by Stephanie Overby

Outsourcing: The Demise of the Offshore Captive Center

Jun 30, 20096 mins
IT LeadershipOutsourcing

Citi, AXA, AOL and others have shed their wholly-owned Indian IT services subsidiaries. Analysts say sales of offshore captive centers may be more than just a sign of the recessionary times: The concept of owning an offshore services unit may have outlived its value for most companies.

The offshore captive center was once the Holy Grail of offshore outsourcing. As companies got a taste of the cost savings possible by outsourcing IT and business process work to lower cost countries, they began to salivate over the thought of bypassing the offshore vendors (and their pesky profit margins) altogether and saving even more money by setting up their own service shops in India.

But today, those offshore captive centers have become drain on many of the companies that created them—so much so that some organizations are desperate to divest themselves of their offshore units.

In October 2008, financial services leviathan Citi announced a deal to unload its offshore business process outsourcing center to Tata Consultancy Services (TCS). Citi made a similar move last month when it sold its captive Indian IT services unit to Wipro. Also in May, outsourcer Capita Group snapped up a 600-person captive center owned by insurer AXA. And earlier this year, the Economic Times of India reported that IBM and Infosys were bidding on Fidelity’s offshore back office operations.

These companies weren’t the first big name corporations to back away from their commitment to captive service operations in India. Over the past two years, AOL, Aviva, Prudential UK and Philips—among others—have put their offshore IT and business process services subsidiaries on the block.

And, analysts say, they won’t be the last to get out of the Indian services business.

The Changing Economics of Offshore Outsourcing

The global economic recession is a major motivator of these divestitures. According to Gartner, captive centers represent a large, fixed cost for companies—and one that has been growing due to inflationary pressures and exchange rate fluctuations. The near-term benefit of getting those subsidiaries off the books is of great value to struggling companies, particularly those in the most hard-hit sectors of the economy, such as financial services.

“There are a number of drivers for [these transactions],” explains David Rutchik, a partner with outsourcing consultancy Pace Harmon. “And one is to generate some cash.”

Such transactions, generally, reflect the reactionary nature of most decisions to insource—or outsource—operations offshore. “Long-term cost savings have rarely been the driver for significant outsourcing decisions in the past,” explains Scott Feuless, a senior consultant with IT consultancy Compass. “It’s generally been more about meeting short-term budgetary goals: getting assets off the books, temporarily improving cash flow, or all of the above. Companies are realizing that they may have to change their sourcing decisions from time to time to continue getting the most bang for their buck.”

But the dramatic about face by companies like Citi, which at one point employed more than 13,000 people in its Indian IT and business processing subsidiaries, may also indicate that these captive offshore centers have outlived their value.

“The larger issue is that these captive centers are difficult to manage and quite a distraction from a company’s core business,” says Rutchik. “They haven’t been the panacea they were expected to be.”

The Evolution of the Offshore Captive Center

At one time, setting up an offshore IT services center made perfect sense. When Indian outsourcing providers’ capabilities were immature, explains Rutchik, some Fortune 500 companies feared fledgling outsourcers couldn’t support their requirements. Instead, they set up their own subsidiaries to provide IT services or back office support in India.

For others, like Aviva, which sold its offshore shop to WNS Global Services last year, the captive center was the ultimate end state of offshoring. They began by outsourcing to a third party in India to take advantage of the Indian provider’s infrastructure and human resources. But in what became known as the build-operate-transfer model, the ultimate goal was to take ownership of the offshore operation to reap the cost-savings associated with eliminating the vendor middle man.

Now the build-operate-transfer process is taking place in reverse as companies resell these operations back to IT services providers.

In the last decade, the capabilities of Indian outsourcing providers’ have greatly improved, says Rutchik, and running a captive center no longer seems worth the effort.

“It takes lot of overhead and management attention to manage internal facilities and personnel and deal with the labor laws in another country,” says Rutchik. “You’re exposing yourself to a lot of administrative burden just to do back-office type work in lower cost locations.”

Western companies that set up shop in India have also struggled to hire the best and brightest; many Indian professionals prefer to work for IT vendors that can offer a greater variety of work experiences and more opportunities for career advancement.

Another reason American companies setup up captive centers—to gain greater control over resources—has proven to be a double-edge sword.

“If you owned your own facility, you could absorb incremental increases in demand more effectively,” explains Rutchik. “You had a couple hundred people working for you in India and [if] suddenly you had 20 percent more work, you could have them absorb that. If you were working with an outsourcing provider, you would have to pay 20 percent more.”

But that benefit has become a burden as demand has diminished. If you have 20 percent less work today and have a well-constructed contract with an offshore provider, your costs will go down. But “when you have your own people, you either have to pay for that excess capacity or terminate people and deal with all kinds of difficult issues having to do with layoffs,” explains Rutchik. Ditto for investments in other fixed costs such as IT infrastructure and office space.

Operating a large subsidiary in India can also tie up capital a company wants to use to forge new outsourcing deals in other countries. “Large companies are realizing that there is no ‘best’ country to get your resources from,” says Feuless of Compass. “Increasingly they are looking to the major outsourcers to provide best of breed sourcing on a global basis.”

Indeed, most companies that have inked deals to sell their captive centers have simultaneously contracted with the buyers to provide IT and business process services back to them. Citi, for example, now has a nine-and-a-half year, $2.5 billion contract with TCS and a six-year, $500 million deal with Wipro.

There are some instances in which offshore captive center ownership still makes sense. If a company wants to offshore a customer-facing or highly sensitive activity, or it already operates in the local market providing other services, owning a services subsidiary may still provide a return on investment. But for typical business process and IT services, says Rutchik, “with all the choices and capabilities there are today, there’s no reason to do it.”