McKinsey – Why the Customer pays for Risk Reply

In the forthcoming McKinsey Insights article “Avoiding Blindspots in Your Next Joint Venture” the authors point out some of their recent research into the failure of JVs. Further to my previous post about the need to design accurate risk models into a JV/Alliance/PPP, the authors note:

“At the beginning of any JV relationship, parent companies naturally have different risk profiles and appetites for risk, reflecting their unique backgrounds, experiences, and portfolios of initiatives, as well as their different exposures to market risk. Parent companies often neglect this aspect of planning, preferring to avoid conflict with their prospective partners and getting to mutually agreeable terms—even if those terms aren’t best for either the JV or its parents. But left unaddressed, such asymmetries often come to light during launch, expand once operations are under way, and ultimately can undermine the long-term success of the joint venture.

Certainly, some JVs must be rigidly defined to be effective and enforce the right behavior. But when that isn’t the case, JV planners too often leave contingency planning to the lawyers, focusing on legal protection and risk mitigation without the business sense, which shows up in the legalese of the arbitration process and exit provisions. Both tend to be adversarial processes that kick in after problems arise, when in fact contingency planning should just as often focus on the collaborative processes that anticipate changes and create mechanisms or agreements that enable parent companies to adapt with less dysfunction. As the head of strategy for one insurance company noted, “If a JV is set up correctly, particularly regarding governance and restructuring, it should be able to weather most storms between the parents.” Such mechanisms might include, for example, release valves in service-level agreements, partner-performance management, go/no-go triggers, or dynamic value-sharing arrangements and can allow a joint venture to maintain balance in spite of partners’ different or evolving priorities and risks.”

Designing proper risk models need not be adversarial. In the hands of a skilled lawyer or commercial manager it is a sharp and powerful weapon at the negotiating table. This does not mean that the contract is not a win/win deal. On the contrary, insight into the proper and necessary allocation of risk is essential for a win/win deal. Anything else is simply wilful blindness. In fact, a more mathematical approach to risk modelling lays the foundation for a negotiating process that is more inquisitorial rather than adversarial. The primary questions remain: is the management sophisticated enough and does the business have the stomach for it?

Improving Contract Management: manage the deal not the database 1

The guys at Selectica have some great points but to make expensive enterprise software work it’s important to work a system and not to work the software:

  1. Don’t try and put all your contractual information in one single database at once.  Not only do individuals have different ways and systems (what I call the e-Hub of someone’s daily life) from which they manage their data they may also run into legal issues around probity and confidentiality (by cross-contaminating case management with archival material).  Businesses do not need to invest in costly customisation but do need to strike a financial balance between customisation and counter-intuitive vendor processes.  One neat tool is to create  a visual model of the deal (its structures, functions and concepts) and provide hyperlinks to the various file systems.  This removes the need to develop a common taxonomy as workers now have a visual reference point (rather than a word) for their own understanding.
  2. With process automation it is critical to ensure that the business doesn’t  codefy its culture.  This will only calcify bottlenecks.  A firm needs to make sure that it re-engineers its CLM process before it creates a workflow from it.  Remove non-tasks and automate simple clerical work and approvals.
  3. The business also needs to make sure that experts are not only notified but they are also edified  and contextualised.  When pushing workflows out to experts, such as in-house counsel, outside counsel etc then these people must have a clear view of the dependent components of the deal’s architecture.  Businesses can speed this process and reduce its costs by linking their own systems to online legal databases such as Thomson Reuters (Westlaw AU, FirstPoint), Lexis Nexis or CCH.

In summ, good contract management needs a highly cross-functional and multi-disciplinary approach if it is not only to be successful but also if it isn’t going to add additional cost and friction to business operations.  Enterprise products such as Selectica’s are a great start but customers must be careful to make sure that the software supports their own system otherwise they will spend all their money and time working the software.

CONTRACT ACCOUNTING: Squeezing more profit out of in-flight accounts Reply

Most large accounts suffer from the same problem:  The variation between the crazy thing a business promised the customer and the ability to deliver it within profit margins.  In the multi-divisional organisation most departments and teams understand this.  Most senior executives understand the need to win bids versus the need to keep their jobs through sensible estimation and know it is a fine line to tread.

