Stress Testing Your Financial Model

Transcription

1 Stress Testing Your Financial Model The Power of Financial Model Auditing in Mitigating Infrastructure Project Risk Author Financial models are standard analytical tools for equity investors, debt providers, vendors, and governments in determining the financial feasibility and bankability of infrastructure projects. The go/no go decision for a project often hinges on the financial model which means that errors in mechanics of the model can result in misleading forecasts and potentially crippling financial decisions. Financial models are frequently large and complex, reflecting the dynamics of the operations of the underlying asset, contractual obligations, and the funding and ownership structures being considered. During infrastructure project development, there is often extreme time pressure to get the model done as soon as physically possible. Under these circumstances, unintentional errors may arise and multiply. A model audit an independent review of the mathematics and logic of financial models is a best practice, key requirement of financiers in many major financial transactions. In markets such as the UK, Europe, and Australia, model audits are required prior to the commitment of debt. In

2 the case of P3s, PPPs, and PFIs around the world, government agencies responsible for the procurement of projects require confirmation that financial models used to value infrastructure assets have had their mathematical structure and logical integrity tested. Although model auditing may seem like merely one more project hurdle to get through, in reality it functions as an essential tool in risk assessment and mitigation: Once the financial model has been stabilized (as it may fluctuate considerably in the early days of a project), prompt attention to model auditing can ensure that errors are caught early on to avoid weakening the business case and investor interest. Model accuracy must be a top-of-mind priority for infrastructure projects with budgets in the hundreds of millions or billions and life spans measured in decades. Risk Assessment through Model Auditing To provide comprehensive risk assessment for an infrastructure project, a model audit should include the following four steps: Step one is a review of the internal logic and formulae incorporated in the financial model and a review of whether the various calculations are correct and internally consistent for a given set of base case assumptions. Often, this bare bones level of review is all that is undertaken. But in itself it is insufficient for risk mitigation. Step two includes verifying the mathematics and logic of the model under a range of assumptions and scenarios to enable infrastructure project stakeholders to assess the full range of potential risks as well as upside opportunities. A financial model that incorporates sensitivity testing and allows lenders to test downside scenarios will increase lenders confidence in the project and hence the bankability of the project. Step three involves cross-checking that inputs and assumptions contained in the financial model reflect and are consistent with the due diligence reports prepared by project experts. Finally, step four involves a comparison of the model s formulae and logic against key contractual obligations. With respect to financing documents, this would include the review of the mechanics of cash flow waterfalls, reserve account movements, dividend distributions, debt service coverage ratio calculations, and the calculation methodology, and indexation of availability payments. Copyright 2013 Marsh & McLennan Companies 2

3 Exhibit 1: Common Model Errors Simple Mathematical Errors Complex Errors Due Diligence Report errors Formulae referring to incorrect assumptions Over-depreciation of assets Inconsistent assumptions in different sections of models Inflexibility to changes in key dates, due to implicit hard-coding of timing in formulae Incomplete executive summaries Inconsistent and incorrect application of sensitivity factors Over- or under-estimation of interest costs and fees when transitioning from the construction to the operations phase Incorrect discounting methodology in Net Present Value calculations Errors and inconsistencies in the calculations of financial ratios Incorrect application of inflation indexation Inconsistencies between the cash flow waterfall, inflows and outflows from reserves, coverage ratios, and the lock-up mechanism formulated in the model and the cash flow priority and definitions described in financing agreements Inconsistencies within financing documents relating to calculation of lenders ratios Assumptions entered into the model do not match due diligence reports Case Studies: What Model Auditing Can Accomplish As an example of how model auditing can improve infrastructure project risk mitigation, Mercer analyzed a sample of 16 projects for which we undertook model audits during We corrected formulae based on the errors and inconsistencies we identified in the review of the base case scenario of the models. We then compared the projected Debt Service Cover Ratios (DSCRs) and internal rates of return (IRRs) pre- and post-corrections, under the base case scenarios: On four projects (25 percent) the minimum DSCR significantly improved once mathematical errors and inconsistencies were corrected. On one project, there was a significant reduction in the equity IRR, while on two other projects there was a significant increase in the equity IRR. The project IRR of one project increased significantly. The DSCRs and IRRs of all but four projects (75 percent) changed. Net Present Values, proposed availability-based payments and total construction period costs were some of the other model outputs that were affected. Mercer also identified errors relating to sensitivities and alternative scenarios in all the models, which would have impacted results if input assumptions were changed. An example of one project where model auditing made a difference was an infrastructure project in North America. The model calculated multiple IRRs using different approaches. One of the projected IRRs changed by almost four percent on correcting the errors we Copyright 2013 Marsh & McLennan Companies 3

