Here Comes That Rainy Day

You wake up in the morning, and everything is fine. You roll into your office, check the e-mail, and find your document management vendor has been purchased by another vendor. Do you panic?

If you made the right decisions when initially selecting your vendor/partner and kept abreast of both the market and your service-level agreements, panic may be unnecessary. Sometimes, though, it takes a disaster to learn about disaster recovery, and it takes a vendor acquisition to learn about vendor management.

“It's been somewhat disastrous at times in my experience,” says Jeff Fabry, vice president and CIO of Island Insurance Companies. Fabry has been through M&As before and knows how difficult they can be. “We had a vendor that ended up almost going out of business, and it was bought by a company that was bought by another,” he says. “That transition has completely trashed one of our projects.”

There are many questions from an insurance company point of view that need to be answered when vendors merge or are acquired, points out Donald Light, a senior analyst in the insurance practice at Celent. “First, how can you be sure the terms of your licensing agreement will be maintained?” asks Light. “There are changes in personnel, changes in method, and potentially changes in performance.”

On the positive side, the acquirer wants all the current customers to stay in place and be happy, notes Light. “They have an incentive to meet with you and lay out what they see–what you already have and how it will get better,” he says. “Establishing personal relationships with the new company at an appropriate level is important, doing a health check of current relationships is important, and understanding in the longer term what this will mean in terms of a road map also is important.”

INITIATING A PLAN

Island Insurance is a small company and doesn't have a detailed vendor management program, but Fabry maintains vendor management is both a huge part of what his IT department does and “a huge pain in the neck.”

Located in Hawaii, Island has a difficult time getting enough developers to handle internal issues, so the company increasingly relies on vendor solutions. “Because of that, we have an ever-growing portfolio of vendors we need to manage,” says Fabry.

For a midsize-to-large insurance company, Jim Dean, vice president of Robert E. Nolan Co., believes it is a best practice to have a group established to handle vendor management. “It will be focused on identifying which vendors it actually wants to work with and which pass financial analysis, trying to do some long-term contracts, and securing pricing with all the contract negotiations going through the vendor management group,” he says.

Normally a vendor management group would be staffed by specialists from the business side, the IT side, or the legal side. “In some ways, they are like a program management group because they are coordinating a lot of activities as opposed to specializing in them,” says Dean.

HOW TO PREPARE

When initially looking at a vendor, Fabry has learned to study the size and nature of the company. “What is its makeup and its profitability?” he asks. “Most companies are fairly comfortable in giving you some [financial] numbers.”

From there, Fabry believes in trying to figure out whether the vendor could be an acquisition target. Some vendors are willing to share what they consider their place is in the market, but others are hesitant.

It is important to know how many customers a vendor has, advises Fabry. “If it has one or two customers, it is a more likely target than if it has 100 customers,” he says. “Even if it does have a large customer base and it does get acquired, the chances of the acquiring company screwing it up is much less than if it had just one or two customers.”

The first step for a carrier, in Dean's view, is to prepare an inventory of vendors and determine which vendors are parts of a critical path of its business operations. “There are some vendors that provide a unique service that is customized to you that you can't do without,” he says. “It's critical you identify those that are really keys to the business operations, and if they have problems, you have problems, so you need to be prepared for [their problems].”

He suggests for these critical vendors a carrier maintain news alerts to investigate where the vendor is financially and determine whether the vendor is a potential target for an acquisition. “You have to have a proactive type of information service working for you,” he says.

If one of a carrier's critical vendors falls under the heading of a target for acquisition, Dean recommends the carrier examine its contracts to determine what intellectual property rights it may have: Does it have a long-term contract with these vendors? What are the transfer rights of the software or licensing? Does it make sense to extend the contract at that point to try to get more favorable terms in case an acquisition takes place?

“At that point you want to identify what alternatives you have,” says Dean. One of three things is likely to happen during an acquisition, but Dean maintains they aren't all bad.

1. Does a buyer have a complementary product, service, or market? If it does, Dean believes it isn't likely to change, but there probably will be more capital put into the company, which normally is a good thing.

2. Is the acquiring company buying market share? “Is it buying someone who is in the same business so it is going to absorb that business into its operations?” Dean asks. In such a case, the buyer may be changing the acquisition to another platform, which is going to have a major impact on customers.

3. Is the buyer buying the company to build revenue, and is it going to run it separately as a stand-alone operation? If that is the case, Dean doesn't believe there will be much of an impact on the customers.

WHO'S BUYING?

“If a vendor is an acquisition target, it is helpful for carriers to determine who is likely to buy the vendor and why, what the impact will be, and what the alternatives are,” suggests Dean. “Would I go out and buy other software?”

One concern for carriers is there may be a monopoly for the vendor's kind of service, so Dean suggests carriers may want to extend their current pricing agreement with the vendor. “You have to start looking at your alternatives,” he adds.

Some may think this is a lot of effort spent for something that may never happen, but Dean contends going through the process allows a carrier to compose its thoughts and discuss the issue with competitors to see their position.

Some of the aftershocks for insurers whose vendor is acquired by a larger vendor include the worry the insurer might no longer be viewed as a key strategic client. “There is a lot of disruption that occurs around those types of acquisitions for clients,” says Matt Josefowicz, director of the insurance practice at Novarica.

BIG VENDORS ONLY?

So, does it make more sense to go only with the large vendors that seemingly are above the fray? “I'm not going that far,” says Fabry.

