The global surge of activity in the infrastructure sector has been very happily regarded by many people, including us here at Corality.
The increased activity in global infrastructure has resulted in an influx of client consulting requests for professional services firms, lawyers, engineering consultants and financial advisors – which is good news for many organisations in the consulting sector. However, there are some clear warning signs that we all need to consider to ensure that the quality of financial modelling stays at the high standard required for investment analysis.
We have observed a number of changes over the last twelve months in the financial modelling industry, or more specifically, the project finance modelling sector, based primarily from our experience in financial model audits (i.e., independent review of clients’ financial models prior to a PPP – public private partnership - bid submission).
Some of the changes we have seen:
Transaction innovation is rapidly evolving when increased activity drives increased intellectual competition
Average transaction size has increased with a number of ‘mega deals’ in the sector
Team sizes on the average transaction has decreased as a function of resourcing issues
Transaction volumes are exceedingly high
Due to the incredible increase in activity, the finance sector is stretched to meet the sheer volume of infrastructure transactions and this brings in a range of risk factors.
Decreased number of resources
Despite larger projects, there are less available people to dedicate to them. It may be tempting to take on more projects and stretch the resources; however, by loading people with an increased workload there is exposure to risk for fatigue, errors and costly shortcuts.
A tendency toward increased model errors
Analysts with limited experienced in transaction modelling may be brought in to assist with the workload simply due to an imbalanced project to resources ratio. This can result in an increase of financial model errors and second guessing model accuracy.
The inherent project complexity is increasing, which results in far larger models. When you combine this with a financial modeller’s limited experience, it is a recipe for disaster.
Working effectively with financial model auditors
The increased level of demand for financial model audits has resulted in new market competitors, often offering consulting services at a lower price point than established players. These new competitors are enticing to price conscious advisors and sponsors’ looking to retain margin, and it is important to work effectively with your model auditor to get the best possible outcome. We welcome new players in the industry, as it has traditionally been driven by passive performance from the accounting firms and I think we would all benefit from lifting the bar for the industry. I strongly recommend picking a financial model auditor that possesses these characteristics:
Dedicated financial modelling/model audit team - You can’t do a good job with financial modelling as a side business – it is too hard and requires constant focus and training
A proven and efficient process to manage iterations, cell-by-cell, documentation review etc.
Agreed internal protocols for which model audit software is used (being clever isn’t sufficient in this game – process is critical) - Ask your model auditor which software packages they use and how they use them
These are guidelines that will help you filter out which financial model auditor to mandate. While we, at Corality, do offer these services, the reality is that we are often conflicted on the larger infrastructure projects. From our financial model development teams, we have not shied away from engaging external model auditors to review our financial models and the guidelines pointed out above certainly apply in those situations.
Financial model audit – sense checking the scope and the fees
Sense check the fees to understand how much time will be spent on a model audit. A calculation example highlights the issue: Let’s assume that you are asking for a quote on a model audit expecting it to be in the order of $30,000-$50,000 and you get a quote for $10,000 dollars for a model audit of an infrastructure financial model (which typically have 3,000-5,000 unique formulae + transaction documentation). Let’s assume an average fee per hour for a credible professional services firm to be, say ~$300 per hour. $10,000/$300 p.h. = ~33 hours. It is naïve to believe that 33 hours on a infrastructure model audit, often going over 3-5 iterations at the bid stage, plus the detailed review of term sheets, project deeds, payment mechanism, tax and accounting opinions, etc., can be completed in this time frame with any level of quality. Financial model audits require a significant investment in time to get a quality outcome.
+ Inexperienced financial modeller
+ Under-resourced transaction advisory team
+ Complex transaction structure
+ Inherently complex underlying assets
+ Weak model audits
= Disaster waiting to happen.
The media often reports on spreadsheet errors and readers are shocked when they hear about lack of review and quality review procedures. My view is that the reality is a lot worse than then worst reported cases – scary – so it is worth keeping in mind how you can best reduce risk of errors to obtain the most confident outcome in your financial model.
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