The standard way to manage this sharing is with a series of transition services agreements, or TSAs. These agreements cover the period during which the assets required to perform certain of the divested business' operations remain with its former corporate parent. The TSA enables the parties to continue to operate as they have all along, but with the goal of separating in a reasonable period. The service-producing assets reside in the former affiliate, and the receiver buys the outputs of those assets as transition services.
Nearly all M&A transactions require some form of TSA. Some are fairly straightforward, but other TSAs are both complex and crucial to the separating business. In the latter category, for example, are some agreements covering information technology systems infrastructure. In effect, information technology transition services agreements amount to IT outsourcing transactions between two parties who aren't in the outsourcing business -- and don't want to be. Worse yet, the unwanted burden comes at a time when you want to move rapidly toward operational efficiencies.
In this context, the case for tactical use of a real outsourcing agreement -- with a provider that is in the outsourcing business -- is compelling.
Since the word "outsourcing" has taken on many meanings, let's begin that case by clarifying our terms. Although outsourcing is often very complex, outsourcing transactions have one common denominator. When a company outsources, it takes a process, transfers the assets required to perform that process to a third party and buys the process back as a service. The assets performing the service reside in an entity other than the one receiving the services. This is the same asset-to-services state that exists in the M&A context after closing but prior to operational convergence.
Done properly, outsourcing can act as a facilitator in divestitures; in acquisitions, it can provide a relatively easy way to merge incoming operations. It can lower post-closing operational risks, disentangle operations more efficiently and ultimately lessen the time it takes to realize the operational efficiencies that may have been a significant consideration when evaluating the deal in the first place. In short, outsourcing may be a logical alternative to traditional transition services arrangements, particularly in information technology, but also in finance, accounting and other areas that are heavily process driven.
Many of the same skills and steps are involved in negotiating information technology outsourcing deals and TSAs, so they are very similar transactionally. Yet outsourcing can eliminate many of the operational difficulties associated with the TSA. It can eliminate the need to perform multiple migrations and can be useful both defensively and as proactive preparation for an upcoming corporate event.
Outsourcing is defensively useful as a buffer against hardball negotiation tactics. When a company is divesting a subsidiary that is truly integrated, it is not unusual for that subsidiary to provide certain services to its affiliate companies. When the divestiture occurs, not only will the assets required to perform those services move to the buyer, so will the people in most cases.
A while ago, I assisted a large corporate client with the technology aspects of divesting a full one-third of its corporate mass. In that deal, the buyer was using transition services for the human resources IT function as leverage in the corporate deal, knowing that without the divested entity's employees, the seller's human resources function would come to a grinding halt.
We immediately began a process to outsource the function, identifying suppliers that could bring the operational experience that the seller would lack after the deal closed. We closed the outsourcing deal early enough before the close of the corporate deal that certain knowledge transfer could take place before we lost the divested employees. By outsourcing the function, we were able to remove the function from the discussion.
As a proactive tool, outsourcing can be used to prepare the operations for the transition without the real-time stress of expiring transition services. In this case, the seller would outsource its entire function, which allows migration to happen in advance. The contract involved in the outsourcing would have provisions for either splitting the operations if there is a corporate event or allowing the operations to continue, making the transition period more of a billing and legal issue rather than an operational issue.
In an outsourced environment, no migration is required when the companies split. They each simply become customers of the same outsourcing provider. As a result, when the divestiture happens, the transition becomes a nearly pure legal exercise, with very little operational impact.
This is useful in any dynamic environment. The examples above relate to divesting businesses, but acquiring businesses can gain similar advantages since migrating into an outsourced environment can be much easier than combining operations internally. For one thing, the outsourcers frequently have migration expertise far superior to that of their customers, so outsourcing can put the function where the necessary knowledge resides.
An outsourcing provider's staff is also better positioned to accomplish what is, after all, a separation. It is not uncommon for parties, in their generosity toward their former colleagues, to take on responsibilities that are either very risky or illegal, such as providing access to software or services as a service bureau to the former affiliate in violation of its licenses. Outsourcing makes such behavior much more difficult.
