Why it pays to invest in outsourcing despite its scandalous record
Outsourcing has seen more than its fair share of blunder and scandal, to the benefit of neither shareholders nor voters. Yet slow but steady improvements mean now may be the time to invest, says Jonathan Compton.
It seems absurd now that in the second half of the 20th century the main business of government – apart from the military and emergency services – was to own and operate businesses.
Yet this was the legacy of total government control during World War II, allied to a subsequent explosion of the state’s role in social security, health and education (still the three largest areas of government expenditure today).
Hence it largely owned and operated almost all public transport, trains, planes and buses, coal mines, steel mills, the docks and harbours, telephony, radio and most TV. It controlled over 95% of all electricity, gas and water production, became (briefly) the largest car manufacturer, the largest shipbuilder and the dominant housebuilder.
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At the local level councils were big business, in home and office building, utilities, recreation, rubbish collection and sewage. Some even owned pubs, breweries and theatres.
The problem was simple. Central and local governments are incompetent when it comes to running businesses. As a result, between the mid-1960s and early 1980s a common moniker for Britain was “the sick man of Europe”. Something had to give.
A Conservative government was elected in 1979 after a wave of high inflation, low growth and massive industrial unrest. It saw outsourcing as the silver bullet to improve growth and productivity while also meeting the ideological aims of breaking the power of union – which, whatever your politics, had become a state within a state – along with smaller government and a leaner civil service. Modern outsourcing was born.
The birth of outsourcing
The initial steps were timid, selling shares in the old empire-wide telephone company Cable & Wireless (most of which has since been bought up by a variety of companies) and the aeroplane manufacturer British Aerospace (now BAE Systems, a top-ten defence company globally).
These experiments and further electoral success opened the way for a mass sell-off of profitable businesses – starting with British Telecom in 1984 – and the closure of those that had lost their comparative advantages, such as steel, mining and shipbuilding. And most unusually, the world followed the UK’s example.
Alongside these headline-grabbing sales, local authorities and government departments were cajoled or coerced via funding cuts to imitate the “modern” private sector. (The inverted commas reflect the fact that pre-war, many giant corporations attempted to control the entire supply chain.
The best example was Henry Ford, who tried to own the car-manufacturing process from rubber plantations – for tyres – to steel mills. Despite booming sales, he was narrowly saved from bankruptcy by military contracts in World War II.) Slowly, functions once viewed as core – such as payroll or rubbish collection – were farmed out.
Perhaps surprisingly, the Great Leap Forward and the first signs of long-term problems happened under the Labour government of 1997-2010. It took the good and bad smaller experiments and went for broke, most infamously in private finance initiatives (PFIs) and also involving public private partnerships (PPPs), again – to their cost – widely imitated overseas.
The ideology was simple: “choice and competition” would spur efficiency and performance across the public sector, provide better value for money and by a sleight of hand, keep rapidly rising borrowing “off balance sheet”, thus making government debt look artificially low. But PFIs proved disastrous.
In 2006, St Barts Health Trust, the largest in England, signed a near-£1.2bn PFI contract. By the time it ends the cost will end up being more than £6bn. Overall, the £13bn of PFI funding for hospitals for NHS England will end up costing £80bn by the time the last contract ends in 2050.
PFIs were not confined to hospitals, but included many other areas from schools to street lighting. In 2018 the now-Conservative chancellor, Rishi Sunak, announced the end of new PFI contracts, but the damage has been done and the same chancellor pledged to re-brand PPPs instead – similar structures under a different name.
Outsourcing blunders are plentiful
Health and school-related PFIs gave outsourcing a bad name in terms of value for money and the instances of outsourcing blunders would fill a library. One report by Reform, an independent think-tank, analysed investigations by the National Audit Office (NAO), Parliamentary select committees and other statutory bodies on £71bn-worth of outsourcing contracts between 2016 and 2019. Of this, £14bn was found to have been entirely wasted (the report did not analyse whether the other £57bn represented good value).
The largest single cause of waste was the Ministry of Defence (MoD), which accounted for 27% of the total, including a 17-year delay in decommissioning nuclear submarines and a failed army recruitment scheme (run by Capita). The MoD has serious form when it comes to wasting money; my favourite remains the Eurofighter/Typhoon aircraft. At the turn of the century the MoD/RAF decided to save money on its £105bn order by removing the nose cannon as it was considered outdated. Even to a layman, a fighter without a gun is a bizarre decision at the best of times.
But it so changed the aerodynamics that they then had to put concrete in the nose. This made the dynamics worse, so eventually the cannon was reinserted, but so much money had been wasted that the order had to be more than halved, seriously affecting the UK’s air defence capabilities.
Reform also highlighted some smaller losses – though still huge sums of money. Learndirect, an adult education and apprenticeships quango, was privatised in 2011. The main beneficiaries were the new private-equity owners, an arm of Lloyds Bank, who extracted tens of millions of pounds. The programme was damned in an Ofsted report, but £105m of funding continued from the Department for Education.
High-profile outsourcing blunders do little to instil public trust – such as the 2012 London Olympics incident, when the army had to be drafted in after G4S couldn’t deliver sufficient security personnel. And in 2016, 17 privately built schools in Edinburgh had to close because of “unsafe defects”, an odd euphemism for walls falling down. Another G4S blunder in 2017 was its running of immigration centres which were deemed “chaotic, incompetent and abusive”.
Outsourcing now accounts for a third of the government’s annual budget (pre-Covid-19) at just under £300bn. In practice we have come full circle – the government is yet again running businesses, but this time at one remove by outsourcing. It seeps into every part of our lives.
Your passport is effectively issued by French company Atos (better known perhaps for wrongly assessing 158,300 disabled and sick people as capable of work thus losing their benefits between 2010 and 2013; it is now embroiled in its own “accounting errors” scandal). Until 2015 driving licences were effectively issued by big computing companies. So great was the mess that the DVLA (the vehicle-licensing authority) brought the IT back in house, but now delays, incompetence and strikes dominate.
Far more important is the outsourcing of catching criminals. There were 5.8 million crimes reported in England and Wales last year, of which 730,000 (13%) were fraud offences, over 80% committed online. But the telephone-operated Crime Survey and senior police investigators estimate there were more like 4.3 million fraud offences, making it far and away the dominant criminal activity.
Do the police hunt down fraudsters? No. It is outsourced, until recently to private US company Concentrix (despite its poor record of delivering on other outsourcing contracts). Staff frequently failed to file (ie, binned) crime reports. Fewer than 5% of all crimes came to court. The overall conviction rate was below 1%. Only one in 700 scams resulted in a conviction (down 62% over the last decade); this is not surprising, given that fewer than 1% of police officers investigate fraud despite the number of cases quadrupling since 2017.
Thus the largest and fastest-growing area of criminal activity has effectively been ignored by both the police and government – outsourcing at its very worst. (The police are now tendering for new “partners” rather than trying to find the criminal
Yet outsourcing is here to stay
However, for all the greed, incompetence and many blunders, outsourcing is here to stay.
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Jonathan Compton was MD at Bedlam Asset Management and has spent 30 years in fund management, stockbroking and corporate finance.