An article in WSJ (June 8, 2009) comments on organizations selling or closing their captives in India. I view this move from insourcing to outsourcing as a form of industry consolidation. I think acquisition of captives can be a bright spot for the services vendors in the current economic scenario. Such deals carry lower risks – primarily because of the revenue stream (at least for short term) and lower integration risk, as the vendor may already be providing services to the seller. The captives can also help vendor get into new areas such as product development and allow them to establish strategic, C-level relationships with the seller. From a valuation perspective, firms can possibly acquire captives at cheaper multiples these days and derive high returns over time when the market values the combined operations at higher multiples typically associated with well run, pure service plays.

Overall, captive acquisitions are great opportunities for the vendors to deploy their capital.

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A multitude of cash rich companies in IT services and BPO sectors are forecasting declining revenues due to demand contraction. I think that at least a few of these companies will attempt to make up for their revenues declines through inorganic strategies. These strategies will also facilitate growth in their market share.

Acquisitions would make the most sense if the returns due to synergies exceed the cost of capital. For cash rich companies, the cost of capital should be calculated taking into account not only the rate of return on their cash equivalents but also the opportunity cost (such as the NPV of R&D, expanded sales and marketing etc.)

Two major pitfalls of growth through acquisitions:
* Good acquisition candidates are sought after assets, so their prices may not remain low due to their intrinsic value. Also, the business models of companies in IT services and BPO are very similar so the acquirers would likely go after same targets, accentuating the possibility of competing bids or outright bidding wars (e.g. Axon deal)
* The margin of error for the integration process will be small and acquirer’s investors would expect the synergies to be accretive to revenues and profits in a short time frame. Not all companies in the sector have the track record of executing on such integrations.

These issues notwithstanding, I think there would be M&A activity where larger companies would go after mostly niche players or captives. Chances of a large, transformative deals happening are relatively smaller. Another option for the cash rich companies is to ‘buy revenues’ through long term deals with their customers that may require upfront cash outlay from the vendor. TCS has already been doing such deals.

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This very readable book by Charles Morris is a good account of history, policies, market forces and events that have led to the current financial crisis. The author has also tried to estimate the extent of damage which, judging by the ongoing developments, appears accurate.
For students of economic history, the book provides description of the ‘decade of greed’, which has a number of similarities with the recent leverage and private equity fueled M&A boom. The book also serves as a primer on financial innovations such as CMOs, CDOs and more.

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In my opinion, there is a linkage between urbanization and offshoring/outsourcing. As the urban population has grown worldwide, so has the services sector of the world economy. A larger services sector creates more opportunities for offshoring and outsourcing.

Research from World Bank suggests that urbanization is positively correlated with per capita GDP and growth. The positive correlation between the urbanization and size of services sector is shown in Figure 1 below. I find the data on the BRIC countries particularly interesting – India is very services oriented yet its urban population, as a % of the total, is the smallest of the four. Having witnessed the changes in India over the last few years, I think that urbanization is gradually but surely catching up. An example – companies like Infosys, TCS and Genpact are increasingly setting up operations in the ‘tier-2’ and ‘tier-3’ cities (smaller towns), making these towns more urban.

Figure 1:

As incomes go up, so do demands for goods and services. In urban areas, there is an increased demand for services such as retail, healthcare, education, financial services, entertainment, transportation, communication etc. I think it’s a two way relationship between urbanization and services – increased urbanization leads to increased demand for services. This creates more jobs and growth in urban areas, leading to more urbanization. Figure 2 illustrates this.

Figure 2:

The data is from the World Bank, UN, McKinsey and the Economist.

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A recent Wall Street Journal commentary describes the prominence of M&A in USA by foreign multinationals as compared to the greenfield foreign direct investment (FDI). There is also a shift in the profile of these foreign multinationals - they are not only from developed nations but are increasingly from developing countries like China and India.

