COPYRIGHT INDUSTREAMS LTD.REAL PAYOFFAN INDUSTREAMS INITIATIVETO EXPLORE BETTER WAYS OF WORKING WITH AND GAINING FROM VOLATILITY(for strategy setting, decision-making and value creationin port and infrastructure investment and portfolio management)
COPYRIGHT INDUSTREAMS LTD.Why this initiative? The central challenge is variability in world markets and ofcourse world trade and by extension infrastructure and portmarkets. Through many cases in the ports sector and subsequently inthe wider infrastructure field it is clear to us that the solutioncannot be in prediction alone. Precision forecasting is increasingly being debunked - thelimitations are too great and one of the key reasons why manyprojects and acquisitions do not deliver the expected returns. So the starting point is that payoffs (say in the form of returns)are distributed and cannot be reduced to very specific payoffpoints (e.g. estimating an IRR to be a specific percentage pointsuch as 15% for a 40 year concession). That suggests that we must accept much wider variance in themarket variables we work with and greatly increases theimportance of the factors in our control and the function orbusiness model that turn market variables into payoff (such asconcession agreements, operating model, partnership model,gearing etc. as well as optionality and flexibility). This presents both a great challenge and opportunity fordecision-making and value creation in investing and portfoliomanagement.Ultimately this is about shareholdervalue creation.Shareholders are starting to intuit thatreturns are distributed over a muchwider spectrum than previouslyconceived and with that are going todemand a better understanding of thedown side exposures and how you limitthem as well as your ability to exposeyourself to upsides.Robustness andupside willincreasinglybecome the focusof shareholdersThe fragile willsooner or laterleave the marketplaceNote: Return on investment spread.
COPYRIGHT INDUSTREAMS LTD.What this is about and the potential This is about embracing variability and about creatingvalue from variability. To do that we need new tools and ways of dealing withvariability in decision-making and value creation ininvesting and portfolio management. With this initiative we will explore various solutions. Inthis presentation we introduce a few of the many optionsincluding simple heuristics and the payoff function toaddress central issues in decision-making and what we fornow are calling the “value leap” as outlined to the right. Very simply put it is about creating robustness and upsidein asset and portfolio value as outlined below (for moresee the case).For decision-making: Providingthe means to fully understandingour up and downward exposurealso in the face of skewness andwith that how we make smarttradeoffs as well as utilize orcreate free options thatsubstantially shift our asset value.Value leap: Many operators haveby now honed their skills atcreating value throughunderstanding and influencing themarket place. Most, however, arenot using their business model tofully leverage and protect againstmarket uncertainty. This is wherewe see some of the greatest un-tapped value in todays marketplace for operators.Note: From case outlined later in this presentation (changing NPVrange in USD from -1bn / +1.7bn to -0.3bn / +3.4bn).
COPYRIGHT INDUSTREAMS LTD.Exploring a few of the components1. BackdropEmbracing variability and moving from single payoff pointparadigm to a payoff distribution and with that moving to realinvestment strategies (payoff as expressed in e.g. IRR or NPV).2. FrameworkExploring ways of moving from payoff distribution to payofffunction and utilizing that to working with and creating valuefrom market variability.3. CaseA simulated case showing how we use levers at our disposal tosubstantially shift our payoff distribution and therebyinvestment returns (for inspiration purposes only).In the following we will walk through the preliminary backdrop and framework and a specific case tolay out frameworks and solutions for illustration purposes. It is not meant to be exhaustive in any way– it is purely meant as an introduction and to spur ideas.
COPYRIGHT INDUSTREAMS LTD.Variability in port investing and assetsSTATING THE OBVIOUS…The Compounded Annual Growth Rate(CAGR) for a sample country was 4.7%over a 20 years historical period (heresimulated using partial US ports data).But for the individual ports the rangewas between 0.5% to 10.2% CAGR for97.5% of the ports (weighted byvolume – see the y axis for one portshare of total). The obvious is thateven on a very aggregate level weface substantial variability.…AND IT GETS MUCH WORSE…Our payoff (or lack of) is exposed to numerous factorsincluding the volume distribution in a port among terminals(our terminal vs all the others), average revenue, operatingcosts etc. And the more factors we add the fatter the tailsto either side and the greater the possible future outcomefor our payoff (say IRR or NPV). And this is before evenintroducing any “skewness” which complicate mattersfurther.
