With the new government taking over at the Centre and the reforms proposed, expectations from the infrastructure sector are now high for early and definitive actions to undo the tough times. Innovativeinitiatives are expected to hasten the infrastructure project approval process and if focused government initiatives and reforms are introduced inOil &Gas,River-cleaning and the Coal sector, we could possibly witness much better times for the infrastructure sector. This will definitelyimprove Profitability, Cash andOrder Flow for EPC contractors and also offer them greater opportunities than ever before.
As EPC contractors tackle new opportunities, one critical aspect they need to cover is to contain and manage risks in their businesses. Unfortunately at most SMEs, risk awareness andmanagement is low or rather not well developed and most Infrastructure SME EPC contractors come with a naïve and uni-dimensional view of the world – this is where they expose their businesses to severe unpredictability.
Infrastructure project risks can partly be tackled at the bidding stage and partly at the execution and sub-contracting stages. What this article attempts to do is highlight some of the biggest risks and address possible mitigation by SMEs.
Managing Risks at the Bidding Stage
• Project Financing Risks: Most SMEs have small balance sheets and limited funding lines and thus need to analyse the financial impact of taking on a project and whether they can adequately fund it. I.E. a BOT/BOOT project requires upfront investments and yields backended revenues that are also exposed to market risk. An SME may therefore generally not have the financial appetite to take on such projects. Two other financing risks for many SMEs may pertain to the availability of adequate Bank Guarantee limits and also the ability to finance any cash flow mismatches during the project tenure. The temptation to grow topline for SMEs may be huge but needs to be tempered with this funding reality check.
• Profitability/ Payment risks:It is critical to assess the upfront profitability of a Project and most SMEs generally do it. However most SMEs do not generally factor in possible time and cost overruns in a project. Of the 1035 infrastructure projects completed in India between 1992 and 2009, 41% faced cost overruns and 82% faced time overruns! Therefore while some projects may look tempting at 5-10% gross margin, by the time they get closed, cost overruns and delays will ensure that such projects run at zero or negative gross margins. Typically, projects with gross margins of anything under 20-25% should be examined very critically at the bidding stage. Further and needless to add, a quick background check of your customer, their payment history and payment terms on offer should be considered while taking on a project.
• Execution Risks: While execution risks are tackled during the project execution phase, even at the bidding stage, there is a need for assessment. You must ask questions. Check if the project is exposed to any major execution risks thatmay be potential deal killers – is the project in a disturbed area?Is the project revenue exposed to any market risk (and can the company handle or absorb it)?Are there any pending land acquisition or regulatory approval issues that may make project execution extremely difficult?If there are any project site related imperfections,they must be identified and priced in. Similarly technical specifications should be detailed at the start with the requisite escalation clauses. Site visits for large projects are strongly recommended.
• Contracting: All the major risk issues must be incorporated into a robust contracting document that is fair to both the parties. A typical project will have multiple contracting documents- one with the end customer, one between Project JV partners and then some with the sub-contractors. The detailing in these documents is a must and can’t be underestimated- to the extent possible nothing should be left vague or indeterminate. If relevant- roles and responsibilities of JV partners and sub-contractors should be defined clearly too. Also to be incorporated into the contract document are the detailed technical specs of the project with cost escalation provisions in case the specs change for reasons beyond control. Late delivery penalties should be reviewed critically and negotiated fairly.
Managing Risks at the Execution Stage:
As the project moves into the execution stage, the following must be ensured:
• Monitor all the major critical tasks of the Project:Typically 10-12 major tasks in the project should be identified upfront and planned for. To the extent possible, these major tasks should be broken into key sub-tasks and progress monitored. This breakdown into tasks and sub-tasks will help you identify clearly the things to be done, the risks involved and how to mitigate them. Accordingly all the major client/regulatory approvals, raw materials/sub-contractors required for the project should be identified and lead times planned for. Lest some silly oversight leads to overruns later.
• Be careful about when you start spending big money: Every project has some critical decision points, those should be defined – i.e. when should you start construction or production of various project modules? When does recruitment begin? The answer to these questions is usually dependent upon the project progress (or the lack of it) at the ultimate client. The SME might at times be working for an intermediate aggregator without sufficient visibility to the project progress at the ultimate client and needs to manage these issues carefully. Sometimes an absolutely simple Google Search or a conversation with a friend at the ultimate client may well decode the real status of the project and whether or not you should start spending big money on it.
• Redistribute risk amongst subcontractors: It should be the contracting company’s endeavour to re-distribute part of its share of project risk amongst its subcontractors. This risk distribution could be ensured through robust contracting and through performance guarantees from the sub-contractors or through performance related retention money.
It is critical that SMEs especially in the Infrastructure sector develop robust risk management processes to tackle project risks for profitable growth. If need be, external help should be sought to help the company tackle such issues.
About the Author:
Viren Malhotra is well-known and recognized as a ‘Scale-Up Expert’ among industry peers, specifically SMEs. In his career spanning over two decades, Viren has donned many hats, from investor to entrepreneur to business advisor. He has been instrumental in helping businesses grow organically and scale new heights. He currently works as an independent consultant. With a strong skill set combining market analysis and business planning, Viren has advised many companies/start-ups from textile to EPC to home furnishings among many other industries.