Proctor & Gamble Highlights New Legal and Business Issues in Multi-Sourcing
October 16, 2009 by Bierce & Kenerson, P.C.
Background
This case study examines some extraordinary circumstances involving competitive sourcing of services. It is not typical of the normal competitive sourcing, but it highlights some emerging business and legal issues in managed competitive sourcing of global services.
During the late 1990’s, Proctor & Gamble Co. (“P&G”), maker of soaps, toiletries and personal care consumer goods, created a “shared services” unit to provide a common suite of administrative and operational services to its lines of business. The shared services unit delivers such services as information technology, finance and accounting, logistics support and other administrative functions.
During the spring and summer of 2002, newspapers reported that P&G was in lengthy competitive negotiations with two outsourcing services providers to sell P&G’s shared services unit for $1 billion and hire the winning services provider for an 8 year, $8 billion outsourcing contract covering information technology, human resources and other major administrative functions.
In August 2002, it looked like Affiliated Computer Services, Inc. (“ACS”), of Dallas, Texas, was going to win the bidding, due to the reported withdrawal by Electronic Data Systems Corporation (“EDS”), of Plano, Texas. EDS had reportedly withdrawn from negotiations in June or early July because of pricing.
On September 17, 2002, ACS announced its withdrawal from negotiations with P&G. In an ACS press release, ACS’s President Jeff Rich noted, “While the size of this opportunity was historic and would have been accretive to earnings, we believe the financial, operational and cultural risks were too high.” In other words, the risks were disproportionate tot he profit potential.
At about the same time in mid-September 2002, EDS reported disappointing financial results, causing a one third drop in its share price in one day, due in part to increased costs because of “heavy investment in attempts to obtain new business.” Then, on September 24, 2002, EDS’s stock price plunged roughly another 30% after being downgraded by a Merrill Lynch stock analyst, who concluded that EDS’s free cash flow for the 2002 year could be wiped out by stock repurchase operations necessary to settle derivative instrument exposures. The EDS stock price decline was symbolic of a more general stock market decline on September 24, 2002, to the lowest point in four years (even lower than the post-9/11 trauma in 2001), based on the Dow Jones Industrial Average index.
EDS’s stock price plunge left P&G with a weakened sole bidder. With ACS having publicly withdrawn after EDS had publicly withdrawn, P&G might have been lucky to have any bidder. Or P&G might reevaluate and restructure its strategy.
This case study was completed on September 26, 2002, and is subject to clarification and further consideration.
Business Issues
This scenario underscores the dangers of hyper-aggressive competitive bidding that combines both outsourcing and a sale of significant assets by the customer to the vendor in a glutted market. In this case, the customer was apparently so aggressive on the pricing of its assets that one of two finalist bidders concluded that the deal was uneconomical. When the customer apparently continued to push the second bidder for the same deal as if the competitive bidding process had continued, the second bidder withdrew. This left the customer the prospect of having no bidders despite completion of an arduous, detailed and highly disciplined and managed competitive procurement process.
Further, the publicity surrounding the prospective outsourcing of the customer’s shared services unit, involving approximately 5,700 employees, raised questions about the viability of the outsourcing process and the impact of a possible failure upon the customer’s staff, its customers and its shareholders.
Accordingly, this case study evokes questions about circumstances affecting competitive procurement of long-term services.
Transfer of Customer’s Shared Services Center to the Vendor
Reportedly P&G had bundled its shared services unit — including multiple “back office” functions — into a cost-efficient self-standing business.
Factors in the Competitive Viability of the Transferred Shared Services Unit.
To our knowledge, the press did not comment on the degree to which the P&G shared services unit was ready to become a competitive unit of an outsourcing services provider. To be viable in the new role, the acquired unit would not only have to serve P&G as the customer, but also demonstrate the ability to generate cash flow that justified the price of the unit. The reported $1 billion asking price received no comments on whether the shared services unit had the corporate culture, the business plan, the competitive bidding experience, the inurement to the vicissitudes of competition, the personal accountability and internal leadership necessary to pay off the $1 billion price tag.
Valuation and Accounting Factors.
As with any acquisition of a going business, the questions of valuation, goodwill and other internal accounting practices of the P&G shared services unit have not been publicly defined. However, it is clear that the bidders examined them closely. ACS withdrew, in part, because it could not justify the return on investment. While ACS’s announcement of its withdrawal observed that the cash flow would be “accretive” to ACS’s income statement, it is perfectly conceivable that the successful bidder would have to write off goodwill under financial accounting principles. This might explain why EDS withdrew in August 2002 and ACS withdrew in September 2002.
Negative Market Environment.
Declining financial and stock markets in 2000 through 2002 resulted in the loss of significant shareholder value between the time for planning and execution of the proposed outsourcing. P&G established its Global Services group in 1998. Probably in late 2001, P&G decided to sell it in a massive outsourcing.
