Risk Analysis - Beyond Due Diligence

 

Most investment and origination teams identify risks during the diligence and negotiation phases of the project, but it seems all too often risk management is dropped once the deal closes.  Monitoring the identified risks during the construction and operational phases of projects improves project cash flow and provides transparency to stakeholders. 

Let’s look at how risks identified during the due diligence phase of a project play out during the operational phase of a project.  For instance, the equipment supplier that was pegged as a high financial risk during diligence, did the equipment supplier perform under their warranty or did they file for bankruptcy?  Another example, the battery storage system that was given a high technical risk due to the innovation, did it perform as expected or did it go up in flames?  The sponsor that was extremely responsive during negotiations to get the deal closed, did the sponsor continue to be cooperative during construction and operations or did their communication turn silent?

What happens when risks aren’t monitored?

•   Persistent technical issues slip through the cracks resulting in decreased revenue generation.

•   An equipment supplier or a counter-party file for bankruptcy and the project team is scrambling for replacement contracts at a higher price point.

•   Catastrophic events occur and the project team is scrambling to understand insurance policies and coverages resulting in prolonged outages and insurance negotiations.

•   During the sale (or buy) process for a project, there is a tremendous amount of time and resources dedicated to organize and verify the project risk profile.

All of the above examples have one thing in common: reduced cash flow leading to a reduction in investment returns or debt repayment capacity.  The reduction in cash flow can be avoided by strategically monitoring the risks that were identified during origination and determining a plan to minimize impact to the project cash flows. 

Risk management and analysis can be conducted in a number of ways.  The first step is to establish a set of risk factors common to projects in a portfolio.  During the diligence phase, assess the impact of the risk factors on each project.  This typically is an input into the investment decision.  For example, during the diligence phase it is determined that one of the equipment suppliers is experiencing financial difficulty.  Due to the supplier’s high quality product, the origination team signs with the equipment supplier but notes the consequences in doing so.  The risks in this example are counter-party risk and financial risks in the questionable value of the related equipment warranty and potential replacement costs.

The next step of risk management will occur near the closing date and is to ensure the transfer of the risk assessment to the monitoring or asset management team for ongoing evaluations.  Continuing the example above, the asset managers will periodically, or as decision points occur, analyze the financial condition of the equipment supplier and quantify any impact it has on replacement costs or warranties.  Finally, the asset manager, in conjunction with the rest of the monitoring team, determines an acceptable strategy to reduce the cost impact on the project of a terminated warranty or insolvent equipment supplier.

The process of evaluating risks and outlining a strategy for managing the risk provides a level of transparency to stakeholders in understanding potential unforeseen costs impacting the cash flow of a project.

Garnet 3 can help in improving the cash flow of a project and transparency to stakeholders by helping to create tailored risk criteria and the steps to evaluate risk.

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