The Go East–Outsourcing to China Blog recently did a post on Chinese outsourcing companies, highlighting the lack of expected consolidation of such companies.  Entitled, “Consolidation Among Chinese Outsourcing Companies,” [link no longer exists] the post notes that there are more than 1000 Chinese outsourcing companies and most of them have fewer than 50 employees.  The blogger, Dean Stevens, expected much more in the way of consolidation by now:

I’ve been anticipating a wave of consolidations to create at least a couple of premier outsourcing companies with the scale in terms of resources and revenues to really carry the banner forward for China’s software outsourcing industry.

To date, this issue has generated a lot of smoke, but very little fire.  I hear that all of the companies are talking, and receiving inquiries, but the actual number of intra-China deals has been pretty small.  The deals that have been completed haven’t been well publicized.

Mr. Stevens then seeks to figure out why there has been so few consolidations and then he asks us over here at China Law Blog for our own views on this:

When I ask about the slow progress towards consolidation, I’m given lots of possible explanations, including the very independent nature of Chinese entrepreneurs, the relative lack of transparency in accounting, the scarcity of strong middle managers, the fact that the industry is relatively young, the hope for higher valuations to come along later & etc.  Perhaps the wise folks over at China Law Blog have some thoughts on this’?

All of the reasons proffered by Mr. Stevens make sense.  I also see the frequent failure of Chinese companies to price their services properly as another limiting factor.

We frequently deal with business owners seeking to sell their businesses for more than they are worth.  The small/medium business owner is often a hard charging, optimistic entrepreneur who believes next year will be better than previous years and views his company as “his baby.”  This often leads to pricing the business based more on the time or money that went into it and/or on the business owner’s future hopes for it, rather than than on its true market value.

This problem becomes more pronounced in China, however, because the Chinese business owner seldom has a “trusted adviser,” like an accountant or an attorney who knows the business and has the business owner’s respect.  This trusted adviser often can convince the business owner to price the business more in line with the market and that, in turn, helps lead to the deal getting done.

As Chinese businesses become more sophisticated (this is happening) and as their need for and understanding of outside professionals increases (this is also happening, but very slowly), the “my baby” premium on business sale prices ought to decline and the pace of business sales ought to accelerate.  We should also remember that China allow recently began allowing foreign entities to form Wholly Foreign Owned Entities (WFOEs) in the service sector.

Mr. Stevens sees acceleration in the outsourcing field, based on his own observations and on the field itself:

With an eye towards whether momentum is building, there have been a few relatively small deals.  Late last year, Worksoft bought SureKam and HiSoft bought Ensemble.  Most recently, in a deal very close to my heart, The Symbio Group acquired an absolutely great company in Chengdu called Horizon Software.  While the mega monster company hasn’t emerged yet, I can’t help but wonder whether the wave is at least starting to build.

There are also a number of US firms looking at the Chinese software outsourcing companies with the notion of creating some sort of roll-up play.  Darwin Partners’ merger with Suzsoft is one example of this that I’m familiar with.

I firmly believe that the pace of consolidation within the industry will accelerate.  I’m also absolutely convinced that someone is going to figure out how to do this right and build a truly world class outsourcing company with a foundation in China’s excellent software outsourcing resources.

Mr. Stevens almost has to be right about this.  Large Indian outsourcing companies like Infosys and Wipro are already in China and making expansion plans. The Chinese outsourcing market is too big and growing too fast for consolidation not to occur eventually.

If you want to read more on China’s growing service sectors, check out “Service Sectors in China Will Reign” and “Service Sectors Will Reign in China, Part II, But Nobody Ever Said It Would Be Easy.

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