From 1987 through 2006, the U.S. received a lot of greenfield FDI: $220
billion worth. But over that same period, it received $1.78 trillion of new FDI
via mergers and acquisitions (M&A) with existing U.S. businesses. M&A
activity, not greenfield investment, is far and away the predominant method
foreign companies use to invest in the U.S. It accounts for more than 88% of new
FDI in the U.S. over the past two decades. M&A transactions have been
essential for insourcing companies to expand in -- and generate benefits for --
the U.S.

[Another] feature of insourcing that the Tata [Jaguar, Land Rover]
transaction underscores is who does it. For many decades, the bulk of FDI into
the U.S. flowed from other high-income countries such as Germany, Japan and the
United Kingdom. But in recent years there has been a rise of FDI from
multinational firms based in developing countries such as China and India. In
2006, outward M&A transactions by Indian companies totaled $23 billion, more
than five times the 2005 total and approximately 20 times the annual total in
2000.

The other major force driving this FDI wave is the evolving pattern of
global imbalances. The U.S. current-account deficit has grown dramatically in
recent years. At $739 billion in 2007, it now accounts for about 70% of the
world's total. At the same time, the collection of offsetting,
current-account-surplus countries has expanded to include fast-growth countries
such as China, Russia and Saudi Arabia. Some of the expanding asset purchases of
these new surplus countries are taking the form of insourcing M&A.

So FDI arises overwhelmingly via M&A transactions and
increasingly from new source companies and countries. In recent U.S. policy
discussions about inward FDI, however, these facts have largely been ignored.
Instead, many voices are calling for new restrictions on inward M&A --
especially on transactions from nontraditional countries. All this, despite the
sound operations of the Committee on Foreign Investment in the U.S., which for a
generation has capably reviewed insourcing M&A transactions for possible
national-security risks.

There is no law of physics that the U.S. will continue receiving
transactions like Tata's. The world has recently enjoyed some of strongest, most
widely shared growth ever seen -- in large part due to dramatically liberalized
trade and investment regimes. For globally engaged companies like Tata, all this
means an ever-wider range of countries in which they can expand. For the U.S.,
all this means stiffer competition to attract and retain these companies. The
U.S. share of global FDI inflows has already been declining for decades: from
31.5% in 1988-1990 to 24% in 1998-2000 and to just 16% in 2003-2005.

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The outsourcing landscape can be equated to a service-oriented-architecture (or vice-versa). Just like in SOA, various programs interoperate to achieve the desired outcome, in an outsourcing situation, various businesses, each focused on its core competency, interoperate to deliver value to a customer. Take the example of an automobile company: component suppliers, logistics providers, advertising agencies, IT services providers, payroll services providers, law firms, design firms, strategic advisors, banks and many more work together to design, manufacture, sell and service an automobile.

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Tata group has done about $18 bn in global M&A since 2000. BusinessWeek has a commentary on its post-acquisition integration approach:

• Tata, India's premier industrial group, with an expected $50 billion in sales this year, has a different way to merge—more strategic partner than vulture capitalist. It has applied this approach to $18 billion in overseas deals since 2000.
• In all its deals, Tata has been careful to signal its respect for workers. While it chooses its targets carefully and doesn't do a lot of bottom-fishing, Tata is nonetheless unusual in that it hasn't laid off any workers or shuttered any facilities following its overseas acquisitions (though it has had layoffs at home in the past decade). "Tata buys companies overseas not to reduce costs but to improve [its own] capabilities," says Arun Maira, Boston Consulting Group's chairman in India.
• With its overseas acquisitions, Tata typically leaves executives in place. Instead of dispatching legions of Indians to the new company, Tata sets up a joint management board, which decides on issues ranging from growth targets to the development of new talent. Working groups find common goals, and managers of the acquired company are asked to help smooth out any cultural differences. This approach takes time, says Philippe Varin, chief executive of Corus, which Tata Steel bought for $12 billion last year. But it allows Tata to stay focused on bigger strategic issues "without sweating the small stuff," Varin says.

