HEDGING YOUR BETS?OPTIMISING INVESTMENT OPPORTUNITIES FOR GREATER CASH FLOW

HEDGING YOUR BETS?

OPTIMISING INVESTMENT OPPORTUNITIES FOR GREATER CASH FLOW

It is generally accepted that more companies fail due to lack of cash flow than for want of profit. This is an inevitable position because while profit is a vital indicator of performance, its generation does not necessarily guarantee an organisation’s growth, development, or even survival. For the C-level executive, cash flow also has a particular impact in the planning of short- or long-term investment strategies, where decisions are more often focused on anticipated funding requirements rather than projecting levels of profitability.

Capital budgeting is the process for managing cash flow, where the basic unit of analysis is the investment project. From a finance perspective, projects and programmes represent a series of contingent cash flows over time, whose amount and timing are only partially under the control of the executive. The amount of expenditure these consume directly influences the level of available working capital, which is the primary benchmark for measuring a company’s operational liquidity. The eternal challenge for organisations is keeping this liquidity in the positive position needed to support day-to-day operations – i.e., to service both maturing short-term debt and upcoming operational expenses – and for maintaining the flexibility to respond to emerging opportunities.

Corporations are currently sitting on significant cash reserves to alleviate the risks presented by market volatility. This serves to highlight a flawed approach to evaluating risk, which is denying them potentially lucrative opportunities. Such a position also emphasises the importance of an effective governance framework for proposing, selecting and managing projects. Such a framework should be based on their perceived value and ability to provide maximum returns – balanced against risk across the portfolio.

In project-intensive industries, capital and operating spend remains high. For example, upstream oil and gas expenditures for 2012 are estimated to reach $1.23 trillion1, for telecommunications, 2012 capex alone is expected to reach $320 billion2, while capex spend in mining is likely to remain at a level similar to the $113 billion of 20113. However, one thing remains certain – the better capital can be managed, and the more of it that can be released from existing commitments, the greater the funds available for pursuing higher returns. Return on Capital Employed (ROCE) remains an important metric for organisations focused on capital projects. Examples of the ROCE rates for 2012 in key sectors including oil and gas (BP 17%, Shell 15%), construction (Saipem 15%, Balfour Beatty 12%), energy (RWE 20%, EDF 6%), and engineering (Lockheed Martin 17%, Larsen & Toubro 22%), highlight the value of directing operational cash reserves to the point of highest impact.

1 IHS Upstream Spending Report 2 ‘We Need to Talk About Capex,’ PWC Report 3 ‘Tracking the Trends 2012 – the top 10 trends mining companies may face in the coming year,’ Deloitte Report

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This paper will explore the ability of organisations to augment cash flow in their operations by addressing a key area of stagnant cash reserves – contingency budgets. It will argue that the collective pot of contingency monies is conservatively estimated at between 5–10% of total project operating costs across the portfolio. To free up even a small portion of these budgets can therefore help organisations expand their portfolios to decisive effect. Finally, it will also detail the way forward, and how a more flexible approach to setting contingency budgets requires the adoption of a portfolio approach to risk management.

The eternal challenge for organisations is keeping

this liquidity in the positive position needed to support

day-to-day operations.

AN EMPHASIS ON CAPITAL BUDGETING

The notion that the value of a business is a function of its expected cash flows is deeply ingrained in finance. However, to generate these cash flows organisations have to raise and invest capital in assets and projects – and this capital is not costless. In fact, it is only to the extent that the cash flows exceed the costs of raising capital that they create value for a business.

This places the spotlight on the underlying causes of excessive working capital commitments, and on a company’s working capital position as an indicator of overall operating efficiency. High working capital ratios can suggest that too much money is tied up in receivables and inventories. Typically, the knee-jerk reaction to this problem is to apply the “big squeeze” by proactively collecting receivables, delaying payments to suppliers and cutting inventories across the board. But this approach only attacks the symptoms of working capital issues, not the root causes.

A more effective approach is to fundamentally rethink and streamline key budgeting processes to free up cash reserves and reduce any dependency for outside funding. This places the focus on strategic governance, and on the C-level executive to determine the optimal mix of proposed projects that will yield the best return over a period of time. It is a critical decision process for the executive, and one they will have to stand by because once budgets for fixed investments have been allocated they are not easily reversed.

