Construction Risk or Operating Risk: Which Is Being Bought

Construction risk belongs to a thing that has not been built yet: it may land late, it may cost more than the budget allowed, and it may not perform to its specification. Operating risk belongs to a thing that already works and may simply earn less than anyone expected. One question sorts them. Does the thing being bought have a trading record, or only a plan? The answer selects the whole diligence exercise.

What actually separates construction risk from operating risk?

A household on one salary decides to add a room on the roof. The household agrees a price with a builder, hands over the first instalment, and waits. For the next several months money goes out and nothing at all comes back: no rent, no tenant, not even a room. Every problem in that stretch, a delay in the monsoon, a rise in the price of cement, a wall that has to come down and go up again, is paid for out of the same salary that was already stretched thin. The room is a promise the household is funding.

Now take the household on the next street, buying a small shop instead. The shop has been trading on that street for nine years. Money went out once, on the day of purchase. From the following morning money comes in. The takings may come in less than the seller suggested they would, and that is the whole of the worry, but something is coming in from the first day, and there is a book of what has been coming in for nine years.

The two households have bought risks that differ in kind, not merely in size. The first has bought a plan. The second has bought a record. Every serious question worth asking about either purchase follows from that one difference, and asking the second household's questions of the first is how a careful person ends up with a thorough answer to the wrong question.

Construction riskThe chance that something still being built lands late, costs more than the budget set aside, or does not work the way its design said it would. is the first household's risk, scaled up. Something is being made that does not yet exist. Money is committed against a drawing, a budget and a date. Nothing else exists to look at, so the only evidence anybody can look at is evidence about the making. Operating riskThe chance that a business which is already working earns less than expected, because volume, price or cost move against it. is the second household's risk. The thing exists, it is producing, and the only question is whether what it produced last year is a fair guide to what it produces next year.

The test that sorts them is small enough to carry around. Does the thing being bought have a trading recordThe history of what a business actually sold, spent and earned over past periods, taken from its own accounts rather than from a forecast., or does it have a plan? A record is a statement about the past that somebody can check. The future has not happened yet, so a plan is a statement about the future that nobody can check. The gap between a record and a plan is not a small difference in confidence. The gap is a difference in what kind of evidence exists at all.

Why is construction risk different in kind rather than just larger?

There is a property of a build that has no counterpart in a working business, and it is worth stating on its own before anything else. During construction there is no revenue at all, so every problem has to be funded from outside rather than absorbed from inside. A working business that has a bad quarter absorbs it: the cash that arrives is smaller, but cash arrives. A build that has a bad quarter has nothing coming in, so it cannot absorb anything. Somebody has to write another cheque.

Take Tapti Crossing Infrastructure Private Limited, an invented single-asset road company formed to build and then operate one crossing, with no other business at all. Its project cost is Rs 1,800 crore, funded Rs 1,260 crore of debt and Rs 540 crore of equity, a 70 to 30 structure. Check the split before reading on: Rs 1,260 crore plus Rs 540 crore is Rs 1,800 crore, and Rs 1,260 crore over Rs 1,800 crore is 70.0 per cent. Until the crossing opens, nothing exists for anybody to pay for, so every rupee of that Rs 1,800 crore is spent before a single rupee of revenue arrives.

The absence of revenue is where a cost overrunMoney spent above what the budget set aside, so somebody has to find the difference before the work can be finished. bites in a way it never bites in a trading business. If the build costs more than Rs 1,800 crore, the extra cannot come out of this year's takings. There are none. The extra comes from a sponsor putting in more equity, or from a lender agreeing to advance more, or from the work stopping. Three doors exist and no more, and two of them require somebody else to say yes.

Delay does the same thing from a different angle. A month of delay does not merely push the opening back by a month. A month of delay adds a month of cost with no revenue against it, and pushes back the first day of every year of earnings that follows. Cost without revenue and a first day that keeps moving are why completionIn a build, the point at which the asset is finished, tested and handed over to whoever will run it. On a transaction, the separate day on which the purchase actually takes effect. is the pivot of the whole exercise on an asset under construction, and why a purchase of one is written around it.

The third question is the quietest and often the most expensive. Even a build that finishes on time and on budget can finish wrong. The specificationThe written statement of what a built asset must do and to what standard, against which it is tested before anyone accepts it. is the written statement of what the thing must actually do, and the gap between an asset that exists and an asset that performs to its specification is where a buyer finds out whether anybody wrote a testing regime into the paper. A crossing that opens but carries less than it was designed for has finished, in a sense that satisfies nobody.

