Lessons from IT outsourcing disasters

By Stephanie Overby, ComputerWorld

CIO – Two weeks ago, the CIO of Texas penned a seven-page letter outlining the “chronic failures” of the state’s nearly four-year outsourcing relationship–a deal the Texas governor had briefly suspended in 2008 citing service delivery problems that he said put the state’s agencies in danger.

In May, Indiana sued its former IT services provider for $1.3 billion for breach of contract, following the 2009 gubernatorial cancellation of a deal to streamline the state’s welfare system.

Last summer, the CIO of Virginia was fired after criticism by state officials that the 10-year, $2.3 billion outsourcing deal he signed to transform the state’s IT systems was costly and inefficient and he withheld payments to the vendor. 

Such public disputes could be seen as signs that the public sector and private outsourcing simply don’t mix. After all, the mega-deals signed by Texas and Virginia in 2006 were hailed as a bellwether for future public outsourcing growth.

But, industry watchers say, these tussles between outsourcers and their state customers are less an indicator that public sector outsourcing is doomed to fail than they are a peek at the current state of IT services.

“The rate of issues in public sector deals is no different than the rate of issues in private sector deals,” says Robert M. Finkel, head of the U.S. technology, communications, and outsourcing practice for law firm Milbank, Tweed, Hadley & McCloy, who has worked on outsourcing deals for AT&T, Tyco, and Unilever. “When deals do go sideways in the private sector, you never hear about them. In the public sector, everyone’s dirty laundry is out there for everyone else to see.”

Unlike corporate IT contracts, with their attendant non-disclosure agreements and confidentiality clauses, state outsourcing customers are required by law to air their grievances. As a result, these troubled or failed state IT services deals offer a rare glimpse at what really happens when an outsourcing relationship goes south and suggest some lessons for all IT services providers and their customers.

1. You get what you pay for

When it comes to IT services–particularly IT transformation efforts–the “cheapest hammer” can prove rather expensive in the long run.

“Price is always a focus in any outsourcing selection process, but government procurement is hyper-focused on it,” says Adam Strichman, founder of outsourcing consultancy Sanda Partners, based in Mechanicsville, Va. “They say that they are looking for the ‘best partner’ and that they want the ‘right fit,’ but the lowest bidder always wins. Governments can get sued if they don’t choose the lowest bidder.”

Vendors and consultants understand the dynamic, and RFP processes devolve into a game of pricing “chicken”. “You end up with hyper-aggressive bids which take unrealistic risks,” says Strichman, who has advised IT service providers bidding on state contracts in his previous consulting positions. “The winner is usually the one who takes the most risks with the loosest of assumptions, leading to the inevitable failure of the deal.”

State CIOs aren’t the only outsourcing customers myopically–and mistakenly–focused on price in today’s uncertain economy. An underbidding vendor becomes and underperforming vendor, and the next thing you know you’re paying an attorney $300 an to craft a “notice to cure” letter.

“Don’t believe the cost savings the consultants throw at you either,” says Strichman. “Just like the vendor, the consultant who pitches the best story about the most cost savings usually wins the business. But it really is about the relationship.”

2. You get what you SLA for

When you hear about an outsourcer’s failure to meet service level agreements (SLAs), there may be a problem with the SLAs themselves.

Looking at the Texas deal, says Strichman, “the SLA structure was flawed from the start.” In government outsourcing contracts, as with many large, private sector deals, everyone wants to make their mark on the master services agreement. It’s a good idea in theory; it gives everyone a sense of ownership over the outsourcing relationship and generates political good will toward the deal. “The problem is that you usually end up with a ‘buffet-sytle’ SLA structure that is easily manipulated by the client,” Strichman says.

A contract may give state agencies a number of options for server availability from 24×7 to 12×5 support, with lower prices for lower availability. A state department will opt for 23×7 support to get the lower price while the outsourcer will essentially provide the more expensive 24×7 support to make sure it meets the SLA. “Multiply by 3000 servers, and [the vendor has] a real problem.,” says Strichman. “People will do what they are incented to do, and each organization will manipulate their own SLAs to lower their price while essentially still having the same service.”

“When you look at these state ‘tragedies,’ most of them were set up to fail from the get go, without the experience and smart governance that was needed to find more successful outcomes,” says Phil Fersht, founder of outsourcing analyst firm Horses for Sources.

3. When the going gets tough, the tough go public

The stakes couldn’t be higher in state government, given that most states face multibillion-dollar budget gaps. Pressure to cut costs while maintaining or improving service cascades quickly down to the IT organization. In most cases, this was the impetus for signing big outsourcing deals in the first place.

When their outsourcing partners fail to deliver, state CIOs use a tool seldom wielded by their corporate counterparts–publicity. “In the private sector, the executives tasked with managing the service provider relationships are largely accountable for making the sourcing a success, otherwise they run the risk of being replaced,” Strichman says. “When things don’t go so well , [they] keep the deliberations private.” Many corporate IT deals also involve an offshore element that the customer may not want public.