In many cases, the solution to this problem is often not better cost and schedule estimation.  In one global outsourcing company some accounts were run as loss-leaders (although this wasn’t the actual intention).  Had the business actually estimated the cost and schedule properly they would never have been able to deliver the solution with the requisite profit margin.  With this knowledge these projects would have been No-Bids.  Large companies need to build brand equity in various solution sectors (in this case, local government ICT outsourcing).  They can afford to break into the market at a loss and then create profitable new accounts through economies of scale.

There is another solution for larger, multi-divisional accounts.  The architecture of such agreements often aggregates risk premiums.  For instance, each team, unable to account precisely for the value of risk creates a risk ‘slush fund’ within their team’s section of the overall cost model.  In total, the final risk premium may be significant (and even price a business out of a bid).

The solution is a 4-step (4Rs) process:

  1. Re-Model.  First of all, the entire contract needs to be modelled as a single architecture.  Creating a single parametric model can be done in one of two ways.  Firstly, the firm can use the same quantitative factors (here we use financial data) across the model.  The firm may prefer to use quantitative factors multiplied by qualitative coefficients (e.g. the Defense sector).  In this case it is best to use existing models which are statistically correct, such as COSYSMO or COSYSMOR.
  2. Re-Package.  Risk needs to be re-packaged and sold to those who are most capable of dealing with it should it be realised.  This means creating an internal hedge market within the capability community to buys and sell risk.  There is a critical lesson to learn from the current crisis: (a) The financial markets are the most mature in their approach and maturity towards risk, but (b) risk needs to be dealt with operationally.  The lesson is clear.  Financial incentives provide the only means to truly motivate businesses to deal with risk but when it comes to actually performing those contingent actions there must be a realistic plan to do it.  Most risk plans are farcical and do not take into account office politics, organisational structures, technical difficulty, information for decision making and compressed time frames.  So, when selling risk ensure that the buyer has an adequate contingency plan to deal with the risk and is not just paying the highest price.
  3. Reduce.  Once these contingencies have been identified and the risks re-packaged the cost of the overall solution should be significantly lower.  If the risk contingencies are not significant then the main cost reduction should be in insurances to cover indemnities, warranties and general liabilities.
  4. Re-Negotiate.  Once the technical detail is calculated the hardest part is realising the gains.  In order to realise financial gains in an in-flight account the contract, or sections thereof, will most likely need to be renegotiated.  Lawyers are loathe to renegotiate contracts.  Despite the additional fee-earning capacity there are two institutional problems, namely:  (a) it may be seen as an admission of defeat that the initial contract is unsatisfactory, and (b) lawyers do not generally understand the financial maths behind the individual risks in the contract architecture.  However, the best way to renegotiate certain clauses is to (i) got through the sales/operational side of the customer’s business, and (ii) offer them money.  For instance, if the business stands to make 3% on its current margin then it could easily offer 0.25% to cover the legal fees of renegotiation or as a good faith payment.  It will, however, be critical to renegotiate the content with the operational/architectural teams as most lawyers only deal in absolutes (i.e. no liability or uncapped liability).

The difficulty with most accounts is seeing them holistically as an integrated architecture.  Most large deals are seen as separate pieces of a larger jigsaw puzzle.  Instead, it is advantageous to see the deal as a single system; all parts operating synergistically.  Modelling the system parametrically fulfils this goal.  Modelling it within financial parameters, in the manner shown above, empowers all departments and teams to work together to create high-performing accounts.

How Integrated Contract Lifecycle Management Can Reduce Legal Fees 1

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In a recent study by the American Bar 58% of procurement departments noted that they had been involved in purchasing legal services for three or more years.  More than half the respondents were Fortune 1000 companies and about a third were Fortune 100.

Despite this trend most legal work is neither panel-based nor subject to competitive reverse-auction processes.  In fact, back in 2007 McKinsey Quarterly ran an article titled “Inventing the 21st Century Purchasing Organization.”  They noted that businesses had woken up to the cost benefits of strategic sourcing and intelligent supply and management.

