How improving your management practices will reduce the risk of suboptimal NPV / IRR.
A project is considered a failure if it did not at least meet its expected business value ‘On-Time, In-Full’ (OTIF). But what about those many marginal projects? From experience we know that there are many, many cases where a combination of circumstance and suboptimal practices have resulted in projects that might not be classified as failures but nevertheless, they failed to provide the full return to their investors.
Among other points, in their paper ‘The Use and Abuse of Feasibility Studies’, W Mackenzie and N Cusworth conclude that feasibility studies tend to focus on technical issues at the expense of critical business and project delivery issues. On the flipside, the following is an example of where the project teams managed to turn the game around from marginal/non-feasible proposals to extremely positive ones.
A North American producer with a potential gold mine in South America found themselves with such a marginal project. The initial feasibility study did not greatly attract investor confidence by posting moderate returns of 15% with a payback of 7 years. The developer could have proceeded on that basis, as yes it would make some money, but instead boldly decided to give the Feasibility Study one more go. The team managed to turn around what seemed to be a doomed value proposition, to a fully funded, now operational venture with returns exceeding market expectations. Less than a year later the team had:
- Increased NPV by 25%,
- Increased IRR by 155%,
- Decreased Startup Capital by 60%, and
- Reduced Payback from 7 to 3 ½ years
What’s going on here?
That’s the subject of this piece. We will share some of our observations with you and provide you with some early warning signs also.
Project Development Phase
This figure illustrates the Project Development Phase we will discuss. Typically, such projects fit in the following space of these six phases:
- Conceptual Scoping Study
- Detailed Design (& Early Works)
Typically, a Bankable Feasibility Study (sometimes referred to as a Definitive Feasibility Study) is produced as a result of the Feasibility phase (there is debate around the suitability of these terms but that’s the subject for another post).
NPV / IRR is locked-in early
It is important to understand that most of the proposed venture’s promise (NPV, IRR) is locked-in at the very early stages of the project. It is also a fact that any changes to the overall configuration of the endeavour are easier and cheaper the earlier they are identified.
From the conceptual stage all the way to the detailed design phase, things can be very fluid. Or should we say: they should be fluid. Because, as the illustration above shows us, this is when it is cheapest and most impactful. Anyone with any project experience will tell you that making design changes during – or worse – after construction, is a nightmare.
In a perfect world, all team members would be on the same page. Instead, the C-Suite is worrying about:
- Raising project finance (it’s competitive!):
- Will our IRR & NPV be attractive enough?
- Is the team systematically considering all options and their relative value? Or,
- How do we keep all our stakeholders happy?
Meanwhile, the Study Manager, Engineering Manager and Project Director are thinking:
- How do we keep everyone in sync and actually make it work, all on time and within budget?
- How do we coordinating the teams and individuals:
- How do we keep the peace and remain impartial?
- How do we get all team members to understand the direction we’re taking, and why we’re taking it?
And the Technical and Operational Specialists are concerned about:
- How do I get enough attention to get my ideas heard?
- Will we actually be able to run it?
Needless to say, this process creates internal tension and conflict before anything has even been decided. Whilst this process may be useful if it can be managed, it can put your project in real danger of suboptimal outcomes if:
- Your team coordination looks to be out of sync, or
- There is a lack of clarity on how to evaluate project improvement suggestions.
Any of which will result in a lower NPV / IRR than the project’s optimum, reducing the strength of the business case when competing for capital. So, what are some of the signs and symptoms to look out for that help gauge which way things are tipping?
Early indicators of a suboptimal project performance:
If you start to notice, or have noticed any of the following on your project you may be at risk of poor performance outcomes:
- Lack of clarity of team direction.
- Confusion regarding option selection process.
- Inconsistency of selected options.
- Incompatible or non synergistic option combinations.
- Lack of transparency around goals and assumptions:
- What is driving our NPV/IRR calculation?
Looking through the lens of people, process and technology, your team members might feel a lack of coordination. Most likely, their process of coordination is not fit for purpose. Furthermore, the tools and technology to evaluate the team’s suggestions on merit might not be adequate to provide the rapid and accurate response the team requires to make quality decisions.
Specific challenges within the stages of the Project Development Cycle include:
Conceptual Scoping Study
- Is the resource of sufficient magnitude to be worth considering? Is this really worth our time and money investigating further?
- Have we sufficiently investigated potential technical or commercial ‘show stoppers’?
- Is the project in an economically viable ‘Ball Park’ of return on investment to attract funding?
- What is a +/- 30% estimate of the project NPV / IRR? Where would that leave us?
- Does the project align to the strategic direction of the company?
- What is the high-level risk profile of the project?
- Is our key corporate constraint upfront CAPEX, IRR Hurdle Rates, or Time to Deliver, or all of the above?
- So many options, so little time!
- How many options as a minimum should we consider for the areas of Mining, Processing, Infrastructure, Financing, etc.?
- How do we rapidly determine if any one option is ‘materially’ worth chasing?
- How can we evaluate all these interdependent options systematically and as efficiently as possible?
- What are the key value drivers the project?
- How exposed are we to all the variable inputs?
- What is the relative impact of each input on project value?
- How do we justify/defend the selection of our project ‘Base Case’?
- How can we show that our Project Risk Profile is reducing?
- How do we optimise the engineering of the Base Case?
- Aligning multiple 3rd party engineering teams is difficult; what will help all parties pull together as one team?
- The evaluation of proposed engineering solutions and their impact on NPV is complex and time-consuming.
- Where do we draw the line on the level of Pre-Preliminary Engineering? Is further engineering having a ‘material’ impact?
- Evaluating the value of what and how much ‘Early Works’ is complicated…
- How will phasing of the Project impact NPV/Cash Flow?
- Gauging the project value impact of CAPEX confidence from the 3rd party team is challenging…
- How does our revised Base Case align with original estimates declared to the market?
- The project has been announced… committed to… time is of the essence!
- Which element should be the key focus of the engineering teams? Which can be done by OEMs or Turnkey EPC?
- What are the trade-offs between deploying ‘off-the-shelf’ solutions vs. ground-up engineering?
- How much engineering can we push to Contractors/EPCs? At what risk to project value?
- Are these engineering solutions fit-for-purpose? What is the NPV impact of ‘technical contingency’ and/or ‘factors of safety’?
- Are there any hidden commercial and technical ‘contingencies’? Where should the responsibility for ‘contingencies’ lie?
- Finding the most effective incentives for 3rd party engineering teams to drive to our corporate / project goals is challenging…
- Which risks are best to remain with the owner and which should we deflect to 3rd Parties?
- Late or early delivery has an impact on project value… but how much?
- What is the minimum Early Works required?
- Which items should our procurement teams focus on wrt NPV? What is their relative importance?
- How do different purchasing/contracting strategies impact NPV?
- What is our exposure and sensitivity to key input commodities (e.g. oil prices)? How might they impact NPV?
- Evaluating the value/risk profile of spares holding levels is difficult…
- Calculating the NPV outcomes for monthly Budget/Actual/Forecast Project Costs is time-consuming…
- Quantifying the value and cost of ‘wriggle room’ for time and budget can be complex…
- Justifying changes to project scope expansions once we ‘get into it’ is not always easy to do.
With all these questions hanging in the air, our final question remains:
When it comes to Development Projects, are you and your team leaving too much money on the table?
Learn how to optimise your project for all it’s worth by applying leading practices through people, process and technology. Take a look at our whitepaper ‘Development Projects: How not to leave too much money on the table’.