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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 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 reengineering.
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.
To
contact Todd T. Pietri email ttp@milestonevp.com
or call 212-223-7400.
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