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The Issue: Assessing the Role of Captive Operations in Global Service Delivery Models
by: Cliff Justice, Managing Director, Globalization Stan Lepeak, Managing Director, Research Aparna Sundaram, Research Associate

Offshore outsourcing is moving beyond point-topoint outsourcing (e.g., from the West to India) toward multi-point, multi-provider global delivery models. Services are simultaneously climbing the value chain from transaction to more strategic, knowledge-based processes (e.g., R&D, financial analysis, marketing, market research). In response, many buyers are seeking to establish offshore captive operations, while others are divesting their captive centers, and still others are leveraging theirs to support partnerships with third-party outsourcing service providers. Most buyers will require a combination of service delivery options, from internal distributed delivery to domestic shared services, offshore captive operations, and third-party outsourcing, to achieve their performance, productivity and cost-reduction objectives. This Perspective presents the pros and cons of captives, a pulse-check on captive center performance, and strategies to generate maximum value from business process outsourcing (BPO) and knowledge process outsourcing (KPO). The Details
Drivers of global outsourcing are shifting from denominatorfocused (e.g., cost reduction) to numerator-focused factors (e.g., performance improvement, revenue enhancement, capital productivity improvement, and risk mitigation. See Figure 1). Concurrently, the functions and processes that buyers are seeking to outsource are moving up the value chain. Service delivery units – whether third-party partner or captive subsidiary – consequently, have greater influence over a buyer’s core activities. For example, an offshore service delivery unit can affect service quality and stability, development and protection of intellectual

property, or the cost, timeliness, or method of exploiting opportunities in the offshore country. Alternatively, offshore partners can contribute intellectual property (IP), created in hyper-competitive and resource-poor environments, to create fundamentally new advantages in quality, speed, efficiency and even innovation. This increased interdependency is necessitating new relationships between buyers and suppliers.

How are Buyers Responding?
EquaTerra has found, through market research and client experience, that buyers are eager to exploit global service delivery to bolster competitive advantage; however, they often fail to create realistic and thorough global sourcing strategies. Some buyers, for example, view a captive center as a lower-cost and lower-risk alternative than using third-party outsourcing. Whether this is the case, however, depends on a variety of specific circumstances.

Figure 1 – The Changing Face of Global Service Delivery
A strategy created yesterday may not have the flexibility to support today’s goals of revenue enhancement or capital productivity improvement. Relationships predicated on cost reduction during the first stage of offshore outsourcing employed robust contracts and service level agreements. Those based on performance enhancements and cost reductions during the second phase focused more on governance and communication processes atop contracts. Now, as global services become increasingly strategic, buyers are seeking ways to gain greater control, for example, through risk-sharing mechanisms and more precise contracts. Detailed contracts may provide more comfort but decrease flexibility and are costly to enforce. The key is to balance control and flexibility in the context of a buyer’s risk profile.

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Captives currently account for $9 billion, or 30 percent of total offshore outsourcing in India, the world’s largest market for global service delivery. BPO services are often housed in captive centers where they are perceived to be lower risk: in 2005, 60 percent of BPO in India was done in captive centers (as opposed to 25 percent of ITO). Buyers establishing captive centers must ensure that they assess operational requirements and future service needs as thoroughly as if they were outsourcing to third parties or they risk consequently underutilizing their centers. An underutilized captive center is likely more expensive than using a third-party outsourcing provider, despite the 15 to 20 percent premium that a buyer typically pays to a service provider. A factor exacerbating costs is that buyers and their captives lack a service provider’s institutional knowledge, brand and facilities. For example, an inexperienced buyer may organize captive operations as an internal local cost center and will under-perform relative to a third party that delivers services as a revenue-generating business. Furthermore, operational inefficiencies can lengthen captive start-up times and expenses. In India, EquaTerra finds that organizations can easily add up to six months to start-up time to understand the local business environment, legal infrastructure, and taxation regulations – important issues that a local service provider typically understands. Below are facts buyers must consider when evaluating their captive operations. While much of the data pertains to the Indian market, the points hold true across many other offshore markets. Costs • Captives often spend more on buildings and furnishings than third-party providers, rent in better locations and neglect to bargain adequately with property developers and managers. Increased demand for real estate in cities where offshore outsourcing is centered – BPO companies are responsible for occupying 50 percent of new commercial real estate in India in the last three years – and regulations favoring local companies amplify the costs to captives. For example, in India, the government allocates land for free or at nominal prices to providers building significant facilities. • After investing in the development of facilities, buyers face increasing labor costs, a lack of institutional knowledge, and an absence of local name recognition. Various market estimates predict that the Indian BPO labor market will fall short by 500,000 or more fulltime equivalent (FTE) employees in the next three to