COPYRIGHT INDUSTREAMS LTD.Real payoff (or return) distributionsIn real life the payoff distributionsare, well, distributed over a largerspectrum (of e.g. potential returnsor net present values). Examples aregiven to the right which are some ofthe potential real distributions andof course any mix thereof.Symmetricalpayoffs withmore or lessvariance.Skewedpayoffs eitherright or lefttail.
COPYRIGHT INDUSTREAMS LTD.Real and false investment objectivesIt may well be thatthere are only tworeal non-narrativeinvestmentobjectives. One isdecreasing theoverall variancethrough marketstructure selection,deal frames etc.(and willingness totradeoff upside forless downside). Theother is creatinginvestments withhigh payoff upsidesand little downside.The diagrams to the left illustrate narrative positions in investments where the expectedsingly point payoff is very different from the real possible payoffs. One in which payoff issymmetrical and where the upside is welcome but the downside might prove detrimentalto the company in question and thus not what they really wanted. The other a pureloosing position where the potential downside is big and the upside capped (sometimesseen in acquisitions).
COPYRIGHT INDUSTREAMS LTD.FRAMEWORK(exploration of concepts for workingwith and gaining from volatility)
COPYRIGHT INDUSTREAMS LTD.From distribution to function Consider the payoff distribution as aresult of market variables and thefunction (or business model) thattranslates these variables intopayoff. Left some of the mostobvious examples. We cannot compute probabilities toany single point of payoff (orreturn). But we know much about how ourfunction works at different marketvariables and thus how thesetranslate into payoff. Using the payoff function is a meansto working with variability. Another way to think of thedifference is as market variablesbeing “x” and the function being“f(x)”.Market variables or xPayoff (or return)MARKET VARIABLES Volume Rates Unit costs Currency exposure Interest rates Etc.FUNCTION Operating model Concession terms Expansion, phasing andother options Funding and ownershipmodel Insurance Etc.Payoff function or f(x)
COPYRIGHT INDUSTREAMS LTD.The function we wish to achieve and avoidVery simplified when we translate real payoff distributions into payoff functions theyroughly match up as laid out below. This gives us a broad idea of what we wish toachieve and avoid for our payoff function (or business model).
COPYRIGHT INDUSTREAMS LTD.What we know and what we control…What we know……is that market variables can vary muchand have a lot of inherent volatility inparticular over long time horizons.What we control……is how our function (or businessmodel) translates that volatility intopayoff.We have all seen outcomes that we thought wereextreme at time of conception of both ends of themarket spectrum in numerous investment casesacross the sector. What has never been observed is aninvestment case turning into the exact expectedreturn values.We chose anddesign ourown payofffunction. Wechosewhether tohardcode it tobe robustwithsubstantialupside orfragile.Conceivable returnscenariosThis never happens
COPYRIGHT INDUSTREAMS LTD.…using it for decision-makingExposureWhere are we? We need to understand our upward anddownward exposure – a single payoff point won’t giveus any information about that. This get’s even worseand much more critical when there is any form ofskewness involved which occurs in all investment casesone way or the other.Value creationSome of the levers at our disposure including very muchoptionality (such as investment phasing or expansions)have the potential to simply improve our payoff functionby limiting down side and increasing upside (but hiddenif only considering single payoff points).TradeoffsOthers situations may be more complex with tradeoffs.Good examples include concession terms or operatingmodels. In such circumstances the payoff function helpus understand what we are trading off and would oftenlead to very different conclusions than a single payoffpoint paradigm would. In the example to the right wethink we have made a decision that provides a smallgain seemingly for free, but in reality has provided muchmore downside and less upside.
