Why it pays to invest in outsourcing despite its scandalous record

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.

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 car-licensing authority) bought 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 policeand 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.

Not only are the current government and prime minister especially obsessive about further expansion, but there is also, as previous Labour administrations discovered, no choice. The role of government has become so complex that it simply cannot be managed internally. Nor should it be – it’s worth remembering that when government ran businesses directly, the outcomes were usually dire.

Having a telephone connected could take weeks; British Rail was a staple for comedians. Gas or electricity breakdowns were common, repairs slow. Water supplies could be erratic, while sewage as often as not was simply dumped in rivers or at sea, only to wash up on the beaches. (Hence after the UK joined the European Union, we were found to have the dirtiest beaches in Europe.)

Moreover, there have been many outsourcing successes. Most important, and for all the many government reports that are nauseatingly self-serving, outsourcing would appear to have resulted in considerable savings overall. These were initially very large, often 20%-30% cheaper than when managed by central or local government. Litter collection has improved dramatically. Private prisons have delivered lower costs and often better conditions. Many simple tasks, once considered core, are now routinely and more effectively outsourced, such as payroll and HR. Outsourced IT has a chequered history, but unnoticed in many areas it has improved services. National Savings & Investments (premium bonds and savings products) was outsourced to Siemens – the savings have been considerable and the service much improved. Even the NHS, one of the world’s most cumbersome bureaucracies, has achieved considerable savings by outsourcing many areas to private providers. Indeed, in residential care, a perennially controversial topic, in many cases private suppliers have been found to provide at least the same level of cover as state-funded operations, but at a lower cost.

Three key lessons for successful outsourcing

Where outsourcing failed it was usually the result of three gigantic errors. First, the private firms were often out of their depth and greedy. An ex-director of one outsourcer told me years ago that the instruction was always to submit the lowest bid, find cheap external expertise afterwards, then hope to squeeze the agreed price higher by bolting on “unforeseen problems” requiring a higher fee. The results of this reckless approach can be seen in the companies themselves.

All of what were once the “Big Six” outsourcing firms – Amey, Capita, Serco, Interserve, G4S and Carillion – have had a torrid history. From 2009 to 2018 only one briefly had a profit margin over 10% (Capita). Two – Interserve and Carillion – went bust. After decades of incompetence and lousy returns for shareholders, G4S was put out of its misery when it was bought by a US company earlier this year. Amey was taken over by Spain’s Ferrovial (which is now keen to get rid of it as soon as possible, leaving just two, both of which, until recently, have been battered. But they, and new entrants, are learning: firstly, to price contacts and risks sensibly and not to leap into areas where they have little expertise; and secondly, to walk away from badly drafted or woolly tenders.

The second error was the utter lack of expertise in the commissioning bodies. Politicians, civil in drawing up complex contracts, especially in relatively new technologies such as wind farms or IT, so inevitably got it wrong. Much derided though the use of consultants has been in aiding the drafting and implementation of these contracts, without them the list of disasters would be longer still.

The third and most important error has been the emphasis on the price. Government rules rightly dictate “best value”, but this was taken to mean “cheapest”. As commissioning bodies slowly learn, they have become better at actually looking at what is being offered. So outsourcing is slowly getting better, although there is far to go. I have avoided discussing the incompetence, waste, theft and nepotism that has occurred during the pandemic – that chapter is still being written. But, ever the optimist, I believe this large bump in the road will prove an exception in an otherwise improving trend.

The final stumbling block remains Parliament itself. There is no single body empowered to look over contracts, the suppliers, or to enforce the often clear findings from the National Audit Office and other bodies. Until that happens, expect more “unexpected” blunders. Meanwhile, given that outsourcing is set to expand even further, and as the terrible history and returns from outsourcing companies look set to reverse, investors can reasonably expect to profit from the largest area of government expenditure. I look at four companies that look well-placed to benefit below.

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