Bankers, autos and tech - Oh my!
by Joshua B. Konvisser, Partner, Pillsbury Winthrop Shaw Pittman LLP
This week’s landmark bankruptcy filing by General Motors is just the latest example of recession-driven retrenching across industries, a trend casting a shadow on outsourcing companies with large client bases in the hardest-hit industries. Depending on restructuring terms, outsourcing firms may be at risk to have large, long-term, ongoing revenue streams rejected in bankruptcy or terminated by an acquiring entity after a ‘fire sale’ purchase. You only have to look at the lists of the top 50 creditors for each of GM and Chrysler to see recognizable outsourcing service providers with a great deal at stake.
One can trace the beginning of the outsourcing sector’s current challenges to the financial meltdown last year, as bankruptcies and sell-offs of leading financial services institutions began to jeopardize outsourcing providers’ revenue from these customers. This was compounded by early termination of outsourcing agreements as the industry eliminated redundant service contracts in newly consolidated firms.
Wall Street’s shake-up was followed in short order by crises in the auto manufacturing sector, typified by recent dramatic ownership changes and organizational revamps at Chrysler and GM. From information technology services, transaction processing and customer service to parts delivery and facility management, each of these hard-hit industries relies extensively on outsourced services.
Bankruptcies and reorganizations are having a profound effect on some outsourcing firms because these service providers typically invest in technology, facilities and other assets early in long-term outsourcing contracts, expecting to recover these costs in later years. The vulnerability in this strategy emerges when ongoing revenue streams are cut off in bankruptcy or other circumstances without allowing for a complete recovery of providers’ early-term investments. This lost investment compounds the loss of expected revenue from having long-term agreements terminated early.
The net result is that we may begin to see a sort of “domino effect,” given the interdependence of the IT and outsourcing sector on the industries it serves, such as financial services and auto manufacturing. Companies in the current environment would be well-advised to not only perform thorough due diligence on existing and potential suppliers and partners, but also to prepare contingency plans in the event access to key suppliers, distributors or business critical software and services is jeopardized. In our practice, colleagues and I advise managers pursuing outsourcing to meet commercial and financial objectives to bear in mind the risks associated with outsourcing – especially long term arrangements – and factor these risks into their decisions and plans. We also urge them to revise the thinking around certain contract terms that might be appropriate in light of the new economy.
While the larger and more well-diversified outsourcing providers should make it through this downturn, smaller and mid-tier providers that are focused on limited service offerings or a single vertical market could face difficulties, even bankruptcy themselves, if revenues decline to levels triggering loan covenants, for example, or simply fall too far below the operating costs of supporting customers.
The last six to twelve months have brought massive changes in the global economy, making it even more critical for organisations to pay careful attention to new risks confronting the outsourcing industry at the same time they evaluate its ability to transform their business. This does not mean that companies should forego an outsourcing if there are significant commercial benefits. However, it does shift the cost-benefit analysis for outsourcing and demand an increased level of diligence and planning. This advice applies equally beyond the sourcing context to any key supplier relationship.
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