• Fatal flaws



    IN a Finex-Citi junior bankers congress in Cagayan de Oro on August 13, a student asked if a project could push through after meeting the hurdle rate or the internal rate of return required by the project proponent. This was during the session on treasury and risk management when we were discussing cost of capital. The question reminded of my previous experience working on power projects.

    In the real world, there is, of course, a natural tendency to focus on the financial returns. Deciding to pull out when a financial model shows a favorable rate of return is not easy. It requires rigid discipline and a mindset to weigh the risks methodically against financial returns.

    We have to be constantly aware and cognizant of other factors that could lead to an investment disaster. We call these the fatal flaws. The more common ones include: legal and regulatory impediments, social impacts, technical and engineering challenges and partnership considerations. The first three factors are fairly straightforward and should come out in the due diligence and the investigation by technical and legal experts.
    Legal impediments include a project’s inability—due to unforeseen situations—to secure the necessary permits.

    We have discovered during the initial visit that the project is in a protected area and we cannot construct. There are also instances of permits being withheld because the local government unit has misconstrued the project.

    For example, there are hydro projects that need tunneling to divert the water flow; but the local authorities insisting that it is a mining operation because of the tunnels. There are also instances when permits are withheld simply because it will benefit the host town or barangay more than the adjoining town. This happens when you have to get provincial endorsements that will cover affected towns both upstream and downstream of a project.

    Sometimes the social costs are just too prohibitive. For instance, you may need to relocate entire barangays because affected upstream areas will become submerged when the dam is put up. For run of river projects, which do not require flooding, the environmental and social impacts to the community may have negative effects because of the construction work. Although the project areas will benefit with the roads that are built in the community, the employment that is generated and the taxes that are contributed; the local community may find it difficult to interact with the technical crews if the local population does not assimilate them
    Among the technical flaws that we saw in some projects was the discovery of high water tables during soil tests that would affect the stability and rigidity of structures, which in turn, will lead to higher structural cost. Another engineering flaw that we’ve seen was the extreme distance that we need to traverse to get to a deep-sea mooring bay. The long distance passed through inhospitable areas and increased costs of construction.

    An important item that need considering before embarking on a project is the partners in the project. Most infrastructure projects have a project life of twenty-five years so it is important that the partners share the vision and principles. The paradox often is that a partner is chosen for the difference in views and ideas and the complementary skill that the partner can bring in. There would also be instances when one party with hard capital creates synergy with the intellectual capital of another party, so both can profit from the partnership.

    The tough thing about these partnerships is precisely such differences. If they are too different, particularly in values and management styles, then the partnership is bound to fail. Partnerships are just like marriages; one must chose well to survive through the challenges ahead. You have to determine that there is right chemistry to avoid the messy divorce in the future.

    Different projects will face different problems. Some of them will be obvious if the right person is looking at them. Others could remain concealed in the complexity. Often times, you will not see these in the initial design assumptions that go into the financial models. It is important to take a step back and make through assessment of the assumptions that go into a financial model. The numbers could be telling you to push forward but you have to evaluate the actual conditions, or possibly the changing conditions on the ground, to ensure that your project does not have any fatal flaws.

    Ned Goseco is currently EVP of the Financial Executives Institute and COO of IDI-Volkswagen, an AC Industrial company.


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