Despite resistance from political and labor lobbies, the offshoring juggernaut rolls on. During 2005 it became evident that the long-term trend towards outsourcing and offshoring is more robust than many thought.

by Arun Jethmalani, ValueNotes

Growth prospects are being fuelled by a range of newer services as well as higher levels of adoption for existing processes. In parallel, customers are maturing rapidly, even as a proliferation of new vendors provide buyers with more options and greater bargaining power.

These diverse forces are shaping a number of trends in business process outsourcing (BPO), which are distinct yet closely interrelated. This article highlights some of these trends, and how they're likely to play out over 2006 and beyond.

Move to Knowledge Services

Rising competition and smarter customers have commoditized many traditional BPO processes in CRM, transcription, data entry and transaction processing. However, during 2005, the successful offshoring of a variety of knowledge services has helped attract the attention of new entrants as well as existing vendors desperate to move up the value chain.

The small beginnings in areas like financial research, risk modeling, market research, R&D, data mining, telemedicine, actuarial services, engineering services, legal services and many others, have shown the way ahead. We believe that investments in knowledge services (often called knowledge process outsourcing or KPO) are likely to turn into a flood during 2006, as the range of offerings expands phenomenally in scope and specialization.

While many of the "sensitive" tasks will move to fully owned offshore captives, a proliferation of third-party vendors will emerge across the world. India will remain the primary destination, but locations like East Europe, China, South America and East Asia will also see a large number of new players, competing not necessarily on cost, but knowledge. In turn, a new breed of buyers will emerge, who see offshoring benefits not merely in terms of cost, but availability of brainpower.

Given the rising weight of knowledge services in the outsourcing industry, we believe that 2006 will mark a major milestone in the industry's transition from low-end, commoditized, process driven services to one where knowledge becomes a key differentiator.

The Rush to Scale and Specialize

Falling unit revenues driven by intensifying competition and the rising share of offshoring, are responsible for two opposing yet complementary trends: towards scale and specialization. On the one hand, an increasing number of players will try to differentiate themselves by way of specialized services and domain knowledge, rather than scale.

At the other end of the spectrum, large, multi-service providers will look to aggressively add new verticals, service offerings and geographies. Moving towards the classic "one-stop" strategy, multi-service vendors believe that scale, coupled with diversification across geography, offerings and verticals will enable large, complex, multi-service contracts. At the same time, in order to compete with niche providers, they will seek to build specialization and scale in each chosen offering.

Given that niche or specialized services command higher billing rates and opportunities for differentiation, the large vendors will continue to seek pure play acquisitions to gain presence in new segments or geographies.

Consolidation amidst Fragmentation

In 2006, the BPO industry will be simultaneously pulled in two opposing directions: towards consolidation and fragmentation.

Acquisition activity reached new highs in 2005, and we expect 2006 to be much busier. However, apart from the news-making mega-deals, we will see a far greater number of small deals. This will be driven by acquisitions in the knowledge services space, as acquirers will find it worthwhile to do small deals to acquire specialized knowledge, capabilities and customers. Given the relatively small size of such "specialists", deal size will be small.

On the flip side, the hype around offshoring is attracting hordes of new entrants. Compelled by the exciting new opportunities, new firms, especially IT service providers and consultants will increasingly muscle into the BPO game. Further, the success of India is driving governments in other parts of the world to provide a range of incentives to encourage new entrepreneurs.

Add to this, the opportunities in knowledge services will attract a new breed of entrepreneurs, typically professionals like lawyers, doctors, engineers, scientists, into the outsourcing business. Minimal entry barriers, low infrastructure and set-up costs will encourage the smallest of KPO set-ups. Unlike commodity services such as call centers, CRM or back-end data processing, the minimum critical mass or size for KPOs need not be very large. High degrees of specialization and innumerable niches will allow even relatively small firms to exist profitably. So even as consolidation picks up pace, the explosion of new service providers will create further fragmentation.

The mushrooming of small niche players will in turn create a large pool of acquisition targets. Many new entrants will struggle to deliver the value proposition necessary to win over increasingly discerning customers, and acquisition by a larger player will be the only way to avoid dropping out altogether.

Overall, during 2006, we believe the forces of fragmentation will be stronger than those of consolidation, leaving us with even more players by 2007. The bad news for all these vendors is that the plethora of acquisition targets will lower valuations. Particularly so for the small, undifferentiated, multi-service outfits without the wherewithal or cash to scale. Leave alone valuations, there will be few backers or buyers at any price.

Offshoring Gains More Momentum

Offshoring will continue its relentless march, as both buyers and their vendors pursue global sourcing and labor arbitrage benefits. We believe that by 2007, almost every major BPO contract will include an offshore component. This incessant race to deliver lower costs via offshoring, in turn will accelerate the trend towards global delivery networks.

The ambitious capacity accretion plans of major US players such as Accenture, Deloitte, IBM, Sutherland and the like will pan out in 2006, when each of them will add a few thousand people offshore. More interestingly, during 2006 we expect the second wave - with medium-sized US and European owned BPOs significantly increasing their investments/capacity in India, China, Philippines and other offshore locations.

But Captives will become Integral to the Mix

As offshoring goes mainstream at large multinational corporations, 2006 will see a spurt in offshore investments by large corporations in fully owned captive centers. This will be guided by two factors. The first is the increasing sensitivity towards IPR, data security and confidentiality; all of which make captives the simpler choice. Secondly, many large companies that have been testing the offshore waters and are now looking to expand, will find captive operations more viable beyond a certain critical mass.

Interestingly, the evolving model of choice will not be pure captive or third-party, but a complementary mix depending on individual needs and risk perceptions. In such a "co-existence" model, in-house best practices will flow to vendors, even as cost efficiency metrics/learnings will flow from third-party vendors to captives.

And Investors will Loosen their Pockets

Attracted by the increasing maturity, growth and M&A activity, the financial community will begin to take a greater interest in BPOs. On the one hand, many BPOs will achieve a scale that will make them candidates for public listing. Already, during 2005, we've seen several BPOs go public in India and the US, and buoyant markets suggest that this will continue.

The availability of exit, both via IPO and M&A will in turn attract more money from venture capitalists and private equity firms. Last year's acquisition of Genpact by private equity firms GAP and Oak Hill in 2005 is merely a pointer of things to come.