Scale And Process Maturity

The offshore services industry in China is currently at an early stage of development and at least 10 years behind India (which itself has taken more than 20 years to reach its current level of maturity). While leading providers with several hundred staff and impressive process skill sets and quality controls are now emerging, these leaders often have foreign management or capital, while the domestic Chinese firms remain fragmented and fail to invest in developing their process skills.

Eric Rongley, CEO of Bleum, a Shanghai-headquartered concern whose 110 staff provide application development and management for clients such as Standard Chartered, RedPrairie, and various U.S. banks, believes that Western-run outsourcing firms will continue to dominate exports to the U.S. “Chinese outsourcing firms have so far only been successful domestically and in Japan,” says Rongley, “while firms with foreign management and talent have been able to successfully compete with providers from India and other offshore destinations for projects in the U.S.”

Legal Environment

Recent estimates put the level of counterfeiting and IP infringement in China as a percentage of economic activity as high as 30% of GDP. While the legislative framework for IP protection is well-developed (a requirement for China’s entry into the WTO), administrative enforcement remains weak. And while China’s IP infringement mirrors that which occurred in Japan and Korea in earlier decades, it is on a larger scale due to the higher levels of current international trade and China’s relatively large size—already the world’s seventh largest economy.

As was the case with Japan and Korea, the impetus for IP protection is most effective when it comes from domestic sources. Encouragingly, Chinese firms are increasingly pursuing their IP rights through the courts. In the past, administrative procedures such as seizures and preliminary injunctions were the only viable avenue to enforce IP rights in China. However, while a lack of judicial training in commercial law remains a lingering obstacle, litigation and arbitration are becoming increasingly viable options for settling IP infringement disputes.

According to Tony Chen of the U.S. law firm Paul Hastings, which has more than 80 employees in three offices in China: “As China gradually improves the IP enforcement regime, companies find that they can take measures to protect themselves by taking time to evaluate partners, selecting which IP to disclose, and implementing various strategies used in other markets.”

While real concerns over judicial independence remain, however, Mithras advises clients to insist on a range of IPR protection mechanisms that are not reliant solely on the Chinese legal system. Such mechanisms may include: rigorous provider screening and due diligence; detailed IP-focused contractual discussions; culturally savvy ongoing relationship management; audit and compliance checks; employee training in IP and data protection; physical and data access restrictions; counseling departing employees and notifying their new employers of their access to trade secrets (enables enjoining the new employer in future litigation); tying employee retirement fund benefits to permanent non-disclosure of IP; and using multiple providers or only outsourcing non-core components of a project.

Robert Lee, CEO of Achievo, a Silicon Valley-headquartered offshore outsourcing provider with operations in China, believes that companies legally based in the U.S. have an advantage in gaining client trust. “We take the issue of IP protection seriously, and as we are headquartered in the U.S. and our contracts are enforceable here, we have developed the level of trust where clients feel safe that we will treat their IP in the same way other domestic providers do,” says Lee, whose firm with 250 staff member provides services from China to clients such as Accela, DaimlerChrysler, and Viador.

Outlook And Conclusions

Given China’s enormous market and confusing internal systems, separating fact from fiction can be difficult. Clearly, China’s offshore outsourcing industry is developing quite rapidly from a low base. Work from Japan, multinationals entering China, and offshore multinationals increasingly looking at diversifying their risk profile will continue to drive the development of the industry toward maturity. Brand-name corporations such as Nokia, GE, Target, DaimlerChrysler, Invista (makers of Teflon and Lycra), Standard Chartered, JPMorgan, and a host of U.S. banks and application software companies are already outsourcing some of their IT needs to providers in China. These projects are being garnered by the first-tier providers, most with foreign management and capital, who are already capable of delivering projects to international standards. Such firms will continue to gain scale and experience in the coming years, and a few are likely to emerge as leaders in the wider global offshore marketplace.

Cyrill Eltschinger, CEO of Beijing-based I.T. United, whose 130 staff provide IT support to companies including Cisco, Kraft, Bayer, Siemens, Airbus, ACS, BMW, and Peugeot, says that “outsourcing to China today is subject to a lot of scrutiny, simply because of the lack of knowledge of what the market has to offer and its development in the last three to five years. Outsourcing to China by 2010 will be an established fact.” China’s numerous domestic providers, however, mirroring their investment practices in manufacturing industries, are taking a short-term approach and are largely failing to invest in process development or actively participate in the necessary industry consolidation.

All this means that, for potential clients, provider selection and rigorous due diligence is critical. For outsourcing firms entering the market, a differentiated focus and ability to build scale are keys to success. For investors in the sector, a profitable strategy would be based around merging or growing the providers that will lead the industry’s service-level maturity and consolidation trends to emerge as dominant players.

Nick Rossiter and Sridhar Vedala are both partners at Mithras Consulting Group (China), and provide strategic consulting, due diligence, and related services to clients, providers, and investors in China’s IT outsourcing and BPO market. They may be contacted at nick.rossiter@mithrasgroup.com and sridhar.vedala@mithrasgroup.com.