Urge to merge

M&A Are mid-tier firms in danger of being squeezed out by top-tier companies?

It's been talked about for almost a year now, but last month, Texas-based EDS finally wrapped up its takeover of Mphasis BFL "� forking out $380 million.

The acquisition will help EDS do some catching up with peers Accenture and IBM, which have been the most aggressive in ramping up their India operations.

It's not a bad deal for Mphasis, though.The Bangalore-based player has been struggling for some time now: growth in the services space has lost momentum over the last six quarters and the June quarter was particularly disappointing with operating margins plunging to 12 per cent. So it's not suprising that when the $20 billion EDS threw shareholders (mainly private equity fund Barings) a lifeline, most of them grabbed it.

This is but a case in point. The larger question is with even top-tier firms finding it difficult to cope with wage inflation and attrition, are mid-tier firms in danger of being squeezed out?

Says James Abraham, director, BCG, "The difficulty that mid-tier firms face, more than being able to pay people, is the ability to get productivity. That's because they seldom have large projects or long- term relationships and so unless they are operating in a strong niche, it would be difficult to do well."

Adds Sid Pai, Partner, TPI, "Currently, talent and capital are available to all, but the smaller services companies may not have as much access to markets as their bigger siblings do."

Private equity funds with large stakes in these firms are understandably anxious to bail out at a good price. Even Mphasis, which has seen its BPO revenues fall consecutively for four quarters, and has had to raise offshore wages by 15-18 per cent this year, could see the writing on the wall.

As Jerry Rao, CEO, Mphasis said on the analysts call, "The concern has been that being a mid-cap, there is a danger that we will get marginalised since the whole play is about size and to get into the top tier." He added the deal would help make Mphasis a top-tier provider.

Other companies are no different. P/E fund General Atlantic Partners has been offloading its stake in Patni Computer Services "� in September 2005, it sold 3.2 per cent weeks before Patni issued an earnings warning. It now holds 16.6 per cent. Patni has had to raise offshore salaries 17 per cent this year "� adjusted operating margins in the June quarter were 15 per cent, down from 19.4 per cent in FY05.

The other side of the story is, of course, the determination of the global majors to scale up their offshore deliver capabilities as fast as possible.

Says Abraham, "Mphasis is a perfect catch for EDS because it gives them a good brand with which they can attract talent both from the campuses and laterally. It takes care of their supply side."

Up against competition from Indian peers who have an enviable offshore-outsourcing proposition and have proved that they can clinch the bigger deals, global majors are under pressure to increase their presence in India.

The ramp-up has been aggressive "� Accenture today has around 20,000 people while IBM has 40,000, its second-largest presence outside of the US. Observes Pai, "It's clear that companies like EDS are buying into firms like Mphasis for their global services delivery presence."

However, with $100 bn of offshoring contracts up for renegotiation in the next couple of years, and clients becoming choosy, recruitments may not suffice.

That's where buyouts come in. Ranjan Biswas, partner, Ernst & Young, believes that global players are also looking to snap up companies that are focused on certain verticals or even horizontals such as network management or testing.

Says he, "Many of them are looking to build on competencies that they lack." Adds Pai, "I do expect more M&A activity both in-bound and out-bound as service providers increase their global development capabilities .MNCs usually use an amalgam of both the organic and inorganic." Industry watchers say IBM, which took over Daksh, could be on the prowl for bigger prey this time round. The hunt is on.