When we launched our fund in June 2001, we planned to invest in three areas:  enterprise software, technology-based business services and information services.  A year and half later, we have invested in five companies but none have been, strictly speaking, software companies.  Four of the companies (DPM, ExpertPlan, Octagon, Medidata) provide outsourced services to either the pharmaceutical or financial services industries and the other company (Knovel) provides online engineering information to corporations and libraries.

The area we find appealing in the business services sector is what analysts term Business Process Outsourcing or BPO.  Traditional outsourcing, such as office cleaning, has been around a long time.  However, unlike BPO companies, garden variety outsourcing concepts don’t dramatically improve efficiency through technology and centralization.  In addition, as Greg Gould of Goldman Sachs points out in his research, BPO goes one step further than traditional data center outsourcing, which CSC, EDS, and IBM Global Services have provided for many years.   In data center outsourcing, service providers deliver more computing power for the dollar by building economies of scale.  Over time these services become commodities, which depresses gross margins to the 20% range.

On the other hand, a successful BPO service provider (Affiliated Computer Services — NYSE : ACS – is the poster child of the space) takes over a specific corporate function (for example loan or claims processing) and improves the workflow with best practices, intelligently deployed technology, and specialized labor.  The benefits thus mainly derive from intellectual capital, finding and fixing “process gaps” and taking advantage of good software.  Customers not only benefit from dramatic savings (Exult – Nasdaq : EXLT – reportedly saved BP Amoco 12% – 16% in worldwide human resources costs) but their capital, time and energy are freed up to focus on what they do best.

Because the expertise behind the BPO service is usually difficult to develop, the gross margins for BPO providers tend to exceed 40%. The BPO space is also attractive to venture funding firms because small BPO providers can successfully compete against large vendors, as specialized process and domain expertise is more important than scale or capital base. Finally, the BPO business models tend to emphasize recurring revenue, which we find attractive due to the stability and visibility it provides.

One central question remains; should BPO providers build or buy their own software?  Each of our BPO portfolio companies has developed proprietary software.  However, prominent public companies, such as Bisys (NYSE: BSG), openly deride this strategy.  Executives at Bisys argue it is too hard to be good at two things simultaneously i.e. delivering a service and developing software.  They would rather buy the “best-of-breed” packages openly available on the market.  When those packages become outmoded, they argue, they can buy the next wave of software that becomes available.  A number of analysts ostensibly agree, as they like Bisys’ low capex.  Certain venture firms that focus exclusively in this area, such as Accretive Technology Partners, also would argue that customers are buying an outcome and while technology enables the process it doesn’t drive the outcome.

However, the most interesting companies we see do in fact develop their own software.  This is because constant process improvement today is as much about software modification as it is about non-technology process re-engineering.  One could in fact make the case that if you are dependent on an outside vendor’s software to deliver your service, you are inhibited from constantly improving your service. 

These are all interesting questions and deserve to be studied.  In the meantime, we are going to be searching for niche BPO providers and hope to make several more investments in this area in 2003