AN EFFECTIVE GOVERNANCE FRAMEWORK

In a business environment guided by the dictum ‘do more with less’, executives must insist upon demonstrable value for every project, and look to balance this against a portfolio of projects competing for finite resources. As a result, the primary role of strategic governance is to answer three critical questions:

1. What activities is the organisation currently funding?

2. What value are these investments returning?

3. What alternative investments could generate higher value?

Project ranking is driven by anticipated returns as the platform for prioritising capital investments. With the growing complexity and cost of projects, and slack demand reducing any opportunity for recovering cost and schedule overruns through higher pricing, the correct evaluation of budgeting requirements is vital for ensuring the right resources are committed at the right time. This can be difficult, particularly when new opportunities emerge that are aligned to strategic objectives but have the potential to compromise the overall financial model. Such an event can of course increase the debt to equity ratio, a worrying development in today’s economically straightened times.

To be effective at an executive level, strategic governance must incorporate capabilities for objectively evaluating existing projects and new proposals against a set of objective criteria. As well as having the ability to pass this criteria down to the project management organisation (PMO), for application in a consistent and standardised way. This approach can quickly reveal key insights and opportunities for improving the portfolio, although executives must ensure this intelligence is collected from all on-going projects and programmes into a truly value-based framework.

‘For project-intensive organisations, there is even more intense pressure on executives to deliver forecasted returns on investment. With the current economic climate, shrinking margins and increased global competition, the impact of huge capital investment projects extending beyond their scope and budget carries significant consequences. This places even greater emphasis on capital planning, a core business process that remains fraught with difficulties’.

Excerpt from Stock Shock: The effect of project and portfolio management on share price. Author: Phil Thornton, Clarity Economics

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CONTINGENCY PLANNING – AN EMPHASIS ON RISK ASSESSMENT

The growth of future cash flow is heavily dependent on an organisation’s approach to risk assessment, its visibility into the factors behind risk, and how a portfolio-wide view of risk is presented to the board. Risk assessment begins at the planning stage of any potential investment, and incorporates components such as the project risk register, to provide insight into any initial concerns. In addition, with scenario modelling this assessment process is then extended into the realm of delivery performance to strengthen an organisation’s ability to both anticipate and respond to any unexpected surprises. Such knowledge then informs the decision about how much contingency is required.

This needs to be a penetrating assessment because most project failures occur due to factors that have a high degree of potential control. By introducing more effective risk management, and analysing and disclosing the risk sensitivity of projects and targets to the board, contingencies can be more accurately mapped to the level of risk deemed acceptable. It will also reveal the degree of uncertainty that exists, and the desired confidence levels for meeting baseline requirements. For executives, this increased risk visibility reinforces assurances that the investment will remain secure and meet all ROI measurements.

THE CHALLENGE OF SETTING CONTINGENCIES

This approach is well established for detailing all the perceived risks in the project lifecycle and for identifying critical decision points. It also provides a good framework for ensuring all decisions are based on accurate information. What lets it down are the traditional silos that disconnect executives from project teams, and isolate different project teams working across the portfolio.

This isolation makes alignment, coordination and communication difficult. As a result, individuals analysing contingency within separate projects tend to make simplifying assumptions about the strategies, decisions and levels of risk. Eventually, this lack of collaboration and standardisation shows up in the form of excessive contingencies that can tie up valuable capital reserves and borrowing capacity. The central concern driving this behaviour is the fear of uncertainty, and the traditional way of coping with uncertainty in project budgets, when for example costs are not accurately known, is to use contingency.

Calculating contingency is not really a science. Organisations might use a formula for calculation, but as it depends so inherently on the risk factors for each individual project, it is hard to give a one-size-fits-all equation. It is also a delicate balancing act, especially for large capital investment projects that have the tendency to experience cost and schedule overruns. The result in many organisations is to employ too large a contingency budget. This in itself is just as undesirable as insufficient contingency, especially when the project forms part of a wider portfolio. Having too much contingency is

uncompetitive and uses up available budget, having too little increases the chance of failure.

With these pressures at work, many project leaders have traditionally added a contingency estimate in their budget – usually somewhere between 5–10%. From this starting figure they can then begin negotiations with both the PMO and with the finance team, confident that the flexibility exists should initial estimating prove a little wayward. For executives, without detailed visibility into the true level of risk facing a project, it can be very difficult to question such a figure.

Organisations can deploy a more conservative budget, but only if a comprehensive risk model is in place to provide the intelligence needed to accurately predict outcomes and the scale of contingencies required. It is those without this capability who get caught out when they cannot increase a non-existent margin, and are therefore experiencing considerable losses.