Not so for the state CIO who can put the screws to his vendor for all the world to see. “There seems to be a willingness with public sector clients to push their vendors more, in part driven by political and budget issues of the states,” says Milbank’s Finkel. “The only way for a client in the private sector to go public is to sue.”

While not all press is good press for an IT leader with a multi-billion dollar outsourcing deal on the brink (just ask Virginia’s former CIO), it can give the customer more power. “The lesson to be learned is that if a party that has a dispute can make it public, they have greater leverage,” Finkel says. “They have the embarrassment factor.”

4. You can’t sue your way to a better relationship, but you can try

Five years ago, says Finkel, you’d find very few outsourcing deals in arbitration or litigation. Not anymore. “There’s an increasing willingness on the part of all parties to go public with their problems,” Finkel says. “In the future, I think we will see many more public disputes. These state outsourcing problems are just a start.”

As more service providers end up with a least one public court judgment on their records, remaining litigation-free is no longer a competitive advantage. “Vendors are much more willing to roll the dice and go to court,” says Finkel. “As the numbers have gotten bigger and the stakes have gotten higher, they’re less willing to give something up than to fight when they think they have a good case.”

But while a court judgment can take the sting out of a bad IT services deal, you can’t litigate yourself to a better outsourcing relationship.

“My fear for the public sector is they will find service providers increasingly wary of taking their business,” says Fersht. Those that are willing to take on state work will charge much higher prices, he adds. Outsourcing problems are more likely to be resolved if vendor and client come together to work on a common roadmap to achieve common goals going forward. “Public sector leads must adopt a more pragmatic approach to dealing with these situations,” warns Fersht. “Otherwise the outcomes are not good for anyone–higher IT costs, negativity for the private IT sector, and bad publicity for project waste by government bodies.”

5. Outsourcing means never having to say you’re sorry

When an IT services deals goes bad, it’s always someone else’s fault. The “it’s not me, it’s you” dynamic just plays more publicly in state outsourcing.

“Public sector IT executives are not under the same pressures to mask the shortcomings of their IT services engagements and are quick to pass the blame onto their provider if objectives are not being met,” says Fersht. “There is a culture in the public sector of attacking suppliers if projects deadlines are not met.”

The IT services providers respond in kind. “The initial vendor response is, ‘It’s not our fault,'” Finkel says. “You gave us bad directions. You changed requirements mid-stream.” (In Indiana’s case, the vendor actually countersued the state for millions in fees, expenses and interest.)

What follows–out in the open in the cases of the states and behind closed doors in the corporate world–is a series of heavily lawyered letters, accusations, and eventually a settlement. “There are a few main reasons that things go off the track in outsourcing but the issues are almost always resolved because both sides are incented to resolve them,” Finkel says. Termination of a deal–as happened in Indiana–is the exception, not the rule.

6. Outsourcing will not cure internal inertia

If you look at troubled state outsourcing deals, they all involve transformation with a capital “T”. Major change itself is not a cause of outsourcing problems, but transformation without conviction is impossible, whether you outsource it to a “transformation expert” or not.

“Almost all government bids involve a large consolidation–the classic low hanging fruit that enables the deal to save money,” says Strichman. “Here is the problem: it often can’t be done for the very same reasons the government couldn’t do it before.” No one inside the organization wants it to happen. “There are powerful organizational fiefdoms which fight to be maintained. There are political lightning rods related to closing an office and representatives fight it. Also, the public fallout can be bad, as usually these regional IT locations serve ‘double duty’ as something else like a Medicare offices in the case of Indiana,” Strichman says.

The transformation doesn’t happen, costs rise instead of decline (At one point during its outsourcing, Virginia’s IT group reported a $6.2 million budget deficit), and the deal is deemed a “failure”.

“The plan was impossible from the start, and both sides should never have agreed to it,” Strichman says. For transformation outsourcing to have a fighting chance, IT must consolidate what it can and generate consensus on future consolidation before signing on the dotted line.

7. If at first you don’t succeed, try again. And again

In March, Virginia appointed a new CIO. Job number one for him will be resuscitating IT’s outsourcing relationship.

It could happen.

It took San Diego County two outsourcing contracts–and three different CIOs–before it got its outsourcing deal on the right track.

If a deal is just going to die, says Finkel, it will probably be an early death. “Almost all disputes of significance arise during the transition, in the first six months or a year. That’s when the terminations happen,” Finkel says. “In most other cases, things get back on track over time. You put more money into the deal or adjust the pricing or renegotiate service levels, but things get back on track.

And there are often second careers for public sector CIOs after the outsourcing dust settles–in outsourcing consulting.