Cultural Risk – A Subset Of Completion Risk In Middle East Project Finance

Cultural Risk – A Subset Of Completion Risk In Middle East Project Finance

By Saleh S Jallad

Dr Jallad is Group Vice President, Treasury, Insurance & Government Relations, at Consolidated Contractors International Company (CCC), and publisher of MEES.

Engineering, procurement and construction (EPC) contracts typically account for up to 80% of the total cost of project finance deals, with development, finance and legal expenses comprising most of the remainder. Most project revenues are expected to be generated years after draw-down, and specifically after completion on time and within the bid price. Any slippage that is not promptly cured during the construction phase may have a detrimental impact on the entire project, its debt and debt service, its profitability and ultimately its economic viability. Notwithstanding the negative impact on the host government and its international credibility, the reputation of the EPC contractor, an important asset for its existence in the highly competitive construction industry, could be also drastically hurt.

Project finance lenders extend debt to projects, on the basis of an intricate and interdependent set of legal contracts and technical documents, way before the works commence. In most developing countries, lenders demand the clear legal and financial support of the host countries as part of a complex security package. Project assets rarely constitute significant collateral. Therefore it is incumbent on the EPC contractor, in conjunction with the operator, to utilize the right human resources and expertise, from the due diligence stage and throughout the negotiations phase with the potential clients and lenders. The need is more intense if they are also one of the sponsors of the project, regardless of the level of participation. Economic and technical feasibility studies, modeling, sensitivity analysis and a variety of examinations of legal and regulatory factors are among the factors to be seriously considered. But they may not be sufficient.

It should not surprise any party involved in project finance to discover on financial close that the project they conceived, and on which they had spent millions in various currencies, does not end up exactly as planned. Alterations are normally made and accepted by all parties at the negotiating table during the many months of negotiations. Compromises are often difficult, with contractors usually under considerable pressure from the client and project sponsors. Consequently, it is advisable to have sophisticated risk matrixes and related tools as a back-up during negotiations. The result is always the allocation of the identified commercial, financial and political risks and the corresponding cost, monetary or contractual, to the entity that is judged best able to manage them. Often, those legal, commercial, technical and political skills required during the negotiations process are most critical in the final hours before signature.

Project Finance Defined

Based on my own experience in financing construction projects, the following new definition of project finance is more realistic, comprehensive and practical than the various definitions available in books or professional journals:

“Project finance is the art of understanding, negotiating, allocating and mitigating the risks inherent in economically viable projects, managed by creditworthy multinational consortia, for the purpose of efficiently raising long-term funds to develop, construct and operate profitably highly leveraged projects; with the proviso that the recourse of the debtors relies fundamentally on the cash flow generated by the project over the debt period, and not on the balance sheet of the sponsors.”

The literature and practice regarding identification, evaluation, pricing and mitigating the ever growing list of risks is growing continually. Though acknowledged by a few practitioners in the construction industry, the risk emanating from cultural differences among the participants, which we prefer to name ‘cultural risk’, is rarely or inadequately tackled on a formal basis, seriously investigated, priced or contractually mitigated as part of the overall risk evaluation at the development stage. It is most often realized only after its impact is felt, and that is usually too late. Cultural risk is normally manifested in a detrimental impact on the profit and loss calculus of the contractors, as it has a direct but initially concealed impact on the completion obligation of the consortium, and probably on the economic viability of the overall project. As the risks inherent in a project increase, the financial and contractual liabilities normally deepen. It is more likely then that cultural differences become more significant under the project finance structure.

A review of the many projects developed recently by credible multinational consortia in the Middle East would indicate that the majority suffered considerable delays, cost overruns, and serious threats of abandonment or termination. Of course, the problems could be related to a number of material variables that can be easily observed and rationally explained. However, assuming, other things being equal, that all other risk factors are satisfactorily evaluated, priced, mitigated and contractually protected as per current methods, we still find an increasing number of projects failing to achieve their expected contractual and economic goals. Although we continue to observe success stories in the Middle East, the existence of both failure and success in the same ‘business ecosystem’ suggests that cultural risk may be evident as a significant subset of completion risk, particularly under project finance agreements.

Success Through Flexibility

Success in many projects can be attributed to some degree to the willingness and ability of a multinational management to incorporate in their cultural behavior a flexibility and sensitivity towards the other cultures involved. This style of management can help such companies to achieve higher levels of performance, but there is no magic formula or fixed set of rules that can guarantee mutually beneficial managerial compromises. Flexibility under the various business conditions in the Middle East has been a potent mechanism for success. Among the requirements for success are: entrepreneurial acumen; compassionate labor management to encourage long-term loyalty to the firm; in-house and outside professional training and capacity building; closing the gap between productivity and pay; pursuit of long-term institution building and succession development; and augmenting the accountability of the management.

The ‘behavioral matrix’ below (see table), is supported by personal experience and studies by the World Economic Forum findings published in The Arab World Competitive Report (2007), and demonstrates the hypothesis that cultural risk is a significant subset of the completion risk in project finance. The matrix is based on the findings of the Japanese authors, Kunshima, et al, of The Principles of Construction Management, and relevant material found in various editions of The International Construction Law Review, particularly Kris Nielson’s Trends and Revolving Risks In Design – Build, BOT And BOOT Projects (Vol 14, Part 2, April 1997, pp 191-192). While the matrix can be modified in many ways, it will always show that different cultural behavior can have a significant effect on the management of projects that are led by multinational consortia.