Figure 2 – Defining an Offshore Captive Operational Model
Offshore captive operations are quite simply buyers’ internal shared services center operations, established or extended to a lower cost, a.k.a. “offshore” market. EquaTerra defines shared – or enterprise – services as follows: 1. A collection of activities that cross various functional boundaries and can individually or collectively be provided to internal operating groups by a common service organization. 2. A service enterprise that creates and sells common, measurable and scaleable services to business entities within the same corporate structure for a fee. 3. A passion to transform end-to-end business process through scale, automation, standardization, aggressive performance management, customer orientation and wage arbitrage via a global network of captive or outsourced service centers. Organizations deploying captive operations have similar goals as those deploying traditional enterprise or shared services operations. For companies that are not yet global, captives lower costs primarily through labor arbitrage – though EquaTerra is increasingly finding that buyers are seeking skilled, not just cheaper, labor in offshore markets. For those that are already global, captive centers often present gains through process improvements. In both cases, captive operations also present similar challenges to offshore outsourcing, such as language and cultural barriers, time zone differences, and legal and regulatory complexity. five years. While this number is disputed – particularly by India-based service providers – the trend toward a tighter and more expensive labor market is clear. Thirdparty service providers are able to recruit employees and control attrition by offering clearer career paths in entrepreneurial environments. Additionally, providers are able to access labor arbitrage opportunities in an everexpanding number of different geographic locations. Providers in multiple locations can employ flexible models that allow for work transfer across international locations to mitigate dynamic risks and hedge against any exposure to currency risk.

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• Parent companies typically send top managers to the offshore outsourcing locations to set up captives. Travel and opportunity costs for these managers increase start-up costs by 60 to 70 percent over third-party providers. Expatriate salaries keep operating costs up during steady state. Long-staying managers also expose the organization to additional taxes, at least in India. A recent court decision stated that profit taxes would be applied to centers that had foreign employees working in-country for more than 90 days. While BPO firms had previously been exempt from corporate taxes in India, corporate taxes of 34 percent or at the minimum alternate tax rate of 11 percent (whichever is higher) are levied if the center is deemed to operate at less than an arm’s length from the parent. The 90-day clause is one measure of estimating “arm’s length.” Attrition • Attrition rates at captives are often 10 to 20 percent higher than at larger service provider companies, where the average rate is approximately 20 percent. Captives must, consequently, spend more on advertising, recruitment, training and retention fees. Local service providers can better control these expenses with corporate performance-linked pay schemes, professional development programs, and flat organizational structures that encourage collaboration. • Buyers typically pay a 30 percent premium to recruit employees in knowledge-based services from the open market; providers with established local presence can limit exposure to these costs. Scale The scope and complexity of services must be compared with size and scale in order to justify the overhead costs of a small captive center. An R&D captive center, for example, with higher-value resources can justify a smaller scale than a customer-care captive. • Achieving economies of scale is critical for captives that perform high-volume transactions or mundane tasks, such as application development and testing, claims processing, or accounts payable/receivable. Captives executing these services often cannot achieve economies of scale and operate efficiently, because they are unable to seek volume from third-party buyers and parent companies often send low volumes of work. McKinsey & Company finds, for example, that the average captive’s costs are 30 percent higher than those of third-party outsourcing providers, largely due to less effective operating practices.

• Knowledge process outsourcing (KPO) captives performing R&D, analytical analysis and other strategic functions can operate on reduced scales. KPO services are typically more rewarding (monetarily and personally) and more integrated with headquarters operations; consequently, professionals in the local market desire positions in KPO establishments. KPO firms still need to address scale: KPO firm Evalueserve cites inefficiencies in captive KPO centers on the order of 7 percent, due to lower staff-to-billable professionals ratios (a smaller captive with 50 FTEs would likely operate in the 1:4 to 5 range, at best, as opposed to 1:8 for third-party providers). Inadequate scale added inefficiencies of 10 to 15 percent during start up and 3 to 5 percent in steady state, according to the same report. • Lack of scale can cause even shutting down to become expensive irrespective of the type of service. If no buyer can be found for a small or under-utilized captive, processing paperwork, transfer contracts and divesting facilities to shut down a facility can take up to two years. As organizations seek to send offshore more strategic functions, EquaTerra expects the number of captive centers to grow approximately 30 percent in India alone over the next two to three years. Organizations establishing these captives may be new entrants to the market with inadequate experience to pursue opportunities beyond labor arbitrage. These captives will risk following the poor performance of some of their predecessors and may quickly see a need to re-examine their outsourcing choices.

