Contract Complexity

* Click here to read Part I of this two part series 

As the markets adjust to the new economic reality, what has the impact been on outsourcing contracts? SSON speaks with Richard Cumbley, Partner, Technology, Media and Telecoms, Linklaters LLP, London

SSON: Richard, a common complaint we hear from customers is that service providers don’t go the extra mile to deliver a "future state" vision, but are fairly constant with their services delivery. Given customers’ escalating expectations, how do they get a supplier to commit to and deliver to their end-state vision?

Richard Cumbley: This really goes back to the idea of what kind of a commercial model is agreed to at the outset. Often, the reason customers ask these questions three years into a deal is because they themselves weren’t clear on what they wanted at the outset of the deal. Customers aren’t to blame for that incidentally – typically that happens because their advisers don’t challenge them to look at the issues, and suppliers daren’t challenge them for fear of losing the deal. But if a customer can identify real, hard metrics that identify his expectations at the outset of a deal – for example, driving efficiencies into your back office by increasing year on year the number of invoices processed or supplier queries answered per FTE- then you have a firm idea of how success is defined for both parties. Customers often struggle to articulate those clear metrics, because they usually involve some form of compromise; in articulating clear metrics you have to swap a vague idea of a "transformed future state" for a something precise – a 15% reduction in the number of days it takes to get your accounts payable settled over three years, say. A "transformed future state" is easier to write; it’s easier to settle on in an agreement because it means all things to all people; and it’s easier to gripe about three years in; but it’s impossible to deliver satisfactorily, and results in the kind of concerns you flag. So if customers can clearly articulate what success means, they’ll give their suppliers a fighting chance of being successful, and drive real value for both their businesses. That doesn’t address what happens if someone’s idea of what success means changes half way through a contract, but that’s a whole topic in itself!

SSON: So, how successful are outsourcing deals today? Are customers happy with the services being provided?

RC: Deloitte did some research last year, which showed that about 70% of all outsourcing deals are going well. That is a long way from perfect, but the industry as a whole ought to be pleased with that number, as it’s a significant advance on four or five years ago. For the 30% that are going wrong, other research seems to indicate that it’s more about the "failure to invest in relationships" as opposed to the nature of the agreements that are being put together. That suggests a bigger problem around contract management.

SSON: So what are you advising your clients?

RC: A crucial issue is how they are managing contracts once they are signed: How much are they planning to spend? Who will manage it? We generally advise clients to budget between five and nine percent of contract revenue on managing a contract. Our own research seems to indicate a typical spend currently of only three to five percent, here in the UK. Additionally, what we’ve seen in the more successful contract management examples is replacing "procurement functions" with "supplier management" functions. "Procurement" tends to deal only with putting contracts in place; but supplier management functions help create and support ongoing relationships. The very best examples we see create career structures for those managing suppliers and incentivize them on a "whole of contract life" basis. They look beyond simple reduction of procurement costs to assessing whole of life contract value and bonus accordingly.

SSON: What about if the relationship does go wrong, or either side wants out for whatever reason. What do we stand with exit clauses today?

RC: Customers, certainly well-advised customers, have always sought the ability to exit a contract and take all the things they need with them. But there’s no question that market experiences during the exits from the mega-deals entered into five or more years ago (e.g. JPMorgan/IBM and Sainsbury’s/Accenture, both of which we worked on) has given the industry and its advisers much greater practical experience of what does and does not work well. As a result, we are seeing customers being more specific in terms of demanding access to software and source code, access to expertise and personnel. So we are witnessing some tougher exit provisions from customers.

One thing we are seeing a lot more of is use of "step-in" concepts, which is an idea copied from project finance deals. In project finance arrangements, "step in" rights were often given to debt providers, in order that they could resolve practical performance problems that might prevent them getting paid out. In sourcing arrangements, "step-in" rights give customers the ability to parachute in an entire management team or service delivery team and take back control of a service for a fixed period – three, six, nine months – to fix a problem rather than terminating an entire agreement; many suppliers fear these provisions, but in the circumstances where we have seen "step-in" used, they have helped restore previously rocky commercial arrangements to much healthier footing – either because a customer understands the supplier’s challenges much better than before, or because the customer has genuinely transformed the suppliers performance.

SSON: But is this not a big selling point for providers? That they excel at taking in a process and improving it?

RC: Yes, but it goes back to the original contract. If you lock down a provider with lengthy contract specifications ("input based service descriptions" to use some jargon), they don’t have the flexibility to bring improvements to the table. But if you are clear in saying you’d like a 50% improvement in FTE efficiency (an "output based service description"), it does allow for flexibility. In any case, "step-in" is less about innovation or improvement, and more about remediation.

SSON: Is it a more cautious world today? Do you see this reflected in geographic decisions?

RC: If you are a customer, the world feels a bit less stable today, yes. As a result we’re seeing fewer ambitious deals, deals that push the envelope in terms of location for an extra 5% savings. The labour arbitrage may be less in India or Poland than it was, but those destinations feel relatively secure right now in the outsourcing sector in Europe (but that is a European perspective; my colleagues in Tokyo and Sao Paolo agree with the principle, but identify other territories as "safe"!). Supplier security is also very important. Satyam had a big impact on people. So big, safe names are in vogue again.What’s also changing is the type of deals being done. Two years ago, our clients were looking to do innovative deals, both in terms of services and pricing mechanisms. Since Lehman, the focus has moved to straightforward, plain vanilla deals – albeit large - that deliver cost-savings quickly; data-center consolidation, for example.

SSON: What about the funding model? How have markets impacted suppliers’ ability to pitch for and underwrite deals?

RC: The cash flow model for most large deals is pretty standard: lose money in the first few years, break even in year three, and make money in the last two years. This means suppliers have to be able to fund the early years, though. With cash and funding generally harder to come by, we’ve seen a couple of very large deals not get to signature recently because the vendor was not willing or able to fund the deal. That funding shortfall is also driving some supplier consolidation.

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Linklaters has specialized in outsourcing contracts, representing both the buy as well as sell sides, for more than fifteen years; they currently have a team of 70 outsourcing specialists operating mainly across Europe and Asia.