Another challenge is the lack of transparency and accountability on how contingency budgets are spent. In practice, relatively few projects return leftover contingency funds to the sponsor. Generally, project directors regard contingency funds as theirs to use; if the risks fail to materialise, the funds are expended on something else, such as project improvements or the purchase of additional equipment. As these budgets are held at task or project level, they afford executives no centralised view of available cash resources. Instead, they sit idle in silos, and at the behest of project owners.

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Determining the correlation between projects is

an important factor in highlighting how one project

going over budget can impact others.

EXECUTIVE VISIBILITY INTO RISK

In their article Owning the Right Risks, (Harvard Business Review, 2008), Kevin Buehler, Andrew Freeman and Ron Hulme describe a dysfunctional decision process, typical of many large organisations, in which each executive has a specific and narrow view of project governance, risk and compliance, as well as the associated responsibilities. As a result, key decisions are often taken without the integrated risk perspective that might well have altered their outcome and/or the strategies taken to implement them. Given such structural barriers, it is clear that the best, (perhaps only) effective way to ensure timely, risk-informed, strategic decision-making is with a due diligence process designed specifically for the capital project portfolio.

Traditional risk management methods are not up to this challenge, because they rely frequently on individuals to subjectively analyse risk. It’s an approach that attempts to estimate but not identify, assess or mitigate the specific risks on a particular project. They have also suffered from the explosion of ‘big data’, which continually threatens to overwhelm any risk assessment process. Change is needed, particularly in the area of executive visibility of risk across the portfolio. Such visibility stretches the benefits of risk assessment beyond a single project, helping organisations place individual exposures in context to the wider portfolio in terms of their interdependencies, shared resources and ultimate goals.

Determining the correlation between projects is an important factor in highlighting how one project going over budget can impact others – for example, if the price of steel goes up then the costs of other projects using steel will also increase. Or the dependency between projects may be more subtle – for example, if multiple plants or processes are built to the same design, any flaw would be likely to occur in all of them, potentially affecting the performance of the entire portfolio. Organisations may not be able to avoid such dependencies but must certainly know where they are, and understand their combined effect when setting the overall level of contingency.

EXECUTIVE OWNERSHIP OF PORTFOLIO RISK

How responsible is the C-level for calculating risk and managing contingency cash flows? Obviously their primary concern is to set a consolidated risk balance that is acceptable to shareholders and stakeholders while being able to meet revenue and growth targets. It doesn’t help that the most important projects in the company’s capex portfolio tend to be those that carry the most risk, due to their large size and complexity. Cost overruns and schedule delays on these “mega-projects” cannot easily be offset by better-than-expected performance on other (smaller) projects, so the expectations for contingency funds are even higher.

By taking ownership of a centralised risk assessment process, executives are in a position to own a more realistic appreciation of the level of risk residing in the portfolio, to create buy-in on project assumptions and to spread this awareness throughout the organisation. This is essential for removing the main – or only – reason for project failure: optimism, which arises when actions and costs are forced to meet predetermined targets. This is the ‘optimism bias’ at work, the cognitive mechanisms that guide a person’s judgements and decision-making processes based on a subconscious inclination to believe that others are more at risk of a negative event.

In addition, this consolidated view of risk enables the board to structure the portfolio in line with their strategic appetite for risk. From the myriad investment opportunities that present themselves each year, executives have access to the risk intelligence they need to weave together a matrix of higher risk/higher return projects with lower risk/lower return activities – and for creating a balance that conforms to their commitment to shareholder expectations.

From this level of insight, executives can gain the flexibility needed to reduce contingency budgets without increasing the risk of failure. In addition, by managing the overall level of risk in the portfolio, and keeping it within predefined thresholds, contingency budgets can be more accurately spread. Such a measure allows organisations the opportunity to hedge against risks across the portfolio. They can do so based on the expectation that some projects may come in under the budget and others may fall over the budget, thereby minimising the net effect on the total budget for all projects.

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MITIGATING RISK

The central management of contingency funds provides management with quicker and more accurate information regarding the adequacy of current contingency budgets. Thus, they are better able to make decisions regarding redistribution or return of unspent funds. This is crucial for the success of a portfolio management strategy, as projects previously unfunded at the start of the fiscal year could be reactivated based on the return of unused contingency funds.

Contingency budgets also assume a central role in any risk mitigation strategy to limit the effects of future problems in a project, such as capital storage for revenue shortfall and facility improvement.