How are Outsourcing Service Providers Responding?
Multinational and domestic third-party service providers continue to build out their own delivery capabilities in India and other lower-cost markets. This pressures captives to compete for increasingly scarce and expensive resources, as explained above. While some service providers offer “build/operate/transfer” services to Western buyers, leading providers increasingly offer outsourcing services only. EquaTerra finds buyer interest in completing transfers to be waning. Buyers with captives find themselves competing with service providers for talent and resources, simultaneously purchasing services in other operational areas from the same providers.

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Service providers also are expanding their offerings to include KPO services. As the range of services available through third-party providers expands, the advantages of captives diminish, though there are still industry- and buyer-specific services that are not readily available on the open market. One way service providers are expanding their offerings is through partnerships with captive centers. In the most popular model, providers take over non-core functions from captive centers, enabling the centers to focus more exclusively on strategic services. More innovative models involve service providers and captives contributing valuable intellectual property (IP) to execute strategic services. Partnership and hybrid models are further detailed below. Service providers are expanding their service delivery footprint globally. This is, in part, out of the necessity to support workforce needs, address costs, diversify and target new markets. Expansion can also make the service provider more competitive relative to a single-country captive given the expanded access to a diverse and potentially more costcompetitive global resource pool. Global diversification has required providers to develop expertise in disaggregating services – even knowledge-based ones – distributing the components in a way that leverages skill sets, time zones and cost savings, while hedging against risk. Few buyers will have the resources, expertise or desire to build out a multicountry captive model with the speed, efficiency or scale of a global service provider. India-based service providers are building out their Western operations, putting them closer to buyers and enabling them to deliver services that require a local presence to facilitate remote execution. Service providers continue to make acquisitions of captive operations (Infosys recently acquired Philips’ Electronic captive F&A shared services centers and Citigroup’s captive is being pursued) to increase their services and global footprints. Some captives have consequently been sold or become successful service providers (e.g. GE’s is now Genpact, British Air’s is WNS). A purchase is the exception, however, not the rule. Buyers should validate whether or not this is a realistic exit strategy.

captive centers become catch-alls for non-essential work sent piecemeal by managers with short-lived interest in using the center. Operating without a strategic goal, the captive center itself fails to cultivate a culture of continuous improvement. Employees at the captive center are unmotivated to learn about or adopt process improvement methods or certifications, such as CMMI and Six Sigma. Buyers that currently deploy, or are rolling out, captive operations need to focus on ways to evaluate and drive performance. Ways to improve performance include aligning or realigning the headquarters organization with the captive, focusing the captive and outsourcing endogenous activities, and creating hybrid partnerships or “virtual captives.” If none of these options are appropriate, there is an opportunity for outright sale. Realignment: Buyers often fail to redesign their global processes when establishing a captive. When starting a captive, organizations sometimes extend existing processes and their inefficiencies to the new office. They should seek to improve performance by realigning the organization to better use the captive center. • Advertising or re-introducing the center to business unit managers, requiring that these managers recommend ways to leverage the center, and formulating a transition plan can enable the captive unit to gain scale, increase resource utilization and staff size, and optimize marginal costs. • Creating or re-framing a transfer pricing system and articulating revenue goals can motivate management at the captive center to seek additional work from these same or new business units within the organization. Revenue goals are only relevant, however, if the captive center has strong local management, an understanding of firm-wide operations, and authority to suggest initiatives to the headquarters or its business units. • Evaluating the captive center’s financial performance in terms of the organization as a whole can expose opportunities to exploit local tax regulations. For example, the Indian BPO tax ruling mentioned earlier allows a captive center to charge an above-market rate (e.g. the U.S. cost price) and gain exemption from taxes, or to charge a market rate (e.g. a premium Indian price, which is in line with the prices that a third-party provider would charge) and pay profit taxes. Upon examination, it may prove beneficial to do the latter, particularly if this drives captive center managers to better control costs or improve processes, or if the center can be used as a tax shelter.

