third party (i.e., financial intermediary) under a leaseback arrangement

Historically, assets ownership transfer to a supplier was an integral part of an Infrastructure Outsourcing (IO) engagement. Outsourcing suppliers needed to own the assets to deliver the benefits of the outsourcing to the buyer, i.e.

• Financial benefits (e.g., one-time cash infusion, increase in ROA) were contingent on the transfer of the assets off the buyer's balance sheet, which required the change in ownership
• Operational benefits (e.g., cost savings from improved operations, benefits of additional scale) required assumption of the control over assets and proximity to them

Over time three market trends reversed this dependence on the asset ownership transfer in the IT infrastructure outsourcing. They include:

• The separation of asset control from asset ownership through fast adoption of remote infrastructure-management tools
• The emergence of third-party financing alternatives disintegrating financial and operational benefits of the infrastructure outsourcing
• Looming changes in asset accounting leading to stricter rules of asset lease accounting in the outsourcing engagements

As a result, buyers can achieve the majority of the benefits of outsourcing without change in the ownership of the IT assets. Buyers can:

• Benefit from a one-time cash infusion by engaging in a third-party leaseback of their assets instead of entering into an outsourcing contract
• Increase their return on assets (ROA) by transferring assets off their balance sheet. However, this is likely to diminish as a benefit due to stricter accounting rules
• Save money from operational improvement (e.g., asset consolidation, instance rationalization) through remote management of the buyer's assets

Savings from the increased IT scale of the supplier--in Utility Computing (UC), for example--is the only remaining benefit that requires asset ownership transfer to supplier. Nonetheless these savings are insignificant for clients that are already at a scale, or have high and stable assets utilization.

As a result, both buyers and suppliers are increasingly investigating the asset-light model of outsourcing as an alternative. The reasons for their interest stem from the shortcomings of the asset ownership transfer. In other words, not all buyers want to forfeit their assets and not all suppliers are in a hurry to accept them.

Asset Light Provides Better Supplier/Buyer Alignment

Buyers look at the asset light outsourcing as an alternative due to the benefits of owning the assets. The model provides a better alignment of the supplier's incentives with a buyer's goals.

Some buyers find it beneficial to own their IT assets for flexibility reasons (e.g., uncertainty of the business and IT volume growth, merger and acquisition activity, and broad changes in the technology landscape). In addition, certain buyers like to maintain control over the assets that are core to their strategic advantage. Finally, buyers with large IT operations often prefer to take advantage of scale themselves rather than pass it on to suppliers.

Suppliers, in turn, see the asset-light model as a solution to their struggle to make the economics of the asset-based outsourcing work for them. Increased capital expenditure requirements in asset-heavy deals coupled with the shortening of the average deal duration in IO can seriously diminish return on investment (ROI) for the suppliers.

Finally, new technologies serve as a catalyst for the asset-free approach. They prove more susceptible to the asset-light approach due to the constant change of the asset base and the difficulty of predicting the technology road map. In such conditions, the common output-based pricing model (e.g., price per server, price per MIPS) typical for the asset-heavy deals fails to adapt to the changing nature of the assets base, prompting departure from the asset-based pricing and adoption of alternative models.

The asset-light outsourcing approach instituted itself through the emergence and growing adoption of Remote Infrastructure Management Outsourcing (RIMO) and the arrival of new, primarily offshore RIMO-focused market entrants. We predict that the RIMO market, which is approaching $1 billion today, will grow to over $8 billion in the next five years, further promoting the asset-light outsourcing model.

This growth will come from two sources: expansion of the outsourcing market from the entry of the new buyers that were avoiding outsourcing based on the traditional model and the new RIMO entrants successfully competing for the new outsourcing business and renewals of existing clients.

A Decline in Outsourcing Revenues

This shift from asset-heavy to asset-light deals will lead to a sizable decline in outsourcing revenues. We observed that when RIMO suppliers win the deal competitively, the contract size ends up being two-three times smaller than it would have been if a traditional supplier had won the deal due to the exclusion of the assets. We call this phenomenon asset deflation of the outsourcing deals.

It is also worth noting that the asset-heavy deals are not likely to disappear soon. First of all, there still is a significant number of buyers that do not envision benefits by owning IT assets. Secondly, the long-delayed adoption of the Utility Computing model can introduce significant adjustment to the asset-light trend because asset ownership transfer is a cornerstone of the UC model.

Finally, suppliers that also possess a hardware and software business (e.g., IBM, Oracle) are driving a significant share of the outsourcing market. For such suppliers, assuming assets of the buyer along with the refresh responsibility presents an ideal way to acquire a captive customer for their hardware and software businesses.

Lessons from the Outsourcing Journal:

• The asset-light model of infrastructure outsourcing has proven itself as a viable alternative to the traditional asset-heavy model. Multiple market factors are likely to draw further adoption of this model, but it is unlikely to come to a "winner-takes-all" situation. Both models will coexist offering increased number of options to the buyers.
• This shift from asset-heavy to asset-light deals will lead to a sizable decline in outsourcing revenues. When RIMO suppliers win the deal competitively, the contract size ends up being two-three times smaller than it would have been if a traditional supplier had won the deal due to the exclusion of the assets.
• The model provides a better alignment of the supplier's incentives with a buyer's goals.

Publish Date: February 2007

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Copyright © 2007 - Everest Partners, L.P.

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