May 2014


A two-envelope approach for improving procurement

By Mauro Chiesa

Shareholders today are looking for lower risk and higher dividend yields and do not appreciate hearing of cost overruns. Currently we are in a buyers’ market, and to make the most of it, the mining company must stick to a procurement strategy that better shares the risk with suppliers and controls costs.

An effective way to achieve this dual objective is through a “two-envelope” approach, where suppliers bidding on a contract are required to submit technical bids separately from financial bids. On the bid-opening day, the technical envelopes are opened first to ensure that only bids that satisfy all the desired technical specifications are considered. Then the financial terms corresponding only to the clean technical bids are opened to guarantee that the buyer can compare “apples to apples.”

Too often, bidders offer perks like hockey tickets, vacations, addenda or modifications in order to secure supply contracts. Some potential bidders stay out of the process if they feel others have bought the deal, thus defeating the competitive process. By announcing the two-envelope process well in advance, a mining company adds a degree of legitimacy and transparency that should attract a broader response and lower prices. Though relatively simple, the overall process requires forethought and planning to evoke the broadest response on both the technical requirements and financial considerations. The bidder sees lost procurement bids as a costly process, so transparency and objectivity are essential for justifying the pursuit.

The first step one must take is to complete an expression of interest call. This is basically the broad delineation of the buyer’s eventual needs. Equipment procurement is relatively straightforward, but acquiring an engineering, procurement and construction management (EPCM) role is much more complex. It may help if the buyer outlines the eventual two-envelope process so as to reduce the perceived process risk.

Once the buying company sees the responses to the expression of interest, it can then define the required qualifications. Again, while simpler for off-the-shelf equipment, the issues are more complex if one is looking for an EPCM. In such cases, the capacities required and the risk matrix become more complex, and any early feedback becomes invaluable. The buyer should also stipulate the remaining process with clarity and then follow with a question-and-answer session to obtain clarifications from potential bidders. The buyer should then announce the bidders that have met the criteria.

At this point, the buyer can put out its call for bids and/or proposals with detailed technical and financial specifications. It should also include a process memorandum that lays out the remaining two-envelope process in detail. For complex projects, the process is as important as the product being procured, as the transaction costs incurred by all bidders are not small. An opaque process is difficult to price and therefore easy to avoid.

There are a number of components regarding the request for bids/proposal stage. They can include bidders’ conferences, where all comments and questions on the specifications are addressed, and answers are distributed to everyone. In a changing market, the feedback may suggest altering the specifications or the risk matrix itself. If the technical or bid-process alterations are numerous, the buyer can host a final bidders’ conference to make sure that all issues have been answered and distributed. In a situation where staple financing is requested from the bidders, the financiers may also wish to attend to ensure that all terms and conditions are fully understood.

As part of the request for the bids/proposals phase, the buyer should also clarify its transaction closing process, the role of bid-performance bonds, and its appellate process for any bidder that feels it was not treated or reviewed fairly. Should there be funding issues including staple financing from the winning bidder, ample time should be granted as the closing requirements tend to be more complex. This too is appreciated in today’s market, as supplier financing is often in debt form and can offer leverage for the equity markets.

In summary, the two-envelope process assures fair treatment to all bidders and thus offers feedback from the broadest response base possible on the technical specifications. It then evokes the best price for those technical specifications. Both of these objectives should allow the CFO and the project manager greater funding leeway in meeting any project’s budget objective.

Mauro Chiesa has 33 years of experience in financing and advising extractive and infrastructure projects, including multinational banks in New York, the World Bank Group in Washington, D.C. and EDC in Ottawa. . He will be chairing a session at CIM 2014's Management and Finance Day.




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