The Advisor Perspective – Critical Points to Consider
Buyers must consider factors such as their individual circumstances, as well as those related to their industry and competitive landscape, when creating a global service delivery strategy. Organizations often fail to adequately incorporate these factors in their outsourcing strategies – particularly when establishing captive centers. Frequently,

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Partnership: A partnership with a third-party service provider can create opportunities for both product or service innovation that are beyond what many captives can achieve independently given skills or cost constraints. Partnerships can enhance overall process performance, better utilize assets, and create a better risk profile. Ideally, a partnership can both drive innovation while keeping costs low and efficiency high. There are many types of partnerships open to buyers. At one end of the spectrum, captives and partners perform separate but complementary activities as part of an overall service chain. In the hybrid partnerships or virtual captive models discussed below, partners are brought in to perform some or all of the activities within the captive center itself. In these models, the buyer maintains control and ownership of the captive center but does not directly perform all of the work in the center. The nature and depth of a partnership depend on various specific buyer factors, including needs, sophistication and risk profile. • Offshore partnerships in locations like Russia, India and China must innovate ways to gain leverage in extremely competitive environments despite a lack of access to robust infrastructure, laws, financial markets and other resources that buyers take for granted. As a result, buyers involved in these partnerships have been able to develop and leverage IP – in terms of processes, technologies, products, disaster recovery systems and more – more effectively than they would have been able to do independently. Boeing provides a successful example of this. The company maintained control of its own IP while leveraging over 40 partnerships for their IP. The Boeing R&D captive, together with its third-party partners, designed parts of the 787 Dreamliner. The partnership enabled Boeing to introduce a fuel-efficient, mid-sized aircraft to the market bucking the industry trend toward larger aircrafts and earning $100 billion in a single day. • Third-party providers are experienced in distributing non-core activities to global locations. Consequently, they are skilled at disaggregating and modularizing business processes, managing stable global delivery, and shifting work from one country to another to hedge against natural, regulatory and financial risk. Partnership can increase flexibility by enabling the captive center and the headquarters organization to make better use of resources, speed up response times and reduce financial burdens. Finally, the current appreciation of the Indian rupee is highlighting the advantages of multicountry operations.

• A third party could make use of a captive’s excess facilities, particularly if the captive is in a location that the provider is not or if the work requires specialized technology or equipment. Partnership with a third party could also gain the organization and/or captive access to the institutional resources of, and/or financial incentives targeted to, the former. • For any of the above benefits to accrue, additional measures are required, such as realigning the parent company around an offshore outsourcing strategy. The primary shortcomings of a partnership are heightened risk and complexity. A buyer could end up with numerous partnerships that lack a unified goal. Captives, including those already in partnerships with third parties, will need to develop governance processes to manage third parties. For this success to be replicated by other companies, a strong understanding of the offshore outsourcing market, KPO performance drivers and metrics, relationship management processes, and governance mechanisms, are critical. Hybrid Partnership: In this version of a partnership, the captive center partners with one or more third-party service provider that offers some of the captive center activities (e.g., infrastructure, HR services, process management) to enhance the center’s performance. The partner is brought directly into the captive’s operations as opposed to providing separate but complementary services externally. Specialization in high-value services, coupled with partnership with a thirdparty provider, can improve the captive’s balance sheet. Captives can create agreements with third-party providers to handoff non-core activities and focus specifically on services that must remain in-house. The scope of a hybrid relationship can range from infrastructure managed services to tactical staff augmentation to full-scope outsourcing of key functions within the center. The buyer keeps overall ownership and control of the center, along with the business unit relationships, though the third-party provider may assume more strategic roles over time. By leveraging the local brand and core capabilities of third-party providers, this approach can potentially make recruiting new staff easier, improve productivity and drive ongoing savings from the center. Virtual Captive: In this more expansive version of the hybrid partnership, the buyer partners with a service provider that will provide nearly all of the captive center operations. The buyer typically retains ownership of key personnel and processes, though this is not always the case. The result is a third-party operated captive center or “virtual captive.” This approach is particularly effective when internal policy or regulations preclude an approach that releases control of processes to a third party.