By the time for conclusion of contract negotiations in anticipated for August – September 2002, several adverse market conditions had occurred. The stock markets had fallen. And the information technology and telecommunications sectors swooned, with sharp declines in corporate purchasing of IT goods and services. Globally, throughout 2002 major IT outsourcers had terminated the employment of tens of thousands of IT workers. Consequently, the business prospects for a new IT services facility would be introduced into the market at a time of grossly excessive capacity for IT services both in the U.S. and worldwide.
The Impact of Corporate Governance and Accountability on Valuation.
President George W. Bush signed the Sarbanes Oxley Act of 2002 designed to root out misfeasance and malfeasance in the executive suites of publicly traded companies. In August 2002, senior executives of publicly traded U.S. companies had to sign and file certifications that the financial statements were not materially misleading. Enron, Tyco International and Adelphia Communications executives were indicted for looting. In late September 2002, the Securities and Exchange Commission indicted Tyco’s former CEO L. Dennis Koslowski, claiming that he should disgorge his personal bonus for having entered into an acquisition with a flagging company (Flag Telecom) at an inflated price, allegedly for the purpose of artificially inflating his personal compensation. Clearly, the regulatory environment counseled extreme caution on valuations of assets in an acquisition.
The “Stalking Horse” in the Bidding
A bidder that has no chance of winning is a “stalking horse”. This case study evokes the question whether ACS ever became a stalking horse, or whether P&G “over reached” on both finalist bidders.
Absolute Ability to Deliver the Full “Program.”
A bidder must determine whether it realistically has the resources to win in a convincing fashion. Otherwise, the competition is a gamble for the bidder. This self-assessment is essential in the “no-bid” decision as well as in the negotiations as the customer’s business rationale and expectations are revealed at the bargaining table.
Comparative Advantage.
If the bidder does not know the identity of its competitor, then it can only guess and rely upon its own self-assessment of capabilities. Once the names of the two finalist bidders became public, some commentators observed that ACS’s bid had not been as strong as EDS’s because ACS, while capable, would have had to “stretch” to satisfy P&G’s contractual expectations.
Rigged Bidding.
Typically, bidders that are not in the “top tier” should ask themselves whether the “rules of engagement” have been “rigged” in favor of a competitor. If this is true, then the competitive procurement process is a sham, and, as a legal matter, the stalking horse may have a legal claim for fraud.
Remedies for the Stalking Horse.
The rational bidder, when it realizes that is has become a stalking horse, should evaluate its possible remedies.
- Litigation for Fraud.
The ethical, savvy service provider is not likely to sue its prospective customer for fraud. Business reputation through avoidance of litigation is generally the customary business policy of outsourcing vendors. However, the benefits of a lawsuit might be achievable through other means (see below) or through non-public dispute resolution mechanisms. Bidders might be entitled to certain legal rights under pre-bidding agreements with the customer that define the rules of the procurement. - Unilateral Direct Boycott.
If it feels that it has been “used” as a stalking horse, it can elect not to participate in future “rigged” bidding wars managed by the same specialized outsourcing advisors. - Complain to the Customer.
A complaint might not necessarily result in compensation. It might, however, restructure the negotiations and re-admit the bidder into the realm of a “viable possibility” instead of a stalking horse. In government contracts, formal contests and appeals can result in substantial delays in the award of the contract. In private transactions, a more informal approach might be productive. The customer might have a self-interest in being responsive. - Request Compensation.
The stalking horse bidder has lost not only its out-of-pocket expenses, but also its prospective profit from alternative application of the same resources to other prospective pursuits. - Sell a Service.
Rather than just demand compensation for its out-of-pocket expenses, the stalking horse bidder might offer to sell some deliverable that resulted from the aborted competitive bidding procedure. This could include:- data discovered during the due diligence phase that could be useful to the implementation of the eventual outsourcing, or to its restructuring during the negotiation phase;
- recommendations of an advisory or consultative nature from a service provider’s perspective (to facilitate negotiations with the remaining bidder(s)); or
- other services or deliverables.
When a Service Provider Should Withdraw from Negotiations
In competitive procurement and auctions, each bidder must analyze the value of the transaction and draw its own conclusions as to circumstances that might make its bid no longer commercially reasonable. Experience suggests that a bidder should withdraw under any of the following conditions:
- Overpriced.
The combination of the costs of acquisition and the reward for future services rendered does not meet the financial hurdles imposed by senior management. The financial hurdles could be imposed either individually on each segment of the operation or globally on the combination of the operations. - Inability to Integrate Personnel.
In this case, ACS alluded to “culture” as a factor. In essence, an observer might conclude that each of the finalist bidders, in its own time, concluded that there were insurmountable cultural differences with the P&G employees who would be in scope and who would become the winning bidder’s employees. - Unsuitability of the Bundle as a Deal or as a Deal Structure.
If both finalist bidders were willing to withdraw, then each must have concluded that the “package” was unsuitable for economic reasons. Suitability might have meant that the post-transaction commitments to be assumed by the winning bidder were excessive. Customers and their specialized consultants may take note of the fact that EDS was invited back into the bidding at a time when ACS was still the sole bidder, and that in order to entice EDS to come back to the negotiating table P&G and its specialized consultant must have acquiesced in some of their demands about the deal structure. - Risk Allocation.
