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The missing link
Again. All gathered together in the meeting room. Various reports and paper
scattered on the table and most likely some power point going on in the
background with various market assessments and return calculations. It is
time again to make another strategic decision about potential investment x or
asset y.
Very meaningful if it was not for the fact that decision bases keep changing
from session to session. One investment a star one year, the next a dog.
How can anyone make meaningful strategic decisions in an environment like
that? Frustrating at best - root cause of immense shareholder value
destruction at worst.
But it’s not for lack of good people on the case or hard work for that matter.
No, the solution lies elsewhere.
And the good news is that with that solution also comes the potential to
substantially improve your return exposure.
3. contact@industreams.com
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The problem
Value
-drivers
Decision
-base
Decision
-making
a. Value drivers shift
constantly, in particular in
terms of the perception of
future developments.
b. Because we base decision-making on
decision bases that estimate one return
figure, our decision-base shifts every
time the value drivers shift.
c. This makes for an unstable base to carry out
strategic decision-making. With constantly
moving parts it leaves us in a terrible position
to make critical calls and worst case make us
unconsciously destroy shareholder value.
4. contact@industreams.com
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The solution
Market
drivers
Decision-
making
Return
exposure
Model
drivers
We need a new framework to work effectively with strategic decision-making. A framework where
the parts are not all constantly moving.
Instead of just working
from decision-base we
need to work with the
full return exposure
including the full
potential downside and a
conceivable upside (this
stabilizes our goal post).
We split value drivers into
market drivers and model
drivers. We control the
investment, operating and
ownership models for any
given investment. This gives
us another fixture for our
strategic decision-making.
Which has many other
benefits discussed later.
Market drivers will continue
to be volatile, but isolating
them and understanding how
we can negate or even benefit
from this volatility leaves us
much better prepared to deal
with it.
With this frame we have a
solid structure to make
strategic decision-making
whilst accepting the volatility
that is all around us.
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What we want to achieve with this
The purpose of this framework
is helping you put in place an
approach that:
A. Employs all levers to
increase investment
returns.
B. Aggressively works on
reducing downside.
C. Creates a robust platform
for strategic decision-
making.
AB
C
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What comes next
1. Paradigm
Shifting the paradigm by moving from one-point
forecasting to working with full return exposure.
2. Models
Employing models and options by identifying the key
components of your business model and associated
options and flexibilities.
3. Testing
Applying a simple test to understand what your
return exposure really looks like and how your
strategic decision-making is impacting it.
Appendix
a. Case illustration
b. What Hutchison and others are doing
This presentation seeks to introduce the
basic components, or missing pieces, we
have identified as necessary to work
meaningfully towards shareholder value
creation in volatile market conditions.
It presents the key components to work
with the framework presented on the
previous slide and will be covered in three
simple steps and illustrated at the end by a
case.
This presentation provides a conceptual
framework only. For application we
encourage you to reach out to us and
initiate dialogue.
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Step 1. Beyond one-point forecasting
When did any projection you ever looked at hold true?
If it was a one line projection into the future our guess is never.
Just think about investments you or your company have been
part of over the last 10 or even just 5 years and how much has
changed.
But this is not due to prediction failure. It is because of the nature
of the markets. Consider the World Bank or IMF, hundreds of
economists employed and really a poor poor track record of
prediction even just for 1 or 2 year predications.
Again it is not because of failure, the world economy is now and
increasingly so becoming interdependent – a super complex
system that is exposed to volatility of all the world markets.
Any form of precision prediction leads to failure, we need to
change that and work with the volatility that is all around us, and
will continue to be there, in a meaningful way. And the best in the
sector are going to be benefitting from it.
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Step 2. Down and up-side exposure
Metrics Estimate
Investment size $500mn
Net Present Value $241mn
Internal Rate of Return 15%
-968mn +1,707mn0 +241mn
Our downside is known and relevant. We
need to acknowledge it and aggressively
work to reduce it (in this case mostly
made up of investment and concession
commitments).
Moving beyond a single point view of the
world – from only working with decision
base to full return exposure
(in this example illustrated in the form of
a wide spectrum of potential NPV
outcomes – for more information see the
case in the appendix).