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In his biography, 'The Age of Turbulence', Alan Greenspan gives an example of capital shifting as a result of creative destruction:

In November 2005, GM announced plans to terminate upto 30,000 employees and close 12 plants by 2008. If you looked at the company's cash flows, you could see GM was directing billions of dollars it historically might have used to create products or build factories into funds to cover future pensions and health benefits for workers and retirees. These funds, in turn, were investing the capital where returns were most promising - in areas like high tech. At the same time Google was growing at a tremendous rate. The company's capital expenditure increased nearly threefold in 2005 to more than $800 million. And in the expectation that the growth would continue, investors bid up the total market value of Google stock to eleven times that of GM's. In fact, the GM pension fund owned Google shares - a textbook example of capital shifting as a result of creative destruction.

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Citigroup recently decided to sell its red umbrella logo back to Travelers. It has been interesting for me to read Sandy Weill’s autobiography ‘The Real Deal’ in this context.

This book is a fascinating recount of how Sandy Weill created his financial empire through numerous transactions including M&As, public offerings and corporate name changes. In his own words, “Always being prepared for the next deal had explained much of my success over the years.”

Commenting on integration challenges pursuant to Citicorp and Travelers merger, he says, “Unlike Traveler’s typical modus operandi where we determined management assignments ahead of time and where we placed a premium on accountability and fast decision making, our approach this time by necessity had to differ”.

His rendering of relations with his team, prodigies and family gives an interesting humane touch to the tale.

Reviews: BusinessWeek, Economist

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Gurcharan Das writes:

Homi Bhabha, the distinguished professor of English at Harvard, recently described India as a multi-lane highway. This is a happy metaphor, I think, because it captures nicely our diverse multilingual, multicultural, open society in which all are moving forward, albeit at different speeds.

Thanks to talented persons in the fast lane, India is now on the verge of becoming a world beater, even a champion, and this is happening after a thousand years. We ought to ensure now that those in the slow lane also get an equal start on the highway so that they too accelerate and change lanes at the right moment

Commenting on Indian government's proposal to expand capacity in higher education (instead of basic education), Mr. Das writes that:

[This] proposal, however, seeks to artificially push persons from the slower to the faster lanes. This will cause accidents on the road and all the lanes will slow down. When high performers observe persons with lower marks stealing ahead by unfair means, they are bound to lose heart. Some of their competitive spirit will die.

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The Economist reviews a book by Jean-Louis Bravard where he argues that:

Outsourcing should be treated much like M&A, for which it is in many cases a substitute. That means fully involving the company's top executives in outsourcing decisions, and expecting outsourcing to be subject to the same “degree of public and shareholder scrutiny” as M&A. It also means looking at many of the same things when judging whether a deal will work or not.

Further, "Five Key Areas to Focus On" include financial engineering, legal issues, communications, human resources and tax.

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Looking back at Indian economy in 2006, Gurcharan Das writes:

2006, the year gone by, was one of the best in India's economic history. We had two successive quarters of 9 per cent growth, following three unprecedented years of 8, and this came on top of a remarkable 6 per cent average growth in the previous 22 years. (Recall that the West's industrial revolution took place at a rate of 3 per cent GDP growth!) As a result, 1 per cent of the country's poor have crossed the poverty line each year since 1980, and this adds up to almost 200 million people. It is less than China's 300 million, but it is significant. Meanwhile, population growth has also begun to slow.

Hence, growth has brought large per capita income gains—from $1,178 in 1980 to $3,051 in 2005 (in ppp).

Although our driving engine is the private economy, you cannot do without the state. Not surprisingly, some of our best-performing sectors have had the best regulators, who have worked hard to create genuine competition in the market—for example, telecom (TRAI), capital markets (SEBI), insurance, and highways.

Every Indian's fondest wish today is for a tough regulator in the power sector, who would implement the Electricity Act, create vigorous competition and have the courage to take on politicians in the states, as Seshan did at the Election Commission or as Justice Sodhi took on the telecom bureaucrats at TRAI. Vajpayee's greatest contribution was to create the conditions for our telecom revolution that has visibly transformed millions of lives. Indians of all persuasions wish fervently that Manmohan Singh's claim to fame would be to create a similar revolution in electric power. Nothing quite diminishes us as a nation as our pathetic power situation.

