Barely a day goes by without a new story linking a trio of private equity firms to increasingly implausible bids or, at least, bids that would have looked implausible as little as a year ago but now look increasingly viable. Retail, a sector with notoriously thin margins and comprehensive execution risk (cf Sainsbury and Marks and Spencer in recent years), has been a particular favourite recently. Now, rumours and facts abound about various IT outsource companies coming under scrutiny. Another sector where margins are thinner than thin (size zero?) and the execution risk often strikingly large.
What would happen if the hedge funds applied their “2 and 20” rule to the outsourcing deals that they win? Two and twenty is where the fund manager takes a flat 2% of assets under management and then 20% of any profits, at a gross level. The actual amounts vary – some funds charge as high as 50%, but they deliver, in return, pretty stellar gains year in year out.
So imagine a company, Joe F Smith & co, signs over its back office services to TwoAndTwenty Capital Partners. JFS pays £100 million per year to operate the services in-house. TATCP offers to do it for less, but wants £2 million flat fee every year as well as the £100 million. If TATCP can reduce the cost of operation, they get 20% of that reduction and the customer, JFS, gets 80%. Is that a good deal for JFS? They pay £102 million for what used to cost them £100 million. If the cost falls to, say £80 million, they pay £86 million (£80 million plus £2 million flat fee plus £4 million as the 20% of saves). TATCP gets £6 million versus its original £2 million.
What if costs go up? Strictly, under hedge fund terms, the clients carry the loss, the hedge fund gets its 2% performance fees but doesn’t get any upside (the “20” disappears). Further, in following years, the hedge fund has to earn back the lost money before its allowed to take any of the “20”. This keeps the fund manager keenly focused on performance and, also, on stability (i.e. low volatility) – making £100 million one year and losing £100 million the next year makes for zero performance earnings over two years and the problem of having to gain the money back the following year before any further upside is received.
In a hedge fund world, there is unlimited upside of course – returns could be 100%, 200% or even 1000% and so performance fees can rapidly become enormous. On the cost side of the equation, it’s unlikely that services will be delivered for less than zero (I’m not yet sure there’s room for advertising supported outsourced IT), so the returns will be capped.
I wonder what the balance of 2 and 20 equivalent would have to be for this model to work? If it were 3 and 30 or 5 and 50 would a company take it up? There’s always the risk that there’ll be a long argument about accountability for cost increases that would defeat the point – the “hedge fund manager” is, after all, not in control of many of the variables unlike when they’re trading and the choice of position is entirely theirs, even if they’re unable to directly influence the market in most cases.
Is this a better model than the glide path that is standard in many contracts where the cost goes lower and lower every year but where change control costs are always added to the top at the original margin?
Of course, there are those who say you should never outsource … but given that companies and governments are going to keep doing it and given, especially, that the big research companies say that somewhere near 2/3rds of outsource deals are significantly renegotiated or exited before their full term has run, there ought to be a better model from the outset that makes things more achievable.
Applying this approach presupposes that the reason for the renegotiations or early exits are related to whether the supplier can make money or the customer sees itself getting value for the price paid – there are probably a dozen other reasons, but I’d expect this pricing/value point to be the single largest reason.