Significant upside is ultimately what
justifies putting in substantial
commitments. We need to actively work
to increase our upside. The more the
better.
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Step 3. Domain exposure
-968mn +1,707mn
+1,707mn
-968mn
Market
Model
Here we add domain
exposure. Our return
exposure is not directly
dictated by market
drivers, they are
translated through the
models we put in place
(we could call it our
business model). This
distinction serves to
provide us with a way to
work meaningfully with
market volatility and
understand how we can
work with our business
model to alter our return
exposure.
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Step 3. Domain exposure (2)
Market Domain Model Domain
Volume
Rates
Unit costs
Tax
Interest rates
Etc.
Concession terms
Operating model
Expansion, phasing and
other options
Funding and ownership
model
Deal structure
Etc.
Market drivers (or x)
Return (or y)
Models (or f(x))
Consider your return as the
combination of market
drivers and the business or
investment model you
employ to turn those drivers
into return.
Another way to think of this
would be to consider the
market drivers as
represented by “x” and your
business or investment
model as “f(x)” that
together produce “y” (the
returns).
Some samples of what goes
with which domain have
been outlined in the table.
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Working with models and options
In the previous section we set the stage for utilizing the models we employ as a separate lever
that deserves more focus and should be a key pillar in our strategic decision-making framework.
In this section we provide a brief introduction to identifying and relating to the various models.
In general we have seen various ways to analyze and break down the components of the
model, but we are seeing some similarities and find the below diagram (see next slide) as a
reasonable framework to use.
Identifying the key components is important. As important, however, is to understand what
flexibilities, entitlements and options you are in possession of (or want to be in possession of).
We use one label here to describe them all as “real options” and they permeate all walks of the
different models, from minor flexibilities (in e.g. the adjustment of labor force) to bigger
“optionalities” such as expansion options and similar (see subsequent slide for illustration).
In a world that is fully predictable, options have no value, but, as we will see, in volatile
circumstances they can be extremely valuable.
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Model identification framework
We see three key focus areas or
models that the best operators
and investors focus on. Each with
different impact and relevance
time horizon wise as well as in
terms of project versus
shareholder level (see diagram
and associated description for
explanation).
Investment Operating Ownership
Concerning everything that relates
to the scope, footprint, design,
investment, obligations and
entitlement that create the frame
for the terminal to operate in the
market.
With the given frame of the
investment model the operating
model concerns the actual usage
and deployment of shorter term
resources to operate and provide
services.
Pertains to the individual
shareholders and how they each
derive their returns from the
shareholding in the project or
terminal company through the
combination of the investment
and operating models.
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The importance of real options
Investment Model
Concession, land and usage terms
Investment commitments and
terms
Expansion and phasing terms
Etc.
Operating Model
Customer agreements and terms
Fixed staff and admin cost structure
Variable staff and consumption
Etc.
Ownership Model
Funding structure
JV and partnership terms
Dividend payout
Etc.
Real
Options
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Introduction
Without a proper testing tool to understand how
our decision-making (including the use of model
components) impacts our return exposure we
are blind.
This section covers our approach to a simple but
comprehensive testing tool.
It should enable you to understand whether you
are making changes for the better or in reality
sub-optimizing or worst case trading off small
upsides for big downsides.
But first one further perspective of why this
matters.
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Which investment would you choose?
Metrics Estimate
Investment size $500mn
Net Present Value $241mn
Internal Rate of Return 15%
Metrics Estimate
Investment size $500mn
Net Present Value $241mn
Internal Rate of Return 15%
Metrics Estimate
Investment size $500mn
Net Present Value $241mn
Internal Rate of Return 15%
1 2 3
These may appear similar, but they are not. Consider the next slide...
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Now, which investment would you choose?
1
2
3
Scenario NPV
Best case +1,707mn
Base case +241mn
Worst case -968mn
Scenario NPV
Best case +1,707mn
Base case +241mn
Worst case -293mn
Scenario NPV
Best case +3,438mn
Base case +241mn
Worst case -293mn
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The key problem
As discussed before the central problem is that the information from a
single point or a base case does not provide nearly enough information
for us to assess, manage or make decisions about investments or
existing assets and portfolios.