The matrix assumes that each of the three regions – the Middle East, US and Japan – comprises a cultural unit, despite internal differences. Moreover, each has a distinct language system, a set of unique historical determinants, religious and ethic paradigms that combined to shape the social characteristics of their ecosystems and the traits of their people. Consequently it is imperative that consortia members ensure that their management representatives are aware from the outset of a spectrum of cultural differences, and are able and willing to employ their personal as well as their technical skills in such matters. Such skills and personal traits will assist in the collective management of the project. Serious and open discussions with respect to specific cultural issues should be conducted at the start of the project and also periodically, particularly when controversial issues appear to rise.

Project Managers’ Roles

The roles of the project managers who are responsible for daily progress are critical. The multinational firms must, therefore, select them based on a careful assessment of their technical, managerial and personal skills in managing people of different cultures. Project managers are the link with the consortia management, and may find themselves reporting to boards composed of different nationalities, belonging to different political and social systems based on conflicting determinants, and probably with some history of national antagonism. Pricing under project finance is more expensive than under traditional contracting, as the risk level in general is higher. This is a well known and accepted reality. Therefore, it is a sensible precaution to increase the level of contingencies in projects to reflect the cultural risks that a multinational management has a high probability of having to face. The rate of risk is a question for the estimators to decide, based among other things on the intricacy of the projects, their location and the nationalities involved.

 

Cultural Risk: A Subset Of Completion Risk For Multinational EPC Consortia

	Factor	Middle East	US	Japan
1	Business ownership	Families	Numerous shareholders	Oligarchs
2	Business objectives	Continuity of family legacy	Profitability	Assertive enduring existence
3	Business principles	Rivalry	Fair competition	Shared competition
4	Entrepreneurship	Very high, based on the business acumen of the entrepreneur; strategic planning is secondary	Strictly limited by management strategic planning	Highly planned and long-term
5	Business Ethics	Uncontrolled; legally inadequate	Legally controlled and enforced	Legally and socially controlled and enforced
6	Business relationship behavior	Harmony with client, tendency to put ‘Company’ rather than ‘Client’ first	Short term relationship but with an eye on the long term; competition principle dominates company behavior with others, including clients	Long term and strong relationship with all entities; harmony standards dominate
7	Auditing and accounting standards	Poor, treated with suspicion	High	Very high
8	Decision process	Top to bottom, autocratic	Top to team	Top to bottom, hierarchical
9	Minority shareholder rights	Unprotected	Legally protected and enforced	Legally protected and enforced
10	Quality of board of management	Low accountability	High accountability	Very high accountability
11	Quality of top management	Family members control	Professional and skilled management	Management by seniority, through the ranks
12	Discipline	Low respect, haphazard enforcement	As per procedures; democratically enforced	Very high respect; hierarchical
13	Law and Order	Avoided if you can, no harsh consequences when enforced	Respected, with harsh consequences upon enforcement	Highly respected, with very harsh social consequences
14	Taxation	Not a serious matter, not treated with concern	Very serious, high priority	Very serious, treated with concern
15	Debt	Shunned and avoided whenever possible	Aggressively pursued; maximum leverage preferred	An important aspect of business
16	Delegation of authority	Poorly practiced wherever it exists	Highly practiced and a must in the firm; decentralized	Highly implemented with strict discipline; concentrated in the top echelon
17	Intellectual property	Low respect, unprotected by the law.	Protected by enforceable laws and respected	Protected by enforceable laws

	Factor	Middle East	US	Japan
18	Employment	Assumed by management  as fixed assets; changing job is not frequent	Variable assets; high frequency of changing jobs, freedom to hire and fire	Lifetime
19	Wage and salary determination	Each company has its individual system; little relationship between job content and remuneration	Collective bargaining driven by market forces	Seniority
20	Pay and productivity	Poorly related to each other	Very important relationship; fair assessment	Important relationship; pay is more affected by seniority, productivity is related to job stability
21	Behavior of employees	Employing individuals, chauvinistic, favoritism, nepotism	Employing skills of individuals as long as they are useful	Employing individuals per se
22	Reward	Very small, very late if any	Big and prompt, normal practice for motivation	Small, in kind, with small bonus
23	Punishment	Benign neglect, relocation and slow dismissal; paternal behavior	Prompt dismissal, no second chance; rational	Relocation, rare dismissal
24	Labor-employee relations	Sense of injustice, fatalism and docility	Cooperative and dynamic; reflecting market conditions	Disciplined and authoritarian; long-term stability
25	Fundamental employee behavior	Passive attendance; minimum enhancement of learning and skills; when externally motivated, their behavior becomes highly individual and assertive	Actively participative; enhancement of learning and skills; highly individualistic; assertive	Actively listen, observe, learn, accumulate work knowledge and continue the hard work; harmony and team work.
26	Loyalty to firm	Very strong	Not so strong	Very strong
27	Interpersonal relationship	Warm and strong, collectively cordial	Individualistic and aloof	Individualistic and stratified
28	Quality of R&D	Poor; of secondary importance to firm	Very high; vital to firm and industry	Very high; vital to the firm
29	Expenditure of R&D	Insignificant assumed as cost only	Of primary importance; assumed as investment, profitability related	Of primary importance to increase their share in the market
30	Training and capacity building	Of secondary importance	Individual enhancement is  encouraged	Important activity to the firm

Source:  Dr Saleh S Jallad.

Copyright MEES 2008.