How to assess the value of a power or infrastructure project during due diligence? The buying and selling of assets requires a professional assessment of the operation and physical condition of the assets. We should be quantifying all the costs that can be measured and comparing them to all the benefits and income that can be predicted. The investment appraisal should answer key questions: Is this investment worthwhile? Is it the best project out of several projects that are candidates for investment? How much will it really cost me? How much will I really benefit?
The aim is to understand how an asset or business will operate in the future, and the factors that are likely to positively and negatively affect that operation. We need to collate evidence in various forms that enable us to generate a solid financial model that forecasts projected income and expenditure. The depth of assessment necessary depends on many factors, but the aim of the assessment is not to completely understand all minor risk factors, but to gain sufficient understanding to mitigate all of the major risk considerations, as efficiently as possible.
This article gives some recommendations on key aspects of the due diligence process for buying and selling infrastructure assets.
Planning: Top-down first, then bottom up
It is surprising how many projects miss fundamental business risks at the first stage of project investigation. It is important to take a high-level view of the business or project activity and understand the principal motivations for the transaction. Before entering detailed technical, legal and financial due diligence investigations, key risks and focus areas need to be understood.
Due diligence activities should be timed according to planned phases, with these initial investigations creating the agenda and detailed scope of the work, taking into account the high-level findings and prioritising those sectors of businesses with the highest potential risk. While staging of these activities may appear to be somewhat more time-consuming and expensive, in reality the enhanced focus on the real business risks which result enable a far more cost-effective and efficient due diligence output.
Businesses are interactive, with contracts, legal and accounting functions completely intertwined and communicating together to enable the business to operate. Technical, accounting and contract due diligence activities need to come together as part of one combined due diligence activity. While specific due diligence activities are necessarily separate, communications between each team need careful coordination and communication, all seeking and supporting a common purpose.
A business may wish to sell its assets for a variety of reasons, and these reasons and motivations must be understood. Communication between due diligence functions, and the ability for the due diligence team to switch between a wide high-level general view and a focused specialist audit, ensures that fundamental business risks and issues are identified and measured.
The engineering assessment is an important part of the due diligence process for buying or selling assets. The purpose, however, is not simply to determine whether the system or machine is operating properly, but to establish whether the technical system can be sustained through the provisioning of adequate operations, maintenance, replacement and upgrade.
The engineering assessment of assets is important as it provides insight into the ‘real value’ of assets which may differ from their current book value. Book value is typically based on accounting policy and tax provisions. One of the fundamental differences between the engineering and accounting value of assets lies in depreciation. Depreciation of assets in accounting terms is normally done on the basis of straight-line depreciation. When assets are assessed from an engineering standpoint, the rate of depreciation takes into account the assets’ actual condition, in-service deterioration and effectively predicts their actual remaining operational life.
It is also important to identify when the condition of assets is expected to deteriorate and if they can grow into serious problems. These assessments should provide an estimation of whether the equipment is meeting or exceeding the required performance levels on a regular basis and whether the value of assets is lower than the book value. This may drive a revision on the basis of actual performance and forecast capability.
Key themes of contractual, regulatory and commercial issues are underpinned by technical performance. If the condition of assets is not adequately assessed, then legal risks and financial liabilities cannot be properly estimated. If it is not possible to know the true ‘fitness for purpose’ of assets that the company has been operating and maintaining, then it is not possible to make a reasonable estimate of the assets’ value. For example, an asset register will not always identify the physical age of an asset or its original installation date. Without this information, it is impossible to establish true value. Clearly, physical inspection and assessment is the best option, but this is not always possible.
CAPEX and OPEX forecasts
During the investment appraisal it is important to assess the adequacy of capital expenditure (CAPEX) and operational expenditure (OPEX) forecasts that are prepared by the company. CAPEX and OPEX forecasts can help to provide some assurance that assets will continue to operate as designed on a continuous basis. CAPEX forecasts drive the longevity of the investment, because the level of cash spent on replacement/upgrade determines the life of the infrastructure assets.