It is my prediction that with the massive oversupply of law students and as more lawyers move out of the profession into traditionally non-aligned areas our age will see a large rise in the need for law firms to become highly competitive.

The American Bar reported an interview with the Chief Procurement Officer of a large company.  He stated that “if you know your business, you should know how long something takes and how much something should cost”.  He had worked in the nuclear power industry and thought that building nuclear power plants was a lot more complex than litigation.  Understandable, although I should add that in most industries (Defence excluded) there is no one on the other side conspiring to destroy your plans.  Needless to say, he has a point.  Most law firms track costs but they don’t track work.  They track bills but they don’t track customer value.  Legal work suffers from a dire lack of transparency largely because it doesn’t need to.  In the legal profession it does no one any good to try and commoditise their work.  However, that’s exactly what needs to happen.  In many areas the rise of the paralegal (e.g. conveyancing) has been aimed at increasing profit margin internally rather than increasing customer value externally.

In order to increase customer value to corporate clients law firms must integrate their services with the company’s business lifecyle.  When this occurs the results will likely decrease total legal spending per project but they will likely increase the total number of projects using external legal assistance.  Why?  for the same reason iTunes didn’t decrease the per capita spend of teenagers on music.  Integrate with their life style.  Give them more opportunities to spend.  With a clear idea of the value external counsel can offer on a specific deal or project and the ability to keep the legal spend down it is likely that managers will seek to use that new found power to cover themselves rather than have their own accounts and reputations wear the risk.  The effect on total law firm revenue should be negligible but the effect on law firm structure should be striking.  As the commercial legal sector strives to accommodate the need for increased throughput there will likely be a greater emphasis on workflow and process.

The graph above outlines (in red) the traditional legal spend.  Very high costs being injected at pre-determined points of the business lifecycle.  This does not take into consideration all the costs which are incurred from failed contracts and poor contract management.  The blue graph outlines the standard curve from contract management expenses.  Current contract management professionals are involved earlier in the business lifecycle.  Where problems arise of specialist legal expertise is involved then external counsel are involved.

Gartner note that in 75% of the contracts they review they find hard dollar savings.  As markets develop and try to develop new revenue models through licensing options and new pricing structures it is vital that the operational parts of the business remain up to speed.

Law firms are very important and they are not going away.  The depth of knowledge they provide and the expertise in navigating transactions, deals and disputes cannot be delivered through new software.  The trick, however, is to  maximise the value for money from law firms.  The best way to achieve value for money is to ensure that detailed legal advice or drafting is injected at the precise point of value from the most valuable person and this is where intelligent procurement will have the most impact.

Most importantly, legal advice and transactional support is not operational. There are very few lawyers in very few sectors who have operational awareness let alone operational experience.  This is where professional contract managers can have the most impact.  By detecting risk in the subtleties and complexities of operational and technical minutiae contracts professionals can have a huge impact.  The company is likely to spend less on legals as well as making it a far wiser and effective spend than now.

What does this say about contract management today?  Contract management is by and large an ineffectual and redundant function.  Sandwiched between project management, operations and legal – and adding little value to any of them – one has to ask what the point is?

What does effective, integrated contract management look like?  It would mean that once operational problems were detected and identified then analysed the contract managers would be able to determine the precise level of legal exposure.  This would require the contract management function to be able to analyse financial, operational and technical issues within contracts and assess them for validity, severity and impact (including probability).  The contract managers are then empowered to assist the business to deal with these problems.  This is not the contracts and commercial departments of today.

The contract management function described above requires a variety of monitoring systems:  From the top down, the business needs to analyse cost structures and EBIT for risks before variances arise.   From the bottom up, the CRM systems need to percolate a wide variety of issues which line managers can analyse for veracity, velocity and trend.

Identifying issues as potential contract problems is NOT the job of most line managers.  The contract professional has that job with the assistance of the program manager/account manager but acting together in an integrated business lifecycle a modern contract management function has the ability to reduce risks and legal spend significantly.