How to value captives of international companies in India?

Captive units have been a popular operating model among large global organizations, given their cost-effectiveness. About 1,600 international companies have started their captive units in India, driven by superior talent availability, coupled with cost advantages and a well-established ecosystem in Indian cities. 

These captive units provide various services such as software development and testing services, design, engineering, research & development, technology support, accounting, payroll processing, insurance, data management, legal, and collections and payments services to their parent entities. 

According to the latest data available, overall employment by these captives is in excess of 1 million and accounts for over 25% of the total information technology (IT) and business process management (BPM) sector employment in India.

While over 100 new international firms aim to open their captive units in India in 2021, many of the existing international firms are looking to divest their captive units. Every time a global firm starts a captive unit in India, many of its contracts with Indian BPM majors are transferred to the captive gradually. This allows the captive to benefit from economies of scale and simultaneously helps the global firm save on higher fees paid to BPMs. 

Over time, the captive units mature enough to function as a Centre of Excellence, thereby adding greater value to their parent entities. Mature captive units often turn into lucrative non-core assets which can be divested by their parent entities during economic downturns. Various other reasons that drive divestment of captives include corporate-level demands such as freeing up capital for growth projects or maintaining lean firms. 

Shifting of more contracts from BPMs to captives, on the other hand, may be aimed at having each of the support functions in-house to address confidentiality/strategic priorities. For example, in 2009, UBS divested its Hyderabad captive unit of 2000 employees for a consideration of $75 million to Cognizant. However, between 2018 and 2020, UBS in-sourced hundreds of roles back into its Hyderabad captive from Cognizant. 

It is a common practice that global majors sign procurement contracts as per existing prices for a period of 5 years from the time of divestment of the captive unit to Indian BPM majors. However, this may not happen all the time. It is possible that the global major may promise to transfer business from its other vendors to the Indian BPM major acquiring its captive unit. 

At what price?

The purchase consideration paid by BPMs to multinationals is mainly driven by the cash flows associated with procurement contracts and associated synergies. 

Deal valuations (at the time of divestment) are largely driven by the transfer pricing arrangements in existence between the global majors and their captives. Usually, the divestment deals are valued at 1 to 1.2x of revenues, which translates to around 10x the private equity multiple at an assumed transfer pricing rate of 18% on costs.

Valuation of these deals is also essential for regulatory compliances such as foreign exchange laws (i.e. FEMA) and income tax laws addressing capital gains tax.

Regulatory compliance-related valuations are triggered not only at the time of divestments but are required for various other purposes, including any restructuring of the captive unit such as the issue of new shares, share buyback, and change of ownership within group entities among others. 

Valuation of the captive units in these instances becomes very tricky as each of these captives can, at best, be valued at their assembled workforce value in the absence of any perpetual procurement contract from the parent entity. Hence, it is essential to review the captive operations in detail to decide whether a discounted cash flow approach rightly captures the firm value or a net asset value adjusted for the assembled workforce. 

A tailored approach

In our experience of captive valuations, the approach largely depends on the ability of the unit to operate individually. Over the years, we valued tiny captives with just two employees to very large captives with hundreds of thousands of employees. While their pricing terms with parent entities are always on a cost plus mark-up basis, we observed that perpetual procurement contracts are largely absent. 

If the captive has over 100 employees who are all well-trained and delivering services independently to the parent entity on a requirement basis, the discounted cash flow approach based on expected growth, pricing, and costs can still be an appropriate mechanism to reflect the value of the captive unit.

In the case of smaller captives that largely function as extended teams to onshore delivery and cannot be carved out as standalone businesses, the net asset approach based valuation is deemed appropriate with an adjustment to the assembled workforce value. Some of the other value drivers include intangible assets generated/held by captives, office space lease agreements, and numerous other types of equipment owned. 

Various licensing agreements held by the captive for the usage of technology or other intellectual properties of the parent entity also drives up valuation estimates. While fair value may not be impacted, commercial valuation of the captive is impacted by the structuring of the transaction that details whether it is a transfer of shares, assets, or business.

An article by Tanwir Shirolkar, a Director in the Transaction Advisory Services practice of Nexdigm (SKP).