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Economist (Sep 21, 06) Technology Quarterly has a commentary on hypervideo. This nascent development, also called video-hyperlinking, makes it easy to link together segments of online video in novel ways.This technology can have far reaching implications for viewers, vloggers, advertisers, technology providers and video-on-demand vendors. The article gives an example:
As the amount of video available online increases, so do the possibilities for linking clips together. Someone watching a documentary about the 20th century, for example, could click on the face of John F. Kennedy and be directed to newsreel footage of him. Further clicks might lead to the trailer for “Thirteen Days”, a film about the Cuban missile crisis, to an interview with protagonist-actor Bruce Greenwood, and to a film promoting tourism in Hollywood. Just as hyperlinking disrupts the traditional structures of written text, the same is true of video.

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Businessweek's issue on competition (Aug 21, '06) lists Harvard College as a Type A organization that competes to attract the best talent.

Harvard College doesn't need to compete, right? Students would kill to get in there. Wrong: No university fights harder to attract the best of the best. Harvard's campaign begins in spring, when it sends letters to no fewer than 70,000 high school juniors with stellar SAT scores. William R. Fitzsimmons, dean of admissions, then dispatches an army of 8,000 alumni into the field to help identify and interview applicants. He also enlists Harvard students and professors. In 2006, all this produced a near-record 23,000 applicants, of whom just 9% were accepted. Then, Fitzsimmons launches a second drive to persuade the lucky few to say yes. The payoff: This year, Harvard grabbed 80%, a yield rate that's the envy of the elites. Harvard has lots of laurels, but it sure doesn't rest on them.

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Economist (Jul 20, 06) has a special report describing how Japan's stagnation from 1990 has resulted in wealth destruction, persistent poor growth, deflation and financial distress. Between 1990 and 2005, [Japan's] real growth averaged just 1.3% a year. Without the malaise, Japan's GDP would have been about 25% higher in real terms than it is now. Over the period from 1997 to 2005, the nominal GDP of neighbouring South Korea, which bore the full brunt of the Asian financial crisis, has risen by 65%; America's is up by 50%.

To understand why this happened and assess Japan's prospects as normality returns, you need to go all the way back to the end of the second world war. At first, Japan's American overlords wanted to rip up the bank-dominated system that had done so much to finance the rise of Japanese militarism—free capital markets and democracy seemed to American idealists, then as now, to go hand-in-hand. Yet by the early 1950s, with a cold war with the Soviet Union and a hot one in Korea, harder noses prevailed. What Americans wanted from Japan was a predictable flow of industrial goods. The Japanese, for their part, argued that banks were the best way to channel scarce resources towards industries that could help rebuild the economy swiftly. So banks, not capital markets, became the chief source of finance.

As Gillian Tett points out in her book, “Saving the Sun”, capital markets were not abolished completely; the Tokyo Stock Exchange reopened. Yet the point of shares was not to raise capital, but cement ties with other business groups in an interlocking set of cross-shareholdings. These groups, with a principal bank at their core, became known as the keiretsu. In this system, the strong carried the weak.

For a while it worked spectacularly. Banks, cosseted by protected markets, regulated interest rates and a maternal finance ministry took in households' cheap savings and channelled them towards chosen industries. Savers did not get much in interest, but back then the Japanese were nothing like the consumers they have become. Japan was making things chiefly for export. And the virtue of the system was that everyone had a job. Between 1960 and 1973 the economy grew by 9.6% a year, twice the OECD average. Unemployment, averaging just 1.3% over the same period, was well under half that of the rest of the OECD.

Even after the 1973 oil shock, growth averaging 3.8% a year, as it did up to 1989, was better than most. But by then Japan was bumping up against the constraints of a maturing economy. Creeping deregulation was eating into banks' protected markets at a time when demand for credit was no longer so great.

By the 1980s, Japan was the world's biggest creditor. But its current-account surplus had become a political thorn in relations with America. The Plaza Accord of 1985 was meant to pull the thorn by blessing a rise in Japan's exchange rate. In 1985-86, the yen rose from ¥260 to ¥150 against the dollar. Fearing that exports and the economy would slump, the BoJ repeatedly cut interest rates.

