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Wednesday, January 12, 2011

A Real Option framework for Dispute Management

Can risk management practices and instruments be used to solve disputes?

Before I leap into this article, I need to set some boundaries because I am sure this topic is likely to solicit potential criticism without clear delineation on what we are talking about. Perhaps I should say what is not in scope to make that simple.

What a risk management or specifically a real option framework for dispute management cannot fix is an ideological dispute. However, it can potentially solve a dispute around scope creep and conflicts of interest.

Let's see.

What is an ideological dispute?
Before we leap into this discussion, a presentation supporting this article can be viewed here [LINK].

Teams, Groups, Business Units, Cultural Cleats that bind people together and even countries have unique ideologies that form a fabric of who they are and what they stand for.  A flag, picture, even a colour can be the genius loci of moment in time and a movement or place for people to unify.  It isn't that two disparate groups of people have different goals, often they don't; what they have in many cases are alternate methods of execution.  Feudal motive is centred around beliefs which are fueled by divide where one can't exist while the other survives. This has been the curse of humanity before Aristotle and I don't believe there is an answer to this type of angst. Only a complete rethink of doctrine will correct these concerns.
Dysfunctional Dispute
Let's stay focused on DYSFUNCTION with the intention to understand what drives DISPUTE, a place where the two generally operate well together.  Some years ago now, the French computer manufacturer Bull contracted Spikes Cavell to conduct a survey in the UK to identify major causes for project failure in the finance sector.

The results were not particularly encouraging:

The driving factors for failure identified some of the following; communication, scope creep and conflicts of interest cause project failure and dispute. It is possible of course that conflicts of interest and expectation setting, fed communication break down and a knock on effect of that is often scope creep.

Scope creep can impact results positively or negatively but it will nearly always cause deadlines to be pushed out, budgets to be inflated away from the baseline and the quality or return on the investment to skew.
What is the underlying problem here?
Too many projects are flagged as either successful or unsuccessful by relying on a binary outcome and they are often reduced to a tick list that has to be satisfied before success can be acknowledged.
"In reality you will find that nearly all activities, certainly the ones that have not been done before, will result in a range of outcomes."
These outcomes are perceived by stakeholders as somewhere between good and bad, where each result has it's own value or price. In some cases that result value will be negative when offset against a baseline and this is especially the case if the baseline measurement is not defined or agreed between stakeholders.

The next problem is that most things we build today are for tomorrow. That is the forward position on any project is uncertain and has a range of potential outcomes.

The problem with planning for a range of outcomes rather than a single result, is that you fall into the realm of an option derivative rather than a forward contract.  Before we can look at how Real Options may help us solve project risk disputes, we need to understand these unique contracts.
Option Derivative vs Forward Contract
A forward contract is perhaps the most simple of agreements. In short, at some point in the future you will deliver a good or service at a specific quality for a specific price. If the price is not paid in one lump at a specified date but on performance, then optionality starts to slip in. If the product is delivered as an outcome of an event then optionality starts to slip in.  Insurance for example is an option instrument and honest people don't burn their house down to make claim on its contents or do they?

An Option be it a call (the right to buy on an event or price) or a put (the right to sell on an event or price) is vastly more sophisticated than a forward agreement because the buyer of the option might or might not exercise their right to trade. The reason that drives the stakeholder to make the exercise decision is based around a signal for the occurrence of an event.  Rightly or wrongly, even the mere perception of something not happening on a project across its delivery window can sway adverse decision.

Most projects have many moving parts and are thus fulfilled when a set of events occur; many probabilities, many outcomes and many options. If a critical path activity fails, an agreement default clause is enacted.  We are of course assuming that a place for failure or default has actually been planned for in the project delivery agreement. That is not often the case. However, all of this are well known facts and many project managers design their projects to treat these problems. The most common method is to establish linear junction points between the project manager and the stakeholders on what makes an activity successful.

So what is the problem?

There are two main issues with this kind of thinking:
[1] It is rare for an option on a project to have a linear behavior against its baseline.  
[2] Two or more options on a project are likely to convolute with each and infer a more complex array of possibilities and outcomes.
So where does real options help us?
Firstly, real options helps us because to even entertain a real option is admitting to oneself or accepting the fact that the project may not be binary in nature. That alone is a conscious awakening and simply grouping options, tracking their probability of failure or the risks that drive that failure will make you a better project manager.

There is more to all of this than recording and monitoring risk which is; How do you decide to move towards or away from risk?

The use of Real options helps project managers do three things very well:
  1. Firstly, they allow a project architect to layout a strategy for maximizing return given a specific risk scenario and more than one scenario.
  2. Secondly, it furnishes the project manager with a target value for executing the tactics around the project strategy. Concisely, when should the project manager engage or reject a strategy or choose a different path is shown by the real option price.
  3. Thirdly, real options offer the project stakeholders a set of choices which close the proximity of uncertainty on planned outcomes.

Real options have two key advantages over linear junction points. They separate the project up into two modes of thinking: Operation and Valuation and they also bind these modes together so that one can't exist without the other (separating the two is a major drive for dispute). To be concise, one can't value an option if they don't know when they are going to exercise it, writes Robert McDonald in his Derivatives Market Book.

Any investment project can be viewed as a call option (the project stakeholder is buying into a project), with the investment cost equal to the strike price and the present value of cash flows from the project equivalent to the asset price. This statement alone is profound and connects project finance to structured finance.

The use of real options also addresses scope creep because it assumes a dynamic Net Present Value (NPV). The valuation of many projects are fraught with disgruntled investors and stakeholders because they are planned off NPV estimations. 
"In reality, the realisation of a static estimate is often never captured because the target is so small."
Most importantly, real options allow us to consciously choose to add or take away a specific feature on a project. These actions will constantly move the return on investment from the originally agreed position however, the NPV decision can be calculated using real options to make an effective choice.  
"In a deeper way, Real Options price the Net Present Value of choice and that equates to a good proxy of opportunity cost."
Not only can real options give investors a choice for adding to or talking away from projects, they can also allow us to cost the resolution of these disputes.

The Curse of Disputes
One of the biggest failings of businesses large and small, is in their resolution of disputes.  So often I see win/loose strategies at point of reconciliation which encourage the disputing parties to move away from payout or restitution. 
"People have a tendency to focus on what was originally promised even if the conditions of engagement have changed."
In the realm of banking for example; a good collections department will avoid aggressive collections stances to encourage renegotiation quickly, why is that? 

In short, collections people know that each day of missed payments not only damages the revenue line but encumbers the debt further.  It also deteriorates the counterparties ability to settle as the continual application of interest and charges on the existing debt, erode the clients equity value in the asset [see slide 7 of the presentation].

As a project manager, if you have built a set of options around each stage of delivery, you are able to present a true position to your stakeholder and you are also able to involve them in "the which path do we choose next" type of discussion.

This is all so logical that I fathom to understand why project managers don't approach project planning in this way but then I suppose being able to value an investment option, albeit it wrapped up in a project, is the alchemy of structured finance not project management.

In investment decision making the most common place I see real options being applied, although it often comes under a different name, is when one is dealing with the Chinese. It would seem strange that they are so good at this when Fischer Black and Myron Shcoles are part of the North American realm of applied finance and real options is a derived concept of the American way for valuation.  None the less, Chinese are good buyers when they are presented with a set of options rather than single payouts and I put it down to years of Sun Tzu indoctrination which bases all decisions around strategies of entry, exit and flow.

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