Is operating risk the smaller risk, or only the more measurable one?

Most people asked which of the two sounds more frightening pick construction risk, and they usually pick it for the wrong reason. Construction risk feels larger because it is harder to see. Operating risk feels smaller because a working business hands over numbers. Operating risk is not the smaller risk, it is the more measurable one, and treating measurable as small is how a buyer underprices exactly the risk it can see.

Consider what a record actually gives. Sundarban Polymers Private Limited, an invented unlisted maker of flexible packaging films that Harivansh Packaging Limited is buying, reports revenue of Rs 880 crore and earnings before interest, tax, depreciation and amortisation (EBITDA) of Rs 132 crore. Divided out, the margin is 15.0 per cent, and that is a fact about a year that happened, taken from accounts that exist. The cost base that produced it can be read line by line, and each line traced to whoever signed it off.

Now notice what none of that settles. The margin does not settle whether next year repeats it. The record does not settle whether the customers who bought last year buy again, at the same volume, at the same price. Nor does the record settle whether the cost of the input film holds. The record measures the risk beautifully and reduces it not at all. A shop with nine years of daily takings can still lose the office block across the road that produced half of them, and the nine years of takings will not have said a word about it in advance.

The mistake has a practical shape. A buyer looks at a business with a long, steady record, concludes that the risk is small because the numbers are tight, and pays a price that only works if the record repeats. The tightness of the numbers was evidence about measurement, not about outcome. Ramp-upThe stretch after an asset first starts working, during which output climbs towards the level it was designed for. risk is the same error wearing a different hat: an asset that has just started operating produces numbers too, and the numbers say almost nothing.

When is each risk live, and can both be live at once?

In most assets the two run in sequence, and the join between them is the day the thing opens. Construction risk is live from the first instalment to handover, and then it is finished. Operating risk starts at handover and never finishes for as long as the asset is held. Drawn as a line, it is one band followed by another band, with a single marker where they meet.

Running in sequence is the ordinary case, and if it were the only case the distinction would be tidy and not very useful. Two situations break the sequence, and they are exactly where the distinction earns its keep.

The first is an operating business that is building something. A packaging maker with eleven working lines that is putting up a twelfth carries both risks at the same moment, on different parts of itself. The eleven lines carry operating risk: they are producing, and the question is whether they keep producing. The twelfth line carries construction risk: it is not producing, and the question is whether it finishes. Neither exercise answers the other, so a buyer of that business is buying two risks in one purchase and has to price and diligence them separately. The household version is a shop that stays open on the ground floor while a first floor is being added above it. The takings are real, the first floor is a promise, and both belong to the same owner.

The second is an asset that has only just opened. The thing exists and is producing, so operating risk is technically live. The record is still too short to answer anything at all about it. A restaurant that opened last month is operating. Its four weeks of takings describe four weeks, one of which had a festival in it. During ramp-up, output is climbing towards a level nobody has yet observed, and a buyer who treats the first months as a record is reading a number that is not yet a number. A newly opened asset is the case where a person can look at real figures and still be looking at a plan.

What evidence answers each risk, and does either set answer the other?

Evidence is the practical half of the subject. Evidence decides what a buyer actually pays somebody to go and look at. Construction risk is answered by four things: the contracts, the budget, the schedule, and somebody independent confirming progress against the second and the third. None of those is a financial statement. All of them are documents about a process that is still running.

Operating risk is answered by two things: the trading record, and whether the conditions that produced it still hold. The record is the accounts, read down to the line level and back over enough periods that a pattern is visible rather than a single year. The conditions are everything the accounts do not show: which customers, on what contracts, at what renewal dates, against which competitors, with what input prices.

The two sets are different documents, read by different people, and neither answers the other question even slightly. A quantity surveyor's report that a build is on schedule says nothing whatever about whether the finished asset will earn its plan. Three years of audited trading says nothing about whether a wall gets built. Put an operating diligence team on an asset under construction and they will produce a careful, well presented report about nothing.

The consequence is that the first question is not one of the questions on the list. The first question selects the list. Get it wrong and every hour after it is spent well on the wrong exercise. An hour spent well on the wrong exercise is a much harder failure to notice than an hour spent badly.

Who bears each risk, and how is that decided?

Here the two part company completely, and the difference has a consequence a buyer can act on rather than merely note.