Instead of weakening, the economy took off. The government plugged its budget deficit and the stockmarket shook off the Wall Street crash of 1987. Property markets blossomed, giving the banks a wonderful new source of lending. By the end of 1989, Japanese shares accounted for half the world's stockmarket capitalisation. Land prices soared. A value was famously put on the grounds of Tokyo's Imperial Palace equal to that of California. Then, on December 25th 1989, the BoJ decided to cool the party and raised interest rates.

The effect was bracing, as share prices fell and land dealings dried up. Japanese banks were unusually sensitive to the value of those assets. Four-fifths of bank loans were reckoned to be related to land, which was often used as collateral. Banks also counted as capital a good part of their equity holdings in other firms. As share values fell, so banks' capital levels were threatened. The system of cross-shareholdings began to work against them.

Yet for some four years an eerie calm prevailed. Optimism was still high that asset values would pick up again. Counting on a recovery, banks often lent more to distressed borrowers or tucked problem loans out of sight in subsidiaries. Bank regulators wanted to see no evil.

Only late in 1994 did a sense take hold that something was going badly wrong. Two poorly run Tokyo credit co-operatives had to be bailed out. More credit co-operatives failed and there was trouble at the seven Jusen, housing-loan corporations founded by the big banks. Their losses, reckoned to be ¥6.4 trillion ($68 billion), were more than the founder banks could muster. For the first time taxpayers contributed to a bail-out, to prevent contagion.

Yet the spreading crisis had already touched the country's big banks. Daiwa Bank, one of the biggest, lost $1.1 billion through a fraudulent employee in New York and was ordered by American regulators to close all its United States operations. A domestic problem, as Hiroshi Nakaso of the BoJ, recounts in a paper* on the crisis, now had an international dimension.

In the spring of 1997 the smallest of three long-term credit banks, Nippon Credit Bank, had to be injected with private and public capital. In the autumn a default by a middle-sized stockbroker, Sanyo Securities, paralysed the interbank market. Soon after came the failure of Hokkaido Takushoku Bank, the dominant bank in the northernmost island of Hokkaido, where it had lent billions against resort developments. Shortly after, Yamaichi Securities, one of the biggest brokers, abruptly collapsed. The BoJ supplied liquidity and what remained was later taken over by Merrill Lynch.

Japan's financial system appeared to be on the edge of a meltdown, like much of Asia's at the time. Reassurances were hurriedly made by the finance minister and the BoJ's governor, and by the following spring ¥30 trillion in public funds was made available as capital for troubled banks. Bad loans in the system were admitted to be at least ¥60 trillion.

The public injections may have been politically unpopular, but they seemed to calm things down—until the collapse of Long Term Credit Bank (LTCB) in the autumn of 1998. With assets of about $240 billion, this was among the world's biggest banks. As Ms Tett recounts, everything was done to prevent the problems coming to light, including dropping boxes of papers down manholes in the basement when inspectors called—not that the regulators wanted to find too much.

By the time of the collapse of LTCB, the scale of Japan's banking crisis had finally sunk in. Japan strengthened the system for deposit insurance. Public funds boosted the capital of the biggest banks and a newly created independent regulator, since renamed the Financial Services Agency, set out to break the cosy ties between banks and their former regulator, the finance ministry. In 1999 another injection of public money encouraged nine of the country's biggest banks to merge into four “megabanks”, which have since consolidated further into three.

This fresh start for the banking system should have been a fresh start for the economy, too. But the recovery never happened. In 2001, with recession again threatening, Junichiro Koizumi became prime minister on a reformist ticket. The following year fears of another crisis grew. As share prices fell, the BoJ announced plans to buy equities from banks.

In 2003 the government finally created a vehicle to clean up bad loans, although doubts about the motives behind this were widespread. And it was not until early 2005 that the banks could claim to have put their bad-debt problems behind them; they are now paying back the public money. After falling for a decade, net lending by banks started to rise again this year. And inflation, measured by “core” consumer prices, which exclude fresh food but include energy, has at long last turned consistently positive.

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