* 93 bln stg public sector contract spend in 2012/13
* Government wants small firms to have 25 pct by 2015
* Possible pick-up in mergers and acquisitions activity
By Christine Murray
LONDON, July 5 (Reuters) - When a modest IT firm in southern England won a 13-million pound local authority contract in 1988, it was a huge coup for a business that had annual revenue of just 4.3 million pounds.
Nowadays that company has annual revenue of 3.4 billion pounds thanks to its dominance of the public sector services market - and Britain's government thinks it's time that Capita returned some of that business to smaller firms.
"We have an oligopoly," said Bill Crothers, the government officer charged with overseeing all central government contracts. "We have a huge concentration of business in relatively few suppliers."
Outsourcing public sector services to private companies has been a controversial issue in Britain since former prime minister Margaret Thatcher introduced compulsory competitive tendering in the 1980s. That forced local authorities to give private firms the chance to run everything from councils' IT systems to hospitals and rubbish collection.
As a result the public services market boomed and is now worth 93 billion pounds, according to figures from market analyst Kable. That makes it second only in size to the U.S. market, says data analyst Information Services Group. Capita, along with Serco which runs NHS health centres, enjoyed double-digit growth for two decades until the current austerity-focused coalition government was elected in 2010.
Now outsourcing is controversial again, with a recession-weary public quick to get angry about private sector payouts given curbs on welfare spending and bleak growth forecasts.
So David Cameron's government is taking aim at the big contractors to both answer voters' calls for a fairer marketplace and to boost the economy by passing more money to small and medium-sized companies (SMEs) - those with fewer than 250 employees and a turnover of less than 50 million euros.
Cameron terms SMEs the engine of economic growth and wants them handling 25 percent of all government contracts by 2015.
Even Rod Aldridge, co-founder of Capita, says change is due. SMEs can't compete in the current climate given the 25-year-old relationships built up between bigger firms and local councils.
"The industry has now got a problem," said Aldridge, who now runs an education foundation. "Lots of small specialists..can't bid for some of the things which are out there. The government is worried because you haven't got competition."
Policymakers started changing the landscape earlier this year. In April the Bank of England revamped its "Funding for Lending" scheme to persuade risk-averse banks to lend to credit-starved small businesses.
Now central government is introducing new procurement practices, with the emphasis on smaller and shorter contracts. Extensions and add-ons - which can multiply the size of a deal several times over - are now banned, and a contract limit of 100 million pounds has been introduced, although Crothers conceded this was more a "direction" than an edict.
Britain's competition watchdog is to examine whether government's biggest IT providers like HP and CapGemini as well as Capita win too great a share of public contracts.
And government officials are examining outsourcing firms' profit margins, comparing public and private sector work to ensure they are in line, said Crothers, a former consultant at U.S.-listed outsourcing and consulting group Accenture.
"If we can see that another market in the UK, a company's private sector clients, are paying a lower price or yielding a lower margin than we are, then something's not right."
SMEs are also taking action to increase their chances of winning contracts. Acknowledging the size and experience of the big firms, many of them are scaling up to compete.
IT firm Invenio already competes with and often wins against major IT firms in the private sector. After three years of not winning public sector business the company, which builds tax management software, partnered up with a major government supplier that they declined to name. Invenio is now in advanced discussions to provide its software to HMRC, in what would be its first UK public sector deal, and hopes to win more.
"SMEs can provide so many things but are never considered seriously," Invenio managing director Partho Bhattacharya said. "I think we are seeing the start of a change. When an SME wins business against a big company they have something special to offer and someone takes the risk and can see that special thing."
David Ascott, a corporate finance partner at Grant Thornton who focuses on business services and private equity, forecast the strongest pickup in activity among mid-sized firms providing services like security and cleaning.
"Structurally it's an unusual industry because you've got lots of big guys then not a lot in the middle. There's probably more consolidation to come in that segment of the market - the creation of another one or two larger players rather than big ones buying them," he said.
One fact is incontestable: both large and small outsourcing firms will be fighting over less money. The UK faces the deepest budget cuts in Europe over the next decade, according to the OECD, so cuts to local government budgets will likely continue.
That will probably make it even harder to persuade embattled local governments and departments to have faith in smaller, untested firms.
Contracts handed to SMEs can go awry, like a 90-million pound Ministry of Justice contract in 2011, which resulted in court translators failing to turn up and others mistranslating hearings to defendants.
The Ministry of Justice has since announced a tender process that favours bigger firms - 500 million pounds of probation services contracts in 21 regional chunks, with the idea that prime providers then subcontract.
And, as ever, the bigger firms will be able to bargain harder.
"(Capita) has got massive infrastructure," said Aldridge. "The economies of scale they've got from this is enormous. The margins that Capita gets come not from bidding for higher margin but from having the infrastructure."