What seems however to be the case is that most manage their assets
and enter into investments using just a one line projection and relating
to a decision base case only.
We need a new tool for testing investment and asset value.
The three cases presented also happen to be from the same investment
(as you will see in the case below) just with slight differences in the
investment model, exemplifying the importance of testing how we can
change our return exposure through working with models.
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Is an easy method of testing what is at
least a conceivable spectrum for your
investment.
Tests for the full downside.
Tests for upside potential.
Allow for graphic and numeric
understanding of how your investment
responds to changes in your
investment, operational and ownership
model.
Is constructed by simply looking at
100% variance on current outlook or
base case up and down for the main
value drivers (in the sample is used
average rate and volume for just one
time period).
As with all investing there are no perfect
options, but any approach that takes in a
substantially wider spectrum than just one
point, base case or single line projection is vastly
superior.
Our approach: The 9 Point Test
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What ultimately matters
Mainly relevant as a
point of reference.
Downside is non-speculative
and very real. We need to
obsess about reducing it.
Upside, although
speculative, shou
ld ultimately be
the purpose of
investing when
dealing with any
investment
where a specific
payoff point
cannot be
forecasted with
any certainty.
It is not only
the worst
and best
case that
matters it is
the space
that defines
up and
downside
and thereby
in reality an
average
across the 9
payoff
points.
As mentioned there are many options to use a greater goal or testing metrics than what is
mostly used today (single point estimates). What really matters is to have a meaningful way
of relating to a relevant spectrum and with that up- and downside (and the relation between
the two).
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Now - how does your investment stack up?
Great!
Very limited downside and
substantial upside.
An even sided gamble…
As much upside as downside.
Terrible!
Tremendous downside and little
upside.
Now consider
the strategy
you employ
and the
associated
agreements
and
parameters
governing
your
investment
(the
investment,
operating and
ownership
models).
Which of
these
diagrams
does it
assimilate?
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Introduction
The three samples used above (in the testing case) all have
the same starting point (and are from the same investment).
20 year concession
1,500 meters of quay and 100ha at cost of $500mn
Capacity 1.5mn TEU (ramp-up period of 6 years)
Average rate at $200 per TEU, average variable cost at $50
per TEU
Fixed cost at $5mn per year
Concession cost at $50mn per year (fixed)
25% corporate tax rate
10% discount rate
In the following we make adjustments to the investment
model and test to see the changes it makes to our return
exposure.
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Sample 1 – Starting point
As capacity is capped at 1,5mn TEU volume only has an impact up to the
base scenario thereafter only avg. rate increase make a difference. The
lowest payoff point mainly consists of investment and concession liabilities.
Return spread (NPV in USD)
Base case +241mn
Average +211mn
Maximum +1,707mn
Minimum -968mn
Max./Min. 1.76 times
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Sample 2 – Concession and phasing terms
To get from Sample 1 to Sample 2 we amended the concession structure as
follows with no change to the base case:
Previous fee $50mn per year
New fee $44.25 per TEU
PV value of concession fee remains $426mn (at 10% discount rate) as per
base case
And added a phasing option:
Previous commitment at $500mn
Option introduced to phase in 2 parts of $250mn per phase
Return spread (NPV in USD)
Base case +241mn
Average +488mn
Maximum +1,703mn
Minimum -293mn
Max./Min. 5.81 times
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Sample 3 – Expansion option
Finally we combined these adjustments with an expansion option to reach
Sample 3 (from Sample 2):
Capacity capped at 1.5mn TEU in base case
Option introduced to double capacity by investing additional $500mn
Return spread (NPV in USD)
Base case +241mn
Average +801mn
Maximum +3,438mn
Minimum -293mn
Max./Min. 11.75 times
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How average return exposure has increased
1
2
3
+211mn
+488mn
+801mn
When comparing
the investment case
above for average
return exposure
(NPV) you will see a
noticeable
difference between
that and the base
case. We have
shifted the entire
return distribution
more almost
$600mn to the
better by just using
a few of the basic
levers from the
investment model..