Certain news reports suggested the transaction would have an estimated value (excluding the acquisition of the shared services unit) of $8 billion for an 8-year term. Another article estimated the overall value of services at between $4 billion and $10 billion over an estimated 10-year term. If the winning bidder has no means of projecting actual revenues, it cannot determine whether the risk of the initial investment — in the acquisition, transition and post-transition commitments relating to the acquisition and transition — was outweighed by the prospective profit. In short, the profitability was not sufficiently clear. - Mismatch of Expectations and Post-Effective Corporate Culture of the Customer.
Having lived with an outsourced “back office” environment already for two or three years, P&G’s end users should probably adapt to the hiring of an external outsourced services provider. However, one might wonder why P&G wanted to outsource the environment to an external services provider. The press reports do not suggest that P&G was unhappy with its shared services unit. But certainly a bidder should ask whether there was any reason for the customer to be unhappy. And if the customer were actually unhappy with the quality of the service, the customer might have unreasonable expectations about the level of responsiveness, service or alignment of its shared services unit. Conversely, if the customer were very happy with the shared services unit, the only reason for outsourcing might have been to generate cash flow from asset divestiture. At that point, the service provider becomes a venture capitalist, hoping that the acquisition will be accretive to the cash flow. In either case, the bidders must analyze the suitability and cultural fit of the bidder with the customer’s expectations.
Lessons Learned from the Customer’s Perspective
Flexibility.
This extraordinary case study suggests that, in complex transactions with multiple functions being outsourced, the customer’s self-assessment and preparation for negotiations should include some flexibility and fall-back positions. Where both finalists are cornered and see no alternative but to walk away from negotiations, clearly the customer has played the game of “corporate chicken” and run both the bidders off the road. Such an outcome would be a serious lost opportunity, not to mention unrecoverable expense, for all involved. What guiding principles should inspire the customer?
True Competition.
The key requirement for a competitive procurement is that it remain truly competitive. If a scoring factor becomes clearly overwhelming for or against one of the finalist bidders, then the continuing bidding war is a farce between the guaranteed winner and the stalking horse.
Why should the customer want true competition? Without a viable final competitor, the guaranteed winner will normally revert to some of the more costly behaviors and tactics evident in a sole-source procurement – delays, quibbling, attempts to apply unfair pressure. Such behaviors normally deprive the customer of the best competitive price, terms and conditions.
Disclosure of Ongoing Negotiations.
Despite corporate policy statements, non-disclosure agreements with employees, contractors, bidders and others, the news of this outsourcing transaction became publicized. Information leaks by disgruntled in-scope employees can have an impact on decision-making and strategy by the prospective service providers, since the employees can identify the other bidders. Every bidder can be expected to want, and get, this information. The bidding could become transparent, not only to the customer and its employees, but also to the bidders.
Acceleration of Benefits.
An accelerated contract yields benefits earlier. Acceleration also facilitates commitments in the transition phase, encouraging in-scope personnel to remain and support the outsourcing, and avoids the risk that the entire project will be abandoned. Abandoned projects, like failed deals, can easily cause loss and disruption, not to mention litigation and continuing distraction.
Ethics in Competitive Procurement.
Competitive procurement has been a fundamental precept of modern capitalism. But when it degrades into stalking horse disguise, one may question whether conduct is ethical and fair. Every customer has an interest in being known for its ethical conduct, and indeed must question its own conduct internally if skewed procurement practices violate stated corporate governance principles. In an era of renewed governmental and shareholder needs for trust and confidence, and to avoid certifying financial statements that do not accurately reflect in all material respects the risks of claims from stalking horses, senior management of major enterprises should ensure that the customer’s stated business ethics are implemented in its competitive procurement practices. See Corporate Governance in Outsourcing
Initial Definition of the “Rules of the Game.”
The customer normally defines the rules of engagement with prospective vendors. The customer must determine the degree to which it wishes to address the legal, business and ethical issues presented in this case study.
Lessons for Multinational Alliances or Teams
Experts in the outsourcing process may wish to rethink their methodologies as a result of this potential fiasco
No Teams for P&G.
The P&G case was limited to single enterprises bidding to take ownership if the shared services business and provide outsourced services in their place. This case differed from the decision by J.P. Morgan, in the famous “Pinnacle Alliance” outsourcing, to hire four vendors to manage complex IT infrastructures, software and other back office operations. P&G insisted on a single point of accountability and single owner of all transferred IT infrastructures.
Subcontractors in the Bidding Process.
Many outsourcing transactions, particularly large and complex ones, may involve foreign subcontractors, such as software developers and maintenance services providers in Asia. Teaming alliances can fall apart if the customer engages in pitting a team against a globally integrated company.
Self-Interest in Competitive Bidding.
In adopting “stalking horse” tactics for a massive outsourcing across multiple functions and countries, the multinational enterprise customer risks alienating the best services providers. It also risks losing the benefits of outsourcing by so narrowly defining the transaction as to prevent the entry of competent competing teams.