What Fabry looks for is a best-of-breed solution, but he is leery of vendors that may have great technology but only a few customers. “I really try to shy away from them unless they have such a compelling product that the risk is worth it,” he says.

What Fabry hopes is the acquiring company recognizes the secret to its acquisition's success and lets the acquired company continue what it is doing. “You would think every company would approach it that way, but some companies have egos and think they know how to do it and no one else does,” he says.

Another issue that scares Fabry is when an established vendor decides to develop a completely new product. “Every vendor seems to want to build a policy admin system,” he says. “They move outside of their comfort zone, and they are never very good at it. I really like the companies that know what they are, are very good at it, and deliver the product they say they are going to deliver.”

But in tough times, vendors are looking for additional revenue and market space. Let the buyer beware in those situations. “A claims system is a heck of a lot different than a transactional billing system,” warns Fabry.

ONCE IN THE FOLD

In looking at their vendor contracts, Josefowicz maintains, at a minimum, carriers need to be getting base code escrow and permanent licenses. “If carriers make a strategic decision to adopt a certain platform and go through all the pain of a conversion implementation, they need to be guaranteed they will continue to have the right to use at least that version of the software,” he says. “And should there be a change of control, [carriers] should have access to the source code and the ability to modify the system and have their service partners work directly with that code.”

Companies should insert key-personnel clauses into the contract, points out Josefowicz. “You can't guarantee an individual will stay with the company, but we believe companies should negotiate penalties or offsets if the key team changes within a certain period of time,” he says. “When you are dealing with a small company, the team is at least as important as the application. When an acquisition happens, there is a potential for disruption.”

Of course, there is no way to obligate people contractually to stay at a vendor, but carriers should be able to negotiate offsets. “In some cases, if they negotiate a heavy enough offset, that may be an incentive for the acquirer to create some incentive retention packages,” says Josefowicz. “The vendor may lose some fees if it loses key personnel.”

Dean points out there may be key personnel with the vendor that could be laid off in an acquisition. “You want to identify a list of key personnel and look at either hiring them or renegotiating a contract if there is a non-hiring agreement, so you can soften the problem in the event of an acquisition,” he says.

He also suggests carriers have their legal staff look at the contracts to see what risks there are if their vendor is absorbed in another operation. “Do you need to tighten up your SLAs now?” asks Dean. “Any type of long-term relationship that is on the critical path of your operations should be taken very seriously.”

Dean stresses the value of establishing a master services agreement with vendors. “If it's a vendor you are going to continue doing business with over the years with lots of different contracts, you can create one single master services contract with all the terms and conditions you are going to work under,” he says. “A lot of times [the vendor management group] will negotiate a price schedule that will be used for all contracts going forward. As each service is provided, you do a statement of works for that work, and the pricing, terms, and conditions already are done.”

RELATIONSHIP CHANGES

There is no doubt the relationship between carrier and vendor will change if the vendor is bought. Usually the issues are scary for the carrier, so the vendor needs to put the deal in the best light possible.

The vendor needs to explain the advantages to the customer of having a new owner, Light believes. “If there are problems, how will those problems be addressed by the new owner?” he asks. “There could be a merger of equals, but how will the customer keep from getting lost? What does it mean in terms of the long-term financial model? Those are legitimate questions [the vendor] gets asked pretty early after the announcement is made.”

Josefowicz also maintains mergers and acquisitions can be beneficial for a carrier. “A small hot-product company that doesn't have a lot of resources can be difficult to work with,” he says. “It may not have the resources available when you need them. For those kinds of things, an acquisition can be a benefit.”

MARKET CONDITIONS

The economic crisis has slowed the volatility in the vendor market that typified the first three quarters of 2008, but Dean believes once the market starts to stabilize M&A activity is going to increase rapidly.

Even with economic turmoil, Josefowicz asserts there will be more activity rather than less in the vendor market. Such activity may be derived from “some small companies that have their pipeline disrupted or may be looking for safety in numbers and to become part of a larger organization that has more resources,” he says.

Most M&A activity in the past year has been about acquiring smaller, more strategic companies rather than merging with equals, observes Josefowicz. “Insurers can look at their portfolio of solutions providers and look at what stage those companies are in and who the acquirers might be,” he says. “If it is what we call a rising star with a good product and not a lot of customers, whoever acquires [the target] is looking to ride the momentum. Hopefully, it will try to retain as much of the team for as long as possible, and the clients will have a better set of resources to work with the same product.”

On the other hand, the small vendor could switch from customer relationships where every customer is a key customer to being a small part of a larger company with perhaps grander ambitions, indicates Josefowicz. “If [the vendor being purchased] is a good product company but so small it hasn't had a lot of sales momentum, generally there are only a handful of customers anyway,” says Josefowicz. “Customers should be concerned how the acquirer will fold that company in.”

If a software portfolio company is buying the vendor, it is important to determine whether it is thinking about blending that new product into its overall product line, points out Josefowicz.

If it's a services company doing the buying, the question becomes whether it is looking to have an asset to implement around, which Josefowicz feels could be a benefit to customers of small companies because there now would be more implementation and support resources.

If a vendor has a large customer base and older technology and hasn't invested much in technology, Josefowicz advises it might be wise for the carrier to migrate off that platform. “The acquirer might be buying the customer base more than the platform,” he says.

For whatever reason a vendor is acquired or not, Light emphasizes the vendor has to keep its equilibrium. “A vendor always should have part of its story be about why it is a good business partner,” he says. “One set of reasons should have to do with stability–a road map of its vision of the future and its confidence it can deliver on that.”