Construction risk is allocated. Risk allocationDeciding, in the wording of an agreement, which party carries a particular thing going wrong and pays for it when it does. means somebody wrote down, in an agreement, who carries a cost overrun and up to what amount, who carries a delay and what it costs them, and who is responsible if the asset does not meet its specification. How those structures are drafted, priced and enforced belongs to project finance. One property of an allocation matters for the distinction: the risk can be moved, and if the paper moved it, it has moved.

Operating risk cannot be moved. There is nobody to move it to. If the customers of an acquired business buy less next year, no counterparty has agreed to make that good. A counterparty who agreed to make that good would in effect be buying the business. So construction risk can be handed to somebody else, and operating risk can only be priced. That is the whole of the difference in one line, and it is the line that changes what a buyer does with each.

Watch what follows from it. On construction risk, the allocation determines whether the risk is really the buyer's at all, so a buyer's first move is to read it. On operating risk, no allocation exists to read, so the buyer's first move is to decide what the risk is worth and put it in the price. Two different first moves, from one difference in whether a thing is transferable.

The neat version overstates it, and one honest qualification is owed. Allocated does not mean vanished. A risk handed to a builder comes back if the builder cannot pay. Who is building therefore sits on the list, and a buyer looks at what that party has actually built before. The allocation converts a construction risk into a question about a counterparty. A counterparty question is different and usually smaller, but it is not nothing.

What does each risk do to the conditions and the timetable?

Two purchases can be struck at the same price and still look nothing alike, and this section is where that becomes visible. The reason is that the risk decides what the conditions are about and who controls the calendar.

An asset under construction brings conditions about completion, testing and handover. The transaction is written around a thing that has to happen physically before anybody can sensibly own it, and the paper has to say what counts as finished, who says so, and what happens if the answer is not yet. The calendar is then set by the build. Nobody in the transaction controls it. A wet month does.

An operating asset brings conditions about consents and approvals: the permissions that have to be obtained and the counterparties who have to agree that their contracts may change hands. Whoever grants those sets the calendar, and that is a different kind of uncertainty altogether. The delay is not physical but administrative, and it usually has a route somebody can follow and chase.

Two purchases at the same price, one of a build and one of a working business, produce transactions with different conditions, different documents and different people waiting on different things. A word of warning on vocabulary, because completion is used here in two senses. In a build, completion means the asset is finished and handed over. On a transaction, completion is the day the purchase actually takes effect, the last of the milestones that runs approach and confidentiality, indicative offer and term sheet, confirmatory diligence, documentation, signing, the conditions period, completion. On a purchase of an asset under construction the two meanings sit in the same room and have to be kept apart in the drafting. Keeping two meanings of one word apart is precisely the sort of thing that gets missed.

Any approval regime's own requirements are set by the regulator.

Which risk is this purchase buying, and how would that be known?

Harivansh Packaging Limited, a listed maker of rigid and flexible packaging, is buying Sundarban Polymers Private Limited, an unlisted maker of flexible packaging films. Nobody has to say which risk that purchase carries. The answer can be read off the target in one step.

Sundarban Polymers reports revenue of Rs 880 crore and EBITDA of Rs 132 crore. Divide: Rs 132 crore over Rs 880 crore is 15.0 per cent. Harivansh Packaging runs exactly that margin on its own Rs 3,180 crore of revenue and Rs 477 crore of EBITDA. The acquirer's pair divides the same way: Rs 477 crore over Rs 3,180 crore is also 15.0 per cent. Two businesses, same margin, and neither figure is doing any work in the risk question. The work is done by something plainer: both of those numbers exist at all.

Revenue of Rs 880 crore is not a projection. The figure records a thing that happened, in a year that closed, in accounts that the buyer's advisers can take apart. A trading record is exactly that. The asset exists, it is producing, and it was producing before anybody proposed to buy it. So this purchase carries operating risk and no construction risk at all, and saying that plainly is what tells the transaction team which diligence to commission and which conditions to expect.

The same thing shows from the price side. The transaction values Sundarban Polymers at an enterprise value of Rs 1,320 crore, or 10.0 times its Rs 132 crore of EBITDA. Check it: Rs 1,320 crore over Rs 132 crore is 10.0. The multiple needed something in order to exist at all, and the requirement is the point. A multiple needs an EBITDA to be struck against, and an EBITDA that actually occurred. A multiple cannot be struck on a business that has not yet earned anything. An asset under construction is therefore valued in a completely different way. Enterprise value is not the amount the sellers receive, and the bridge from enterprise value to what is actually paid belongs to the equity value bridge.

