A question I regularly find myself answering with our clients, both new and established, is “should we rebuild an existing financial model” [or refine an existing model to take into account updated transaction structure, environmental and or market circumstances]. If you acknowledge the potentially huge impact of Model Risk or value process efficiency and third party perception the answer is a resounding YES YES YES.
When should you rebuild a transaction model?
I think that you should rebuild an existing model if you can say yes to any of the following questions.
- Will it satisfy the needs of all stakeholders (equity, project financiers, owners, government etc) for the current stage in the transaction / model life cycle?
- Is mere satisfaction of requirements an acceptable outcome or does this need to “sell” the upcoming transaction / investment decision.
- Will it meet the needs of stakeholders in a timely manner, if this is negotiation of a key contract or financing structure, then can it be worked upon in a live deal situation? Can the term sheet covenants (such as the DSCR, LLCR or PLCR) be appropriately calculated and reported against?
- Has the model been designed and initially constructed with the upcoming purpose in mind? For example if this is the sizing of debt using an LLCR sculpting algorithm and this hasn’t been considered yet then probably not.
- Can it be readily audited or at least checked by a fresh pair of eyes and the results relied upon within a reasonable level of confidence? If the financial model accuracy is IRR +/- 2.00% but a decision is being made based on an IRR of 17.81% being clear of a hurdle rate of 17.50% then this is a real issue.
- Can only one person operate the financial model in a rapid and reliable manner and communicate the results to a wider audience?
- Has a Model Audit quote come back surprisingly high due to the model structure?
- Has the model got a history of not being consistent, reliable, errors being uncovered when all involved thought it was making sense?
There are clearly many factors to consider when deciding whether to rebuild a model. A typical transaction or investment decision involves many different stakeholders, each with very different requirements at different phases within the project lifecycle. Further to this facility limits and equity investments are rarely not tens of millions if not hundreds of millions of dollars – so investing in a decent financial model can pay off often within minutes!
The risks of not rebuilding your financial model
Not addressing these considerations appropriately will always result in a frustrating and inefficient process after which the model is often rebuilt anyway! My opinion is that a model should always be rebuilt, when it will be used for a purpose other than that which it was designed for. When combined with detailed and dynamic reconciliation this approach has not yet failed to deliver a smooth outcome for our clients so I strongly recommend it.