The Emergence of Nearshoring

Few business trends in recent memory have garnered the type of attention that outsourcing has. Driven by increasingly strong pressure to cut costs and focus on core competencies, companies are continuing to look to outside firms to handle non-core business functions such as collections, customer care, and human resources. In the 1990s, many companies in the U.S. began looking into offshoring, sending work over to places such as India and the Philippines. Recently, however, numerous issues have emerged with the offshore model, and executives are starting to look to nearshore providers for their business process outsourcing needs. At Virgo Capital, we believe the nearshoring model offers a unique value proposition when compared to domestic and offshore outsourcing providers, and that it represents an attractive opportunity for the right investors.

With a global market size approaching $300 billion, business process outsourcing (BPO) is nothing new. Beginning in the 1980s, companies such as American Express began offshoring their outsourcing projects, a trend which became mainstream in the 1990s. Until lately, it was not unheard of for managers to expect cost savings of up to 80% from offshoring. A recent study by Ventoro LLC, however, suggests 10% to 20% is more realistic after factoring in all savings and costs. While these savings are still substantial, they do come at a price - poor communication, cultural differences, physical distance to the location, and unstable governments are often cited as issues with offshoring. In fact, these problems have been so great that one in three executives has had to bring a project back onshore after having taken it offshore. Domestic providers mitigate many of these concerns but do not help cut costs, which of course sets the stage for the emergence of nearshoring.

Providing a hybrid solution between domestic outsourcing and offshoring, nearshoring is the outsourcing of business functions to vendors in countries geographically closer to the US. The industry is growing rapidly, and we believe there are four primary drivers to this growth - cost savings, quality and stability of the workforce, geographic proximity, and stable, friendly governments. Michael Flock, Managing Director of Flock Advisors, addresses the first two points in noting that "from the customer's perspective, nearshoring provides all the benefits of offshoring, without a lot of the negatives. As a result, the trend of moving call centers and collection centers outside the U.S. but inside the hemisphere is exploding. The cost advantage of Mexico, the Caribbean, and Central America is almost equal to India and the Philippines, but even more importantly, the employees understand the credit culture. They are also well educated, and depending on the country, don't have the same accent problems that have surfaced elsewhere." In addition to the attractive labor costs, many countries offer tax credits and other incentives for companies willing to locate operations within their borders. Furthermore, nearshore destinations tend to have stable governments who recognize the importance of data security and intellectual property protection, and their geographic proximity allows for clients to monitor their projects closely.

Some of the earliest adopters of the nearshore model are companies in the collections industry. Collections companies assist businesses in pursuing unpaid debts, helping to recover billions of dollars annually on behalf of various credit granting institutions. Rather than attempt to collect on the defaulted debt in-house, credit grantors learned years ago that this task is best handled by a third-party. Such collections companies, which are essentially call centers, were among the first to relocate offshore but were also the first to realize that the quality of high-touch customer contact calls suffered in the hands of someone half a world away. As a result, Canada, Mexico, and the Caribbean, among other locations, have become popular places to relocate this work. Several recent statistics confirm the growth of nearshoring. A recent Business Insight study projects a 17% growth rate in Mexican outsourcing revenues through 2008, and the Caribbean is now home to 85 call centers compared with 45 in 2002. Over 80% of this growth is attributable to contact centers fulfilling projects for Fortune 1000 and other large US corporations.

By providing many of the same benefits of offshoring while allaying a number of its concerns, we believe that nearshoring is well positioned for further rapid growth. We anticipate nearshore destinations like the Caribbean and Canada will continue to take market share from popular offshoring locations like India and the Philippines. While some industries like collections are already taking advantage of this trend, we believe nearshoring will spread to other sectors just as offshoring did in the 1990s. Nearshoring is especially attractive because it provides an improved version of a successful business model in a comparatively underpenetrated, undercapitalized and highly fragmented marketplace. Given the right platform, a strong management team, and experienced financial partners, we believe that the nearshore outsourcing industry represents a promising investment opportunity.

Professional Employer Organizations

Human resources management is one of the most substantial and promising areas in outsourcing today. One of our favorite models is the professional employer organization, or PEO. The value proposition PEOs provide enables clients to cost-effectively outsource the management of human resources, employee benefits, payroll, and workers' compensation, allowing them to focus on core business functions. PEOs deliver these services by establishing and maintaining an employer relationship with the client employees and by contractually assuming certain employer rights, responsibilities, and risk. We believe that significant investment opportunities exist in this consolidating market given the fast growth and low overall market penetration.

The PEO industry was recognized by The Harvard Business Review as the fastest growing business service in the United States in the 1990s. Annual industry revenues today are approximately $50 billion and growing 20% year-over-year. Furthermore, the estimated addressable market penetration is only between 3% and 20%, translating to a market opportunity of $250 billion to $1.7 trillion. Better still, the PEO market remains fragmented, with some 700 PEOs in business today. With a strong platform company, seasoned management and the right financial backing, there is a great deal of potential to grow a company both organically and through acquisitions.

In addition to pursuing growth initiatives, we feel that there is a significant opportunity to use technology to scale a PEO business. Scott Klososky, a leading consultant to the industry and former keynote speaker at the National Association of Professional Employer Organizations (NAPEO), notes that "the PEO industry is poised to take advantage of the technology trend of Service Oriented Architecture which would allow PEOs to easily connect to existing job costing software, time and attendance systems, and accounting systems in order to both receive payroll data and export completed information back to clients. This further lowers the barrier of entry as an outsourcing provider. This level of automation both increases the attractiveness of a PEO to a client, and lowers the internal operating costs." This point fits well with Virgo's belief that adding value to an investment consists of growing top line revenue as well as reducing costs by working with our strategic partners to leverage scalable technology-enabled solutions.

Looking deeper into the PEO space, we see two distinct business models, one where the PEO serves blue-collar workers and another with a focus on white-collar workers. The former is largely an insurance and workers compensation play where companies benefit from reduced premiums through employee pooling and risk sharing, and the latter is grounded more in the traditional outsourcing value proposition. Both models can be lucrative, but each one has distinct risks and rewards. As an example, blue-collar PEOs require an in-depth understanding of risk management, while white-collar PEOs are much more focused on technology capabilities. A recent trend in the PEO industry is to provide the same HR services in an a la carte manner and to not contractually assume full employment obligations. This model, known as the administrative services organization, or ASO, model, has its advantages for a category of clients that want to outsource certain modules of human resources efforts.

Finally, the PEO market is consolidating one, and we believe a few strong leading players will emerge in the coming years. As that consolidation takes place, there will be good liquidity opportunities for scaled, differentiated PEOs. Private equity firms have been quite active in the space of late. Recent investments include Strategic Outsourcing, Inc., with 32,000 work site employees (WSEs), which was purchased in 2005 for $80 million, and Oasis Outsourcing, with 55,000 WSEs, which was acquired in 2006 for $130 million. Given the growth of the market, many investors will do well by simply adding bulk. However, the investors that will truly differentiate themselves are those who partner with the right team and company and help drive a focused strategy, which includes disciplined growth, both organic and through acquisition, and exceptional client service.