Sundarban Polymers has no build. The company has a record instead. The other half of the distinction lives in a business that genuinely carries construction risk, and that business is kept entirely separate.

Where does the other half of the distinction actually live?

Tapti Crossing Infrastructure Private Limited stands entirely separate from the packaging transaction above, and it carries a project rather than a purchase. The company has one asset, no other business, and no recourse beyond the project itself. Tapti Crossing was formed to construct a crossing and then to run it, and that order is the point.

Its project cost is Rs 1,800 crore, funded Rs 1,260 crore of debt and Rs 540 crore of equity, the 70 to 30 structure already checked above. All of it is spent before anything opens. Once it is open, it expects revenue of Rs 310 crore against operating cost of Rs 62 crore. Recompute the EBITDA rather than reading it: Rs 310 crore less Rs 62 crore is Rs 248 crore. The margin looks wrong at first sight, so recompute it: Rs 248 crore over Rs 310 crore is 80.0 per cent.

Eighty per cent. On the packaging side, 15.0 per cent was a perfectly respectable margin for a business turning film into packaging. A crossing that has already been built has almost no cost of production, so 80.0 per cent is unremarkable. The whole cost went in before it opened. An 80.0 per cent margin and a 15.0 per cent margin are both entirely ordinary in their own business. A margin quoted without its business is therefore not a fact at all.

Put the two side by side and the distinction is complete. Sundarban Polymers has a record and no build. Tapti Crossing has a build and, until it opens, no record whatsoever. The buyer of the first asks one question: does Rs 132 crore of EBITDA continue? The funder of the second asks a question that has to be answered first: does Rs 1,800 crore turn into a working crossing? Only after that does anybody get to ask whether Rs 248 crore arrives.

One thing is worth stating plainly. Sundarban Polymers and Tapti Crossing are two different businesses carrying two different risks. No figure attaching to one describes the other. Rs 880 crore is packaging revenue and nothing else. Rs 1,800 crore is a road project cost and nothing else. Reading a number across from one to the other would be inventing a fact about a business that never had it.

How does a lender, an analyst or a transaction team use this?

Start with the transaction team. The distinction does its most immediate work there. Ashwin Rege, who leads the transaction team at Harivansh Packaging Limited, has a budget for advisers and a number of weeks. The first question sets both. Because Sundarban Polymers has a record, the money goes on reading that record: three years of trading line by line, customer concentration, the working capital cycle, the margin and what moves it, and which consents have to come across. Nothing exists for a quantity surveyor to survey, so not one rupee goes on one.

Devyani Kulkarni, chief financial officer of Harivansh Packaging Limited, reads the same distinction one level up, in what it means for the cash. The asset was already producing, so an operating purchase starts contributing from the day after completion. A build contributes nothing until it opens, so the funding has to carry both the purchase and the whole construction period. The two are different funding conversations, and a finance officer who assumed the first while buying the second would run out of room part way through the build.

A lender reads it as the difference between lending against a history and lending against a plan. Lending against a history means underwriting whether something that happened continues. Lending against a plan means underwriting whether something that has never happened will happen. The paperwork around a build is heavier for that reason: much of it substitutes for the record nobody can produce. Notice the household version of the same instinct. A bank will lend against a shop with nine years of takings on terms it will not offer against a shop that is still being fitted out, and nobody finds that surprising.

An analyst on the outside uses the distinction to read what a company has actually told the market. A company announcing the purchase of an operating business has bought a record and can be asked what happens to the record. A company announcing that it is building something has bought a plan and should be asked when it opens and what happens if it does not. The two sets of questions are different, and an analyst who asks the second set about the first sounds thorough and learns nothing. Disclosure requirements on a listed acquirer, and their timing, are set by the market regulator.

What do the two risks have in common?

More than a comparison tends to leave behind. Both are risks to the same cash, and both end up in the same one number that somebody has to be willing to pay. Both are somebody's problem from the day of completion onwards, whichever party that somebody turns out to be. And in both cases the honest position at the end of the exercise is that the arithmetic can be checked by anybody and the outcome cannot.

The difference is only, and entirely, whether the thing exists yet. Existence decides what evidence is available. The evidence decides what diligence is worth commissioning. The diligence decides what the conditions are about and who controls the calendar. The conditions decide whether the risk can be handed to somebody else or has to be carried in the price. One question at the top, and everything else falls out underneath it.

So when an asset is handed over, the multiple is not the place to start. The shortest question comes first. Does it have a record, or does it have a plan?