CAPEX programmes typically include replacement, upgrade and expansion plans. This is more than a list of the equipment that needs replacement. If the business is being sold immediately prior to an asset replacement programme, then substantial resources should be placed into assessing the future cost of replacement. The best CAPEX and OPEX forecasts are produced only after these issues are addressed.
When assessing the adequacy of OPEX forecasts, it is important to check how CAPEX plans are supported, in particular whether the availability of labour, manufacturing goods and raw materials were taken into account and what level of expertise and diligence was used to create the OPEX forecasts. We need to ask a number of questions, such as: Will the acceleration or deceleration of maintenance works affect the quality of assets in the long term? What is the frequency of unscheduled maintenance and are there any penalties associated with operational problems?
For power utilities, fuel cost can account for more than 50 percent of OPEX, and other utility and waste streams may also have significant cost or revenue factors. Understanding the detail of these key contract arrangements allows the investigation of whether the asset fuel supply pricing contract has been “gamed” or not and, more importantly, whether this favourable status quo can be continued or will desist after acquisition.
The real intrinsic value of a technical due diligence exercise is determined by whether the party carrying out this activity can gain an understanding of the previous asset management team’s long-term motivations. If the assessing party fails to understand these business drivers, then the assessment remains within the technical sphere of cost audit and forecast, leaving open the potential for key issues, future costs and risks to be missed.
Assessing revenues and profits
Revenue projections have to be thoroughly reviewed and analysed as a part of a due diligence process. This task is accomplished by carefully examining the modelling and assumptions that support the financial model. Is there a way to boost revenues by raising prices (e.g. tolls, parking meter lease)? Are the assumptions reasonable or convenient? Are the forecasted activities consistent with the company’s past performance in relevant areas? If the performance history and forecasted activities are not the same, then what has changed to bring them together in the future?
It is also important to establish whether there are any penalties that could affect the revenues. For example, are there any fees that could lead to price adjustments if the power-supply quality is sub-standard? Are there any routine price adjustments to account for that? Is the financial forecast made in a way to reduce or eliminate this revenue variability?
Profits, however, are as important as revenues. The important indicators to measure the financial viability of power and infrastructure assets are the values of the profit/revenue and profit/cost ratios whenever the stream of future revenue is fixed or subject to minor variations over time. A 1 percent over-spend on a large project could wipe out a 50 percent under-spend on a small project.
It is important to check whether financial forecasts rely on agreed-upon costs, otherwise there is no guarantee that the planned costs will be the costs that are actually incurred. What is the probability that there will be no changes in the negotiated and agreed-upon costs, and if the costs are likely to change, what impact will this have on the finances of the company? And if these costs have been fixed, are there appropriate caveats in the contracts to demonstrate that? How have the costs been estimated? If valuation is based on the company’s historical performance, then it is worthwhile to check whether the appropriate escalation rates and price control indices have been used.
The dominant contractual responsibility with respect to many infrastructure assets is that the assets that are operated by a private company often need to be returned to the government or sold to other companies. The definition of a “good condition” or serviceable asset becomes a critical issue, because contracts usually require that assets need to be transferred or sold in a serviceable state. A common problem with infrastructure contracts is the situation where “good-condition” is poorly defined, or not defined at all.
“Good condition” may be defined against economic life, technical life, or financial life criteria, but ideally it should be defined against all three if possible. In reality these criteria are regularly too vaguely defined or expressed in terms which are not equivalent to each other. To enable the separate due diligence teams to carry out their functions properly, at an early stage it should be a priority on each side of the transaction to agree a definition which allows a workable assessment to be carried out.
Operating contracts may include a timetable for replacement of assets. Where this is the case, determination of whether the contractual obligations have been met is simple and measurable. Where an operating contract is more vague in defining the requirements for asset replacement, or where the definition of replacement criteria is more qualitative in nature, then a level of uncertainty will arise when the point of handover occurs.
