The Inverted Bid Model - five key questions in solving it

In brief

Industry Super Australia's proposed Inverted Bid Model has generated a lot of interest and discussion. At a recent industry symposium, participants were invited to explore the model, with a view to further refining it for application in the Australian infrastructure market. Partner David Donnelly poses some key questions.

Some questions that don't need to be asked

Industry Super Australia's report¹ makes a number of points that are widely accepted in the industry. These include:

• the need to reduce bid costs and project timeframes for 'greenfields' infrastructure projects;
• the need for a consistent pipeline of infrastructure projects to support investment;
• the natural fit between the stable long-term cash flows that are characteristic of infrastructure assets and the liability profile of the typical superannuation fund; and
• the pressures on government finances and the need to access a broader pool of capital in financing infrastructure development.

This Focus does not question these propositions. Rather, the pertinent questions in advancing the proposed model are whether it will address these points and, if so, whether it will do so in a way that produces better outcomes for the community and for those who ultimately fund the infrastructure (whether taxpayers or end users).

This second question will largely turn on the model's ability to deliver its purported benefits while continuing to deliver the core benefits provided by the current model, in terms of certainty of pricing, risk transfer, innovation and whole-of-life solutions.

Some questions that do need to be answered

A number of questions will need to be answered in finalising the model and refining it for application in the Australian infrastructure market. Outlined below are five key ones.

The 'owner-operator' keystone

The model places long-term equity at the centre of the procurement process. The first step in the process is selecting the equity investor (based on an indicative internal rate of return (IRR) against a government-issued set of requirements). The rationale for this starting point is that long-term equity as the 'owner-operator' of the project has the greatest alignment with the project's long-term success.

However, ownership and operation may be split. For example, private health providers and private prison operators 'operate' private hospitals and private prisons. It is arguable that these parties are closer to the outcomes sought by the government (and end users) and, as operators for the concession term, may be in partnership with government for longer than long-term equity (depending on equity's committed hold period).

This raises the question of why long-term equity should be considered uniquely placed to assist the government in delivering long-term outcomes (and what specific skills they will be bringing to the bid process in terms of allocating risk, and driving innovation and whole-of-life outcomes).

An alternative approach raised in the paper² is for an equity funding competition to be held after the preferred bidder stage for a portion of the equity requirement (in the same manner as the proposed debt competition). This solution should be considered if others are better placed to assist government in procuring a particular project.

Certainty

The long-term equity investor is selected based on an indicative internal rate of return against a government-issued set of requirements. The paper suggests that the government can mitigate the risk of the indicative IRR varying after the equity investor is appointed, by finalising engineering and detailed design enough to allow a detailed risk allocation prior to inviting equity investors to bid on the project.³

This raises a number of issues.

If final engineering and detailed design is not completed before the equity bids being sought, the government is exposed to movements in the bid IRR once the tenders for construction, operations and other services, and debt, are completed. This reduces certainty.

If final engineering and detailed design is completed before the equity bids being sought, this impacts on timelines and scope for innovation. The report cites a 2012 report of HM Treasury 'A new approach to public private partnerships' suggesting 'it will take many months to complete detailed design development and obtain planning approvals for a new asset'.⁴ So, obtaining certainty in terms of long-term equity's IRR at the time of appointment is likely to involve additional government investment (and more time) in bringing a project to market and a reduction in the scope for innovation in the design.

The model also assumes that the risk allocation agreed between long-term equity and the government is accepted by tenderers for the various downstream packages. If not, how is the risk reallocated and priced? For example, if the risk allocation assumes unknown pre-existing contamination is borne by the construction contractor, and this is not able to be achieved through the tender, or not able to be efficiently priced through the tender (ie the proposed transfer does not represent value-for-money for government), how is this addressed?

Innovation

A number of 'greenfields' infrastructure projects have incorporated ancillary 'commercial developments' or 'commercial opportunities' that fund the core project. This reduces the funding required from the government to deliver the project. Once the long-term equity IRR is fixed under the proposed model, a question arises as to how equity is incentivised to take additional risk on commercial developments or commercial opportunities.

Whole-of-life outcomes

The paper notes that a winning consortium may not include the 'best in class' of all the project components.⁵ This is true, although the old expression about a champion team beating a team of champions may apply. By disaggregating the tenders for each component of the project, the key element that is lost is the ability to optimise whole-of-life costs, by trading investments in construction against savings in maintenance and making similar decisions across the project. The ability to ensure compatibility of the respective solutions and manage interfaces between components is also reduced.

A key advantage for equity in bidding under the consortium model is the ability to tailor the governance and management structure to be responsive to a known set of subcontractors (and their particular issues and work styles) and price the effective management of their subcontractors into the overall solution. In the proposed model, long-term equity's IRR is either fixed before counterparty appointment or government certainty is reduced when this is revisited.

A key question for the model will be how it will deliver these types of benefits (and the value that they contribute).

Time and cost reductions

A core benefit of the proposed model is the estimated time and costs savings it will achieve.

These are, naturally, estimates. So, a key question is how certain the proponents of the model are that these savings can be delivered.
Certain aspects of the model appear to point to increases in time and cost. The separate tenders for the various components of the model (and the possible need to revise the indicative IRR – and perhaps other components – in light of tender responses and departures from the assumed risk positions) is an example in relation to time. As is the, alternative, investment by government in bringing a project to market with finalised engineering and detailed design, to fix the long-term equity IRR at the time of appointment.

The movement to a more sustainable capital structure⁶ (which is assumed to mean reduced gearing, including through the construction phase) provides an example in relation to cost.

The ability to deliver time and cost savings will be critical to the model's success.

Conclusion

Neither the current bid model nor the proposed Inverted Bid Model addresses the need for a consistent pipeline of infrastructure projects to support investment.

The proposed Inverted Bid Model has wide support among long-term equity investors, and there is no reason to believe its adoption (on appropriate projects) would not assist in attracting a broader pool of capital into the Australian infrastructure market. However, its success as a bid model will depend on its ability to deliver the benefits it purports to bring while maintaining the benefits inherent in the current model. Answers to the above questions will go a long way to determining whether it is capable of doing so.