Following a decade of relatively steady growth in offshore internal service providers, companies in the past few years have begun to reverse course and shed their captives with increasing frequency. What once seemed for many to be a compelling business case, now seems much less so, as captives have been jettisoned as a means to raise cash, lower risk or redirect resources to other areas.

The trend to monetize captive units perhaps commenced in 2003 when British Airways plc disposed of its Indian back-office unit to private equity firm Warburg Pincus. Now known as WNS, the former unit has joined the ranks of the other rapidly growing Indian outsourcing providers. Former captives have established a proven track record of being able to operate -- and succeed -- independently. A good case in point is Genpact, now India's largest independent business process outsourcing provider, which General Electric Co. spun off in 2004. Unilever plc, Barclays plc, Lehman Brothers Holdings Inc., Citigroup Inc., American International Group Inc. and UBS have all shed captive operations in recent years. Additional captive sales are also being contemplated by financial services and other companies.

For a number of years, setting up a captive seemed like a sure bet. Captives historically have been cost effective and required little initial investment. Aside from cost, another appealing characteristic of the captive model was that it enabled the parent company to retain control over its offshore operations, an important advantage for U.S. and European companies concerned about the protection of intellectual property rights and confidential information in unfamiliar jurisdictions. Some corporations created captives because they could not identify any viable third-party providers with the expertise to provide certain high-end, value-added services. Lastly, captives have helped their affiliates gain first-hand, local market intelligence.

What's behind the increase in captive monetizations? Simply put, for many, the business case for the captive model has weakened to the point where it no longer makes sense to retain them. Cost savings, the driving force behind the creation of captives in the first place, have begun to erode. The cost of capital and operating expenses for office space, equipment, essential services, and training can be high during the startup phase of a captive. Even if the parent corporation can later recoup its startup costs, it may still have to contend with escalating labor costs, high attrition rates, lack of scale, foreign exchange rate volatility, and poor integration, among other issues that have adversely affected captive operations. The cost differential between captives and third-party providers has widened; captives can cost as much as 40% more than third-party service providers, a differential that is hard to justify in almost any environment. In addition, running a captive can distract management and divert resources from a parent's core business, which undercuts the very basis of the offshore outsourcing model.

Another factor underlying the declining popularity of the captive model is the maturation of the provider community. Many third-party service providers now offer unmatched flexibility in pricing and service delivery, as well as multi-country service solutions that mitigate foreign exchange and geopolitical risk.

The captive model may also be susceptible to new regulations that aim, in part, to curtail offshoring. They could also be easy targets for revenue-raising proposals to close the record U.S. federal budget deficit. The Obama administration's recent proposal to remove tax incentives for shifting jobs overseas is a case in point. Though reportedly shelved for the time being, if implemented, the proposal could adversely affect offshore captives controlled by U.S.-based companies, while leaving conventional third-party outsourcing arrangements relatively unaffected. All of the above factors have contributed to the increase in captive monetization transactions.

What has made captive monetizations interesting deals from a practitioner's perspective is that they tend to have relatively complicated structures, combining elements of both traditional M&A and third-party outsourcing transactions. In most deals, the buyer/service provider acquires the captive's assets, which it in turn uses to provide services back to the seller. From the acquisition standpoint, the seller -- as in any M&A deal -- would seek to maximize its sale proceeds and limit post-closing indemnity obligations; the buyer would have the opposite objectives. Each side will likely be inclined to cut its ties with the other as soon as feasible. These M&A objectives are not always consistent with a long-term services contractual arrangement, where the parties have ongoing and interdependent commitments stretching well beyond the closing date. Reconciling these competing acquisition and services objectives can pose some challenges.

In structuring a monetization transaction, a seller should recognize that the real value is often in the services arrangement, not the M&A side. For this reason, a seller would be well-advised in most cases to place greater emphasis in the deal negotiations on issues such as service levels, price certainty, ownership of developed IP, and the allocation of risk in the event of non-performance -- the typical issues in any third-party outsourcing arrangement. It is essential that the service provider-buyer commit to arms-length, market terms in the outsourcing agreement.

The deal structure and terms will also dictate the likely buyer candidates. Financial and strategic acquirers will be potential acquirers if the transaction is fundamentally a sale of a going concern capable of providing services to third parties. Alternatively, some monetizations have been, in essence, a standalone outsourcing transaction, where a service provider effectively pays upfront for the transfer of software, equipment, real estate and other hard assets in return for the right to provide the services to the seller.

What are the key deal issues that parties should consider before entering into a monetization transaction? To begin with, as with all corporate deals, a due diligence exercise must be conducted that includes a review of the target, its employees and operations, the seller's service requirements, and the buyer's service capabilities. As the ability to provide services back to the seller will depend on the quality of the seller's service delivery organization, particular attention should be paid to the background and qualifications of the target's employees, including their benefits arrangements. The parties should also ensure that any intercompany arrangements between the target and its affiliates are at fair market value. The acquisition agreement should also address basic M&A terms regarding purchase price adjustments, seller representations and warranties, closing conditions, and indemnification rights.

In a number of monetization deals, the seller has retained an equity interest in the former captive, thereby enabling the seller to share in the upside potential. Such arrangements add another layer of complexity; the parties will need to address governance rights, transfer restrictions and exit rights, capital contributions, non-competes and corporate opportunity rights, among others.

The parties must also evaluate the hybrid arrangement for potential conflicts between the purchase agreement, shareholder relationship and the services agreement. Some of the most contentious areas tend to be cross termination rights, non-competes, indemnity sharing obligations, relief in the event of non-performance, and ownership of developed intellectual property.

A final point to note is that, in arrangements where the customer becomes a minority owner of the service provider, the customer should insist upon appropriate liquidity and governance rights to protect its investment.

While the captive model will continue to have great utility, and certainly is in no danger of disappearing, we believe monetizations will become an increasingly common exit mechanism over the next few years, particularly in certain industry segments, such as financial services. In addition, new legislation and industry-specific rules will likely compel companies to be careful when evaluating the costs and benefits of retaining control over offshore operations. So if your company has an attractive opportunity to monetize your captive operation, the prudent thing to do would be to consider carefully if the time is right for you, too, to cut the ties that bind you to your captive.

Robert M. Finkel is a partner in the global corporate group of Milbank, Tweed, Hadley & McCloy LLP. Apoorv Kurup is a former associate in the firm.