Achieving the benefits of infrastructure outsourcing used to require the client transfer IT asset ownership to its service provider. The transfer provided not only a one-time cash infusion to the buyer, but also an increase in return on assets (ROA) due to the reduction of its asset base. By negotiating the costs of assets into the contract, the client could also ensure a predictable cost stream over the contract term. The asset transfer also amplified many of the operational benefits of outsourcing transactions, as the service provider possessed the scale and technology management expertise to drive ongoing improvements in operating costs and efficiency.
However, over time, most of these benefits have become achievable without asset ownership transfer. The key contributing factors include the emergence of third-party financing alternatives, remote infrastructure management tools and the introduction of server virtualization technology. A third party lease-back arrangement allows the buyer to eliminate the up-front investment without relinquishing control of the asset base. Most operational efficiencies can now be achieved through remotely led efforts. And the increase in utilization enabled by virtualization eliminates, to some extent, the scale advantage that was traditionally an advantage for a transaction involving transfer of asset ownership to the provider.
Additionally, pending changes in accounting rules will eliminate the advantage of improved ROA that could previously be achieved by either a sale or a sale/leaseback transaction. Current U.S. GAAP does allow ROA benefit if the outsourcing arrangement can be classified as an operating lease. But in August 2010, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) published a joint exposure draft for public comment that, among other changes, would require that all leases be reflected on the balance sheet of lessees and lessors. In March 2011, the joint boards agreed to several changes to the exposure draft but did not change the requirement to record all leases on the balance sheet. However, I anticipate that in the future all lease arrangements will be required to be reflected on the lessees’ balance sheet, including assets transferred from the client and assets procured by the supplier to provide services that fall within the scope of the lease arrangement. On the other hand, the rules, if changed, will not apply to cases in which the client continues to own the assets, even if the service provider controls and operates them. Ala, ROA benefit from asset ownership transfer is eliminated.
Moreover, recent statistics show an accelerated movement toward adoption of an asset light model in which the client either retains ownership of its assets or engages a third party for a sale/leaseback transaction. Everest Group recently published a research study that found service provider asset ownership in high-value infrastructure outsourcing deals declined from 86 percent in 2007 to 15 percent by 2009. Server virtualization technology and Remote Infrastructure Management Outsourcing (RIMO) versus traditional infrastructure outsourcing will gain even more momentum as the offshore players continue to aggressively expand their market share in this sector.
Additional trends observed by the Everest Group research that support and correspond to this change in business model include a reduction in both term length and annual contract value for infrastructure outsourcing transactions. By 2009, the average term had declined to 4.2 years for traditional tier-one providers and to 3 years for offshore providers. And although at least partially due to the recession, both offshore and traditional service providers saw their deal size reduced by more than half in 2009.
There will always be some segment of the market that continues to prefer traditional data center outsourcing and application hosting models. But I believe that the trend toward next generation models involving RIMO or infrastructure managed services is a long-term phenomena. Although this model results in transactions with lower total contract values, I believe it provides better long-term alignment of client interests and provider incentives. Clients often find it beneficial to retain assets due to the inherent flexibility, control and benefits of scale that it enables. And service providers are able to simultaneously reduce their capital outlays and improve their ROA. Given the trend toward shorter deal terms, this benefit takes on even greater importance.