4 identified. Among other issues, Mercer s model audit uncovered that some of the key cash flow components that were allowed for in the cash flow waterfall were not being considered in the IRR calculation. Building it Forward Once the deal closes, model auditing can continue to play an important risk mitigation role. For those holding infrastructure portfolios, a regular audit of financial forecast models can provide a reliable basis for decision making around what to hold, sell, or acquire to build a portfolio aligned with larger strategic goals. Mercer also provides model redevelopment services post-deal for clients to transform their audited bid or financial close models into management models. Such management models can assist board members, executives, and analysts in monitoring the performance of infrastructure assets over the long term. As part of the redevelopment process, we strip out redundant features and functionality that are not relevant after the financial close, and build in features such as dashboard reports, historical data input interfaces, functionality to track historical data against forecasts, and budget re-forecasting functionality. Mercer s Model Auditing Services Mercer is a leading provider of model audit services to the infrastructure community around the world. We work with clients involved in bids for infrastructure assets, in the lead up to financial close, and on an ongoing basis with infrastructure funds. Mercer Model Audit Team members are part of the Marsh & McLennan Companies Global Infrastructure Services group, which offers an experienced team of professionals who are dedicated to advising the infrastructure community throughout the life cycle of a project or asset. Our expertise includes identifying opportunities and associated risks, mitigating risks, facilitating project completion, managing through the operational phase, and exit strategies. The Practice works globally across all sectors of infrastructure development, operation and maintenance in leveraged infrastructure acquisitions, PPP/PFI competitive bids, and non PPP project-financed development. For more information on Mercer s model auditing capabilities or the Global Infrastructure Services group, please contact one of the following practice leaders: Americas/Asia pacific Principal shikha.bajpai@mercer.com UK/Europe/asia pacific Yeeyan Lo Principal yeeyan.lo@mercer.com Copyright 2013 Marsh & McLennan Companies 4

5 MARSH & McLENNAN COMPANIES (NY SE: MMC) is a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy, and human capital. MARSH is a global leader in insurance broking and risk management; GUY CARPENTER is a global leader in providing risk and reinsurance intermediary services; MERCER is a global leader in human resource consulting and related services; and OLIVER WYMAN is a global leader in management consulting. Marsh & McLennan Companies 52,000 colleagues worldwide provide analysis, advice, and transactional capabilities to clients in more than 100 countries. The Company prides itself on being a responsible corporate citizen and making a positive impact in the communities in which it operates. Visit for more corporate information, or to learn more about the Company s world-class capabilities and its solutions to the complex problems enterprises face today. Global Infrastructure services group Contacts Risk Advisory and Insurance Transactional Services Edwin Charnaud Managing Director, Marsh edwin.charnaud@marsh.com Geoffrey Clark Managing Director, Marsh geoffrey.s.clark@marsh.com Martin Bennett Senior Vice President, Marsh martin.bennett@marsh.com Commercial/Market, Operations, Capital Planning Organization, and Strategic Risk Management Allan Kaulbach allan.kaulbach@oliverwyman.com Manny Hontoria manny.hontoria@oliverwyman.com Boris Galonske boris.galonske@oliverwyman.com Dr. Kristina Gerteiser kristina.gerteiser@oliverwyman.com Economics and Regulation Graham Shuttleworth Director, NERA Economic Consulting graham.shuttleworth@nera.com Human Capital Bob Braddick Senior Partner, Mercer robert.braddick@mercer.com Giles Archibald Senior Partner, Mercer giles.archibald@mercer.com Mark Hoble Partner, Mercer mark.w.hoble@mercer.com Financial Model Audit Principal, Mercer shikha.bajpai@mercer.com Investment consulting Karen Chester Partner, Mercer karen.chester@mercer.com Toby Buscombe Principal, Mercer toby.buscombe@mercer.com The information contained herein is based on sources we believe reliable and should be understood to be general risk management and insurance information only. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such. Copyright 2013 Marsh & McLennan Companies. All rights reserved.