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Introduction
It used to be all about the markets, well, mostly at least. Which markets
are hot and which are not (and “picking the winners”).
Whereas this is still something the global port investors clearly obsess
about, a clear difference is possible to spot for those who have been
around some years in the sector.
In short, they are starting to focus much more on the models they use to
invest and extract value from their portfolios. And as part of that they
employ models that assume much more volatility in the markets than
previously.
In this short piece we will be illustrating this trend with a few samples
and uncover some of the key things the best in the market are doing
differently.
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What Hutchison and others are doing (1)
One of the most notable cases was the Hutchison Port Trust IPO in Singapore.
In one single move Hutchison Port Holdings (HPH) transformed their return
exposure completely for all their Pearl River Delta (PRD) assets when they IPO’ed
them on the Singapore Stock Exchange. Not only did they secure a substantial
part of the potential future cash flows they also placed themselves in a role that
gives them many times the upside compared to the stake they have left in the
game.
In 2010/11 when HPH was faced with decisions concerning their PRD
portfolio, including their very profitable Hong Kong and Shenzhen activities, they
probably looked at something resembling the spread of potential returns shown
on next slide.
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What Hutchison and others are doing (2)
Note: The figures used are just samples, they do not reflect specific estimates (and we are only talking
about HPH here rather than the wider set of owners behind the assets for simplification).
Market drivers
Return (NPV)
-$5bn
+$5bn
Market drivers
Return (NPV)
-$5bn
+$5bn
The diagram displays a spectrum from the least optimal to the most optimal
market conditions and a corresponding value of the HPH PRD assets (in NPV)
when matched against a potential sale (or in this case proceeds from an IPO) at
$5bn.
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What Hutchison and others are doing (3)
In the diagram to the left (previous slide), HPH would be assuming that under
reasonable market conditions they would enjoy the same future cash flows as
what they would gain in proceeds from a sale and obviously would gain more by
retaining their holdings under more favorable conditions (and vice versa).
Whether HPH saw more downside than upside has been speculated on and it is of
course entirely possible that they might have been looking at a flattening of the
upside potential as illustrated in the diagram to the right given the market
supply/demand situation and associated rate environment.
That however is not so relevant to the issue at hand. The interesting part is the
constellation they put in place as part of their divestment. Had they just divested
the majority of the holdings you could argue that they would have simply reduced
up- and downside. But instead they made a managing role for themselves, not
entirely different from the more traditional PE structures, in which they receive
bonus based on performance. BUT this was done without adding to the down side
(see next slide).
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What Hutchison and others are doing (4)
In short HPH substantially reduced their down side and instead put in place a
structure that would allow them exposure to a potential upside many times that
of the capital deployed.
Market drivers
Return (NPV)
-$5bn
+$5bn
Market drivers
Return (NPV)
-$5bn
+$5bn
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What Hutchison and others are doing (5)
A more recent example would be the China Merchant Holdings International
(CMHI) acquisition of part of the CMA terminal portfolio for a reported amount of
€400mn.
Very simplified the return exposure might have been as outlined above in the
diagram to the left. But it is possible, as was rumored, that CMHI negotiated a
guarantee providing them with a minimum return for the first 7 years of 7-
8%, substantially reducing the potential downside of the investment (as outlined
in the diagram to the right).
Market drivers
Return (NPV)+€400mn
-€400mn
Market drivers
Return (NPV)+€400mn
<€250mn
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The general trend
The stated examples are just a few snippets of what is visible to the public when
looking at press releases and other such sources.
From direct deal involvement it is clear to us that in particular the more
established operators and investors are starting to behave very different in their
investment and portfolio management approach.
It does, however, not look like an across the board change in the way these
organizations work internally. Governance and procedures seem to remain the
same. As example in the form of some one-line projections to support a business
case that goes to the board.
But in these organizations are people who have been through many investment
cases and today sit with what is often a mixed bag of assets. These decision-
makers are not relying on prediction accuracy anymore.
So what are they doing?