Cost/benefit analysescan also help compare different mitigation strategies to better understand how the money can be spent most effectively. When responses are defined, and the cost of implementing them included in the comparison, it can show the net effect of the response on overall project budgets.

These considerations lead to the conclusion that contingencies should not only be set objectively based on probability considerations, but their control should be retained at the executive level. This would then allow cash reserves to be managed impartially by individuals who maintain a clear strategic viewpoint – thereby ensuring that fund allocation is based on actual needs and business priorities.

THE CHIEF RISK OFFICER

The increasing accountability of executives for prudent financial stewardship is a fundamental driver behind the designation of a new board level role – the Chief Risk Officer (CRO). A key aspect of the role is to maintain a programme-level risk analysis of all on-going projects in order to monitor any vulnerability inside the portfolio, with respect to schedule, cost, scope and performance. This enables organisations to better control the total level of organisational risk, and to map contingency funds against them. This assessment is also forward looking, evaluating the risk of future scope shortfalls and budget and schedule overruns to identify ongoing deficiencies in risk management procedures.

With the CRO consolidating risk assessments and contingency budgets at a portfolio level, these areas are no longer considered in isolation. They are instead viewed with the same interdependencies as the factors impacting project performance – allowing them to be shared and balanced across the portfolio in a central approach to mitigating risk. This is visibility that extends across the portfolio and highlights the elasticity that exists within the organisation for dealing with unexpected events. With these factors in place, organisations are better positioned to offer investors greater confidence to supply funds – or to demonstrate that existing funds are being handled in the most appropriate fashion.

This role is also critical for demonstrating openness and transparency of financial risk across the business, for championing best practices, and for ensuring sound mitigation and contingency planning is in place. This in turn fuels the capital rationing process, by providing insight into previous return-on-investment rates. It helps identify where and why any were lower than anticipated – and whether they dropped below the initial cost of capital.

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CONCLUSION

Today, with time and material contracts far less common, the pressure is on to practice more effective cost management, and to adopt a portfolio approach to monitoring the flow of capital across the lifecycles of individual projects. This has to be the case because the cost of one project can influence funding across the wider portfolio – and if contingencies are expended, the whole cost structure will inexorably creep upward. The traditional response has been to set contingency budgets higher than strictly necessary, in an effort to build probability into cost estimates. However, with the availability of working capital becoming a defining competitive differentiator for project-intensive industries, few can afford to allow excessive funds to be locked down and not contribute directly to the bottom line.

The challenge of freeing up cash flow through reduced contingency budgets does not imply that organisations should not perform risky projects, but rather they should be aware of an optimum overall level for risk, and maintain the capability to adjust project risks accordingly. With the interconnected nature of projects, a consolidated governance framework also enables executives to take overall control of the process for accurately assessing the level of exposure within their investments – and for guiding the PMO to set a minimum level of contingency that is acceptable in relation to financial liquidity.

Such behaviour is already a reality inside a number of leading organisations, driven by a new generation of enterprise project and portfolio management (EPPM) solutions which has gained acceptance as the most effective platform for providing executives with actionable control of the portfolio. Indeed, technology has a significant role to play in realising an effective project governance

structure, delivering the capabilities needed to employ a consistent process for proposing, selecting and managing investments and the projects that support them – not just to completion, but through to value realisation. EPPM drives this focus on value by providing the Board with the visibility needed to accurately assess the financial and operational returns from money spent, to ensure:

• All projects remain aligned with strategic goals

• Spend is balanced across the project and supporting objectives

• Risk and value are balanced appropriately

• Projects underway remain in a healthy condition

The risk management components of these solutions enable a standardised approach to analysing the risk sensitivity of individual projects – and for providing visibility into the impacts these can have. In addition, the effects of alternative mitigation strategies can be evaluated at any stage of the project lifecycle, ensuring the project is managed proactively to avoid the most potentially damaging risks.

These capabilities enable companies to identify, assess and model risks and, in the process, remove much of the uncertainty out of project and portfolio management. In addition, they also generate lessons learned that can be leveraged to improve the outcome of future projects. Ultimately, EPPM provides boards with confidence that project consistency has been increased due to a more centralised process for identifying, monitoring and reporting risk. Only from this position of assurance can contingency budgets be scaled back, with the surplus used for more lucrative investments.

Produced by The EPPM Board for Oracle Primavera

An EPPM Board Thought Leadership paper

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