The process of outsourcing is complex, but so is a well-crafted and -managed TSA formulation. On a macro level, outsourcing involves identifying services to be outsourced, determining their current-state processes, determining current-state costs, crafting a request for proposal, or RFP, selecting a vendor and contracting and migration. The initial costing and operational assessment is referred to as the "base case."
The following description of the steps involved in drafting a TSA for information technology services illustrates how closely transition services agreements resemble outsourcing deals. It also provides a framework for showing how the use of outsourcing can often be a superior tactic.
• Identify and document the transition services. The buyer and seller must describe all shared IT services and then determine which will be provided under the TSA. The level of detail should be sufficient to describe the services adequately. This is equivalent to identifying services to be outsourced.
• Perform due diligence. Although providing standard, day-to-day IT transition services for a divested business does not necessarily present much of an operational challenge, the change in ownership can create some challenging legal issues. For example, once the businesses are no longer related, software license agreements generally won't permit the seller to process the divested unit's work. IT service agreements, especially telecom contracts, often have similar restrictions. To avoid potential legal liabilities, costs and risks, the party providing the services must get vendors' consent to perform transition services.
Similar issues exist in outsourcing, since the supplier will need permission to run the environments in question. These "consents" are routinely handled in the outsourcing context, and when the divestiture occurs, the outsourcer can be quite helpful in obtaining additional consent that might be required.
• Produce a cost model. The finance people should generate a complete analysis of the costs associated with providing the transition services. This is more challenging than it sounds, particularly if there is an informal culture, or if inter-business unit charges were not well defined.
The cost model must take into account the operational reality that some bundles of transition services will continue longer than others, plus any penalties associated with early termination, volume commitments and other cost components that may apply. The pricing model that derives from this costing exercise then has integrity and leaves the provider whole.
This is the costing component of establishing a base case for outsourcing as well. The difference is that the termination scenarios can be made more manageable once the migration issues are dealt with.
• Draft and negotiate the TSA. The TSA and related schedules need to be drafted, negotiated and finalized prior to the transaction closing. Though TSAs are highly customized, there are key issues to keep in mind in working through any transition services arrangement. These are:
1. The ability to change operations. In a TSA situation, there is a real conflict between one party's need to adapt to its business needs and the other's requirement either to remain constant or to adapt to different needs. While this issue does- n't go away with outsourcing, a well-crafted outsourcing relationship will be more adaptable than is possible in most transition services contexts.
2. Risk management. Even a well- drafted TSA arrangement can create business and legal risks. Where a risk can't be avoided, the TSA should be structured to permit the party that faces the brunt of the risk to take necessary actions to manage it. These include such factors as expiring consents, the changing needs of the recipient and changing legal and regulatory landscapes. The cultural dynamics in TSA negotiations can make these issues very difficult to manage.
Because the TSA provider tends to look at the services as a "favor" it is doing and the recipient tends to expect real service-provider standards from the provider, things can get tense, with the party gaining the most from the underlying transaction often taking a hit. Although outsourcing is no panacea for risk mitigation, it has the benefit of avoiding the sibling strife that can occur when affiliates part.
• Plan an exit strategy. By far the most common and, in many ways, the most dangerous condition that arises during a transition period is apathy. It is very easy for inertia to take control, leaving the recipient in the provider's environment for years after the time it is wise or legal to do so.
In this area outsourcing has a clear advantage: There is a disinterested third party who has no incentive to allow the status quo to stand. Operationally, the supplier has little risk, but the legal requirements that must be met after divesting will be built into the outsourcing agreement, and will typically be enforced. This is helpful, since the endgame in this process is to separate the companies. Avoiding much of the operational day-to-day contact is an invaluable first step in doing that.
In most cases outsourcing is not a very good strategy. In other words, if clients are not able to articulate a strategy that doesn't include the word "outsourcing," they may be in some trouble. However, outsourcing can be a very effective tactic, particularly when a strategy is as clear as it is in the context of transitioning companies in and out of an operating environment. In this case, outsourcing as part of your tactical arsenal may provide a way to cut transaction costs, reduce risk and realize the benefit of your deal much more quickly and easily than keeping operations in-house. - Edward Hansen
Edward Hansen is a partner at Morgan, Lewis & Bockius LLP in New York.
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