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A. Avoiding prediction failure (1)
It used to be the general belief that by putting enough resources to work you
should get a fairly precise estimate of a potential set of market drivers. Drivers
that in turn could be used to make a business case and in general form a business
model around to optimize returns for the specific investment in question.
Market drivers
Return (NPV)
Market drivers
Return (NPV)
-$500mn
+$500mn
-$500mn
+$500mn
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A. Avoiding prediction failure (2)
But with a market now littered with projects that in the worst case have no cargo
or prospects of getting any material such, this is changing. As mentioned for some
reason it still seems to be the norm in terms of the actual governance and process
surrounding decision-making for investing and asset management but the
experienced executives are not buying it.
And so they simply assume a much larger potential fall-out range (see right
diagram versus left diagram above).
For a more in depth look at market volatility in the port markets, please see:
www.port-investor.com/market-volatility
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B. Thinking in business/inv. models (1)
With that backdrop it becomes important to distinguish between market drivers
and the model you employ to transform these into return.
Another way to think of this would be to consider the market drivers as the
variable “x” and the business or investment model employed as “f(x)” and the
returns generated from these as “y”.
Market drivers (or x)
Return (or y)
Business/investment model (or f(x))
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B. Thinking in business/inv. models (2)
A few examples given below on what constitutes the aspects considered in terms
of drivers versus model.
Market (drivers) Model (inv./business)
Volume
Rates
Unit costs
Tax
Interest rates
Etc.
Concession terms
Operating model
Expansion, phasing and
other options
Funding and ownership
model
Deal structure
Etc.
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B. Thinking in business/inv. models (3)
And of course the goal for these operators and investors is to create a model that
looks like the model to the right and avoid the one to the left (or transform it). In
other words working to employ a model that provides most possible upside and
least possible downside when considering a wide range of possible market
scenarios.
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B. Thinking in business/inv. models (4)
This is in stark contrast to what most are still doing today, which is optimizing
factors in the model around a decision base or single point rather than the whole
spectrum.
Working with increased focus on the model itself also has the benefit that
through the full cycle from pre- to post-investment, you have control of the model,
you make the decisions that govern it. Not so for the market drivers which you
can at best try to impact. Or to put it another way, you may not be able to dictate
the terms for e.g. a specific concession but ultimately you decide whether or not
to take it.
Ironically despite this, mistakes by investors in terms of the models employed have
previously at large been ignored (although they have been in full control of these).
This as opposed to market prediction mistakes that have been discussed in great
detail (despite the obvious limitations constituents have in this regard).
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C. Using “real options” (1)
In a world that is fully predictable options have no value. But in a world with
plenty of variance they are tremendously valuable.
And what is more, they permeate all walks of the models we employ and thereby
our return exposure.
As very simple illustration we can use put options and expansion options (or
exclusivities that secure upside) to illustrate how real options impact return
exposure (see next slide).
In the left diagram restrictions or lack or options or entitlements is curbing the
upside, whereas a put option is used to limit the downside in the diagram to the
right.
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C. Using “real options” (2)
Real options or flexibilities and entitlements come in all shapes and forms. Some
are very obvious and easy to spot whereas others are more complicated and
hidden in legal terms or inherent in e.g. the chosen operating model.
Market drviers
Return (NPV)
Market drivers
Return (NPV)
-$500mn
+$500mn
-$500mn
+$500mn
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Disclaimer
This presentation is issued for information purposes only and does not constitute an
agreement, offer, obligation or invitation to enter into transactions or investment
business.
With this presentation, INDUSTREAMS LIMITED does not act in any way as your advisor.
This presentation is not intended as, nor should it be, a substitute for consulting with
INDUSTREAMS LIMITED.
Whilst this presentation has been produced from sources believed to be reliable, the
information, views and opinions expressed in this presentation are provided as of the
date of this presentation and remain subject to verification, completion and change
without notice. No representation or warranty whatsoever (whether express or implied)
is or will be made as to, or in relation to, the accuracy, reliability or completeness of the
information contained herein or in the appendices to this presentation.
INDUSTREAMS LIMITED will not be liable towards you or any third party for any eventual
damage you may incur, caused by the information contained in this presentation and its
appendices.