COPYRIGHT INDUSTREAMS LTD.…and value leap through f(x)Value creation through xValue creation through x and f(x)Best of both worldsThe leading operators in general havegreat insight to the market place andhow to impact it. But the biggest areaof untapped value creation and mostoverlooked may well lie in thefunction itself (including optionality).So one way to look at x versus f(x) andvalue creation would be to considervalue creation through x as mainlymarket selection focused. That is tosay select an opportunity that hasreasonable likelihood of delivering apositive return from an average pointof view.f(x) value creation then takes placewithin a given market setting in termsof how best to transform the payoffdistribution by limiting the down side(or left tail) and expanding the upsideas much as possible (right tail).Pre- and post-investmentThis analogy works both forinvesting as well as asset andportfolio management.Whereas x value creation pre-investment is centered aroundmarket selection a goodexample post-investment wouldbe capturing higher marketshare or securing higher rates.For f(x) value creation post-investment would include all thefactors pre-investment(although a number more froma tradeoff perspective) and alsoinclude the development of newoptions as well as moreoperational levers (includingcontracting aspects ofcommercial, operations andprocurement).
COPYRIGHT INDUSTREAMS LTD.CASE(what this could look likefor a sample investment case)
COPYRIGHT INDUSTREAMS LTD.Introduction The following case has been made purely for the purpose of illustrating how a realview of payoff can enable us to vastly alter our payoff function and therebydistribution. It showcases a greenfield investment and how we can use levers to change ourpayoff distribution from a range of -968mn / +1,707mn to -293mn / +3,438mnchanging the potential max gain from 1.76 times to 11.75 times that of our potentialloss (the case was simulated for NPV in USD, but could of course be applied to anymetrics used to measure payoff or returns). The base case scenario has by intention been kept the same throughout thesimulation to show how knowledge of one payoff point provides very littleinformation of our real payoff distribution. Whereas this shows an investment case the same methodology is applicable toinvestment and portfolio management and decision-making in general. In the case we use a few of the obvious levers that can be used to transform ourpayoff distribution but they are just a few of what is conceivably a vast array oflevers.
COPYRIGHT INDUSTREAMS LTD.Base case (greenfield sample)Base case assumptions 20 year concession 1,500 meters of quay and 100ha at cost of 500mn USD Capacity 1.5mn TEU (ramp-up period of 6 years) Average rate at 200 USD per TEU, average variable costat 50 USD per TEU Fixed cost at 5mn USD per year Concession cost at 50mn USD per year (fixed) 25% corporate tax rate 10% discount rateSimulation methodology Base case at index 100 for volume andaverage rate (scenario 11) Payoff function tested for index 0 (scenario1) through to 200 (scenario 21) Average price and volume thus tested fordata sets 0/0, 10/10, 20/20 etc. up to index200/200 of base case (21 scenarios intotal) All other items kept constantNote: NPV values in million USDComments As capacity is capped at1,5mn TEU volume onlyhas an impact up to thebase scenario thereafteronly avg. rate increasemake a difference Lowest payoff pointmainly consisting ofinvestment andconcession liabilitiesReturn spread (NPV in USD)Base case 241mnMinimum -968mnMaximum 1,707mnMax./Min. 1.76 timesBase case
COPYRIGHT INDUSTREAMS LTD.Changing the function (just a few of the levers)Return spread (NPV in USD)Base case 241mnMinimum -543mnMaximum 1,703mnMax./Min. 3.14 timesConcession structure Previous fee $50mn peryear New fee $44.25 per TEU PV value of concessionfee remains $426mn (at10% discount rate) as perbase caseInvestment phasing Previous commitment at500mn USD Option introduced tophase in 2 parts of$250mn per phaseExpansion option Capacity capped at1.5mn TEU in base case Option introduced todouble capacity byinvesting additional$500mn USDReturn spread (NPV in USD)Base case 241mnMinimum -718mnMaximum 1,707mnMax./Min. 2.38 timesReturn spread (NPV in USD)Base case 241mnMinimum -968mnMaximum 3,766mnMax./Min. 3.89 times
COPYRIGHT INDUSTREAMS LTD.Transformed payoff (function and distribution)Combined Changed concessionstructure Investment phasing intwo parts Expansion option toincrease capacityReturn spread (NPV in USD)Base case 241mnMinimum -293mnMaximum 3,438mnMax./Min. 11.75 times
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