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Divestiture: There are situations where realignment of the organization, specialization in the captive, or partnership with a third party will lead to insufficient improvement. Buyers in industries exposed to extreme cost pressures could be better served to sell their captives. While realignment or specialization can boost performance, the costs to do either and the time before benefits are seen could prove to be too costly, particularly if there is the opportunity to sell the center. Many providers are seeking to bolster their credibility in order to gain competitive advantage and win KPO contracts. A captive center may give a provider specialized knowledge and skills, credibility and added capacity. Occasionally, selling off some or all of a captive can prove lucrative to the buyer. General Electric, for example, sold 60 percent of its Indian captive to General Atlantic Partners and Oak Hill Capital Partners. The now renamed Genpact is a 20,000 employee, $500 million company with GE as a primary customer. Captive owners should recognize that the Genpact scenario is unique in terms of the captive center’s capabilities and the price premium it commanded. New entrants and those with existing captive centers should thoroughly examine their offshore outsourcing strategy and business case, inclusive of the following factors: existing market environments, management thinking, overall business strategies and business processes. Second to this, they should create or redesign their offshore outsourcing strategies – not the other way around. Companies must then define their primary offshore outsourcing objectives – cost reduction alone, in addition to performance enhancement, or in addition to revenue enhancement, capital productivity improvement, and risk mitigation. If the goals are numerous, the best strategy may be multi-sourcing. Finally, companies should analyze local market conditions to decide on an appropriate outsourcing strategy.

Both captive centers and third-party providers bring unique advantages to a buyer: the former brings greater control and local presence, and the latter, cost reduction, global delivery and potentially innovative IP. If a buyer is already operating globally, labor arbitrage becomes less significant to the business case. The services a buyer is outsourcing also are crucial: if they are more mundane non-core services, a captive would need scale to achieve cost reduction. Thirdparty providers have economies of scale in their areas of specialization, as well as a global footprint and flexible delivery model – and IP that can spur disruptive innovation. Scale, global locations and flexible delivery can reduce costs and risks and increase productivity significantly, while IP and innovation can open new markets. Simply outsourcing to a third-party provider, however, separates a buyer from the human resources function. The buyer loses ability to motivate managers with non-monetary incentives, such as the award of greater responsibility or authority – measures that could prove significant in competitive labor markets. Moreover, by outsourcing alone, buyers lose a certain degree of opportunity – both to drive process improvements and to develop local institutional capacity. Captive centers can create or expand a company’s local presence, develop and maintain assets in diverse markets, control critical business processes, and improve overall financial performance. As each model brings unique advantages, thorough analysis and possibly a multi-sourcing model is necessary.

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Conclusion
As global outsourcing focuses more on revenue enhancement and capital productivity, in complement with cost reduction, companies have more opportunity and greater risk in global sourcing strategies. Increased interdependence between external service delivery options and core business performance has necessitated new relationships – particularly multi-point global services delivery. Re-examination of an organization’s offshore outsourcing performance will enable a company to proactively manage multiple third parties, internal and captive delivery models to drive an organization’s overall strategic goals. The best combination of models, locations and global services will depend on the objectives, practices and process of the organization in question and its outsourcing objectives, plus a good plan to integrate the two. Organizations that have deployed or are considering deploying offshore captive operations need to clearly define what services those centers can best perform and whether they can perform those services more efficiently and effectively than a third party. This bundle of services will change over time, and, in some cases, outsourcing may become preferable for more routine activities as captives handle specialized services (e.g., regulatory requirements, IP concerns). In other cases, outsourcing can contribute valuable IP and drive innovation while captive centers can focus on project management. Buyers should examine or re-examine their offshore outsourcing strategies in the heightened context of BPO/KPO opportunities to determine the route to maximum value.

About EquaTerra
EquaTerra sourcing advisors help clients achieve sustainable value in their IT and business processes. With an average of more than 20 years of experience in over 600 global transformation and outsourcing projects, our advisors offer unmatched industry expertise. EquaTerra has in-depth functional knowledge in Finance and Accounting, HR, IT, Procurement and other critical business processes with advisors throughout North America, Europe and Asia Pacific. Our people are passionate about providing objective, conflictfree advice to our clients, which has fueled our exponential growth over the past four years. We help clients achieve significant cost savings and process improvements with outsourcing, internal transformation and shared services solutions. It is all we do. If you have questions about this report or would like to learn more about how EquaTerra can help your organization address the points and opportunities discussed, please contact Cliff Justice at Cliff.Justice@EquaTerra.com or +1 925 918 0142. For additional information on EquaTerra, please contact Lee Ann Moore at LeeAnn.Moore@EquaTerra.com or +1 713 669 9292. For more information on EquaTerra’s research efforts, contact Stan Lepeak at Stan.Lepeak@EquaTerra.com or +1 203 458 0677.

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