What is the contract term, and why is the contact term of that duration? Typically contract duration is driven by technology choice or asset type service life expectancy. Combined cycle gas turbine (CCGT) projects are frequently priced on a 20-year term. The Severn Barrage tidal power project would be priced on a 100-year term, a nuclear plant on a 40-year term, and coal plants about 30 years.
In a nutshell, the review of contractual risks and responsibilities goes beyond commercial and financial issues. Examination of the responsibilities per the contract, the carried risks and earning potential is key. It is also important to scrutinise the terms and conditions of the contracts, the manner in which these contracts are implemented and the ways in which they are managed.
Governments are generally key stakeholders in the development of infrastructure. Often, as the scale of infrastructure projects is frequently strategic, governments will introduce legislation to regulate an industry, or to drive investment. Unfortunately, the legislation which encourages or drives profitability or security in a business asset, can be changed. The level of stability of a government in a particular geography directly affects the stability of the investment climate.
One of the examples of regulatory policy affecting asset valuation is the introduction of the Australian carbon tax scheme. Now that the carbon tax has been introduced, rather than investing in technology and projects to mitigate their emissions and therefore tax expenditure, many large Australian businesses with power and energy infrastructure are merely paying the tax as a straight fee, as they believe that the next government will reverse the tax. The uncertainty of long-term regulation has completely stunted the potential for long-term infrastructure investment in climate mitigation projects.
The key to power generation investment is following the regulatory trends that drive pricing. Investments in technologies and supply chain industries supported by European legislation are getting more and more important. For investors in infrastructure, certainty and stability of regulation lifetime is more important than the actual detail. Where regulation or government direction is uncertain, then the risk of an asset returning projected revenues must be sensitive to the level of this uncertainty.
Environmental and HSE issues
Environmental and Health and Safety issues are of paramount importance to the financial sustainability of power and infrastructure companies. These costs, however, are difficult to quantify, and are normally discussed qualitatively. The nature of environmental issues depends on the type of business.
Construction companies may face issues that range from the bill for cancer treatment of patients who were exposed to asbestos during work, clean-up costs associated with oil spills in the Gulf of Mexico, the bridge collapse in Minneapolis that killed and injured many people, to the Fukushima disaster. It is a question of determination of risks and of making sure there is a plan to deal with environmental and HSE risks should they eventuate.
There is no universal set of rules on how to assess the value of HSE liabilities if an incident happens. However, it is fundamental to have a clear understanding of whether HSE risks could have a material influence on the outcome of a due diligence process. Does a management approach involve: i) a steady cycle of planned maintenance; ii) anticipation of possible faults; iii) mitigation of possible faults; or iv) working closely with key stakeholders to prevent any major incidents from happening?
When a company doesn’t have adequate processes in place to manage their assets when a HSE problem happens, it not only has the potential to destroy the value of assets, but could also have far-reaching and damaging HSE consequences. Often, a key indicator is the status of the assets’ current insurance, and records regarding the assets’ engineering risk adjusters audit can often reveal significant issues.
Where to focus?
When planning an infrastructure due diligence project, insufficient attention is often given to three fundamental areas:
• Due diligence activity planning, leadership and communication, with particular attention to top-down, bottom-up and team interface activities
• Use of infrastructure strategic specialists, with the competence to work at both a macro- and micro-detailed level
• Political direction and momentum
Don’t fall into the trap of despatching individual teams of due diligence experts to a company to carry out their functions in detail without first carefully considering and discussing the plan of attack with them, and creating a plan which draws them together in mutual communication. Often for larger assets, it is highly effective to send individuals from technical, financial and legal teams for a scoping visit, and then create a due diligence scope of work and agenda from their feedback on perceived priorities.
At the outset, the principle business sensitivities should be determined and a risk assessment carried out to identify the possible scale of impact to the business. After these key sensitivities have been determined, the necessary knowledge competencies required to accurately predict the range of sensitivities and their likely mean values can be considered and modelled.
*Olga Butler is a senior consultant, energy strategic consulting, in the power industry and utilities group at Parsons Brinckerhoff in London