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Risk tightrope
Russell Webster

Russell Webster

Criminal Justice & substance misuse expert and author of this blog.

Dealing with Revenue Risk in Payment by Results

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I’m delighted to host a short series of posts by Richard Butler and his colleague Holger Westphely from Aylesbury Partnerships on managing risk in payment by results contracts.

 

Managing risk

The focus of this series is on managing revenue risk, raising investment and leveraging management information systems.

The aim is to introduce a few helpful methods and tools that can help in a changing contracting environment; our focus is on PbR but is equally relevant to many other developments in commissioning.

I came to the Social Investment Sector, like an increasing volume of individuals, following a previous career as an investment analyst and have spent the last 5 years working with Social Organisations delivering public services. I was first introduced to PbR, its benefits and headaches, whilst working as interim Finance Director in the first year at 3SC and in the last 5 years we have seen a raft of developments that will ensure that it can’t be ignored by any organisation working in the public sector.

Since 3SC I have set up Aylesbury Partnerships with Holger Westphely, who will also contribute to this series. Our mission at AP is to ensure that the organisations best placed to deliver impact are contracted rather than necessarily those with the strongest balance sheet.

Whilst it remains to be seen whether the financial sector will learn its own lessons in risk to avoid a repeat of its mistakes, it is worth borrowing a few of its tried and tested tools and using them to develop the social sector in an increasingly risky contracting environment.

We will cover the different perspectives on risk of commissioners, investors and delivery organisations and highlight potential opportunities for the voluntary sector to capitalise on its strengths to compete with the private sector for contracts.

Three questions to ask about PbR risk

A big push by government to embrace PbR has led to it becoming a much discussed topic for debate and an area that few organisations delivering public sector contracts can afford to ignore. I will explore some of the key issues through the following 3 questions:

  1. Why do organisations need to improve their understanding of PbR contract risk?
  2. What can organisations do to effectively manage PbR contract risk?
  3. What needs to happen at the sector level to ensure that SMEs, Social Enterprises and Charities are able to deal with PbR risk?

This week’s post focuses on improving understanding of contract risk.

Before getting into any detail its worth defining our perspective on risk.

Having spent the majority of my career in asset management I generally come to social investment from an investor’s perspective.

When we talk about risk, we are primarily interested in its impact on returns. The most obvious risk particular to PbR contracts is revenue uncertainty. More generally the risks we talk about will have a high likelihood (or volatility) and a medium to high impact on a risk register. They could be described as day-to-day business risks, whose management forms part of your core business processes.

 

Risk tightrope

 

Why do organisations need to improve their understanding of PbR contract risk?

Grayling’s recent announcement on probation means that PbR is at the forefront of man minds working in criminal justice.

Even before this it was reasonably familiar with 30% of probation contracts since 2003 including an element of PbR, not to mention the pilots in Doncaster and Peterborough.

Whilst PbR is potentially subject to explosive growth there has been limited progress in building skillsets and infrastructure that would empower smaller organisations to participate in such contracts on their own terms.

There are 3 key reasons why an organisation needs better understanding of risk.

The most obvious is that if your business is becoming more risky then you need to be able to determine whether you are likely to be toppled over.

Secondly as contracts become more risky there is greater need to share that risk and you’ll need to know what you are passing on and who is best placed to take it on.

Finally if you take on additional risk in a contract you’ll need to make sure that the revenue is commensurate with the risk.

 A PbR contract places greater risk on the delivery organisations than a traditional service contract, as the expected revenue amount is uncertain.

Therefore it is crucial to understand how and whether your organisation can cope with the risk that it is assuming – that much is obvious.

However the hard part is to quantify that uncertainty and communicate it to others: vital when raising capital and convincing commissioners.

More risk = complex partnerships

The increased level of risk also forces organisations to work together, whether that is within consortia, sub-contracting relationships or financing arrangements.

That adds complexity, making it harder to fully assess the different potential outcomes.

A transparent allocation of risk between stakeholders is vital to successful and sustainable contract delivery. It should force partners to align incentives, preventing exploitation of smaller organisations. As well as improving relationships with partners and investors, any improved understanding can improve leverage in commissioner negotiations where possible.

Commissioners, investors and trustees need to manage their specific risk exposures in a PbR contract.

Including quantitative measures of risk in regular communications with them is a powerful tool to help manage those crucial relationships. It demonstrates a deep understanding of contract risk and inspires confidence that delivery is well-managed.

Finally you’ll need to be sure that the amount you are being paid is reasonable given the risk you are taking on.

As a former city analyst, I could get carried away with models for pricing risk but since the city has spectacularly proved, they don’t always work.

However common sense, and your auditor, will tell you that certain contract risks will require extra reserves and those extra reserves will have to be funded so you’ll need to make sure that this is priced into you contract.

Final word

So hopefully you’ll agree with us that the public sector commissioning world is becoming a riskier place and it makes sense to understand that risk but let’s end on a more positive note.

‘Risk’ can sound like a very dry subject but all it’s about is getting a better sense of the underlying dynamics at play in a contract and being able to communicate them, which can only improve your ability to deliver and compete.

We see an increasing plethora of data available and tools that can cheaply help you navigate and analyse it with a couple of laptops and a bit of innovation.

Hopefully in the coming blogs we can suggest a few ideas and we’re always happy to chat!

 

Visit us at www.aylesburypartnerships.com

Follow us on Twitter: @AylesburyRisk

 

Related posts you might like:

Complexity and transparency: Thoughts on the MoJ Straw Man Payment Mechanism

It’s great to be able to engage in the development of the MoJ’s proposed payment mechanism. However, the first thing that struck me was its complexity. Clearly a great effort has been made to design a mechanism that creates the right incentives to develop innovative ways to reduce reoffending. Will it be sufficiently transparent to stimulate the wide range of providers needed achieve real innovation or does it favour those with the deepest pockets, who can afford to do the detailed analysis necessary to truly understand the risks inherent in such rehabilitation contracts?

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6 Responses

  1. From a layman’s point of view your opening post seems like a conclusive argument against PbR in the public sector regardless of the huge quantity of other evidence that it drives the wrong kind of behaviour in these very complex and risky environments, and simply doesn’t work.

    1. Some issues in my mind regarding the MoJ’s Transforming Rehabilitation consultation:

      1. All PBR creates a lag in getting back costs. Covering this cash-flow deficit in the first years of a PBR project needs to be considered if the government wants a varied economy of providers rather than a small pool of larger commercial organisations who can take the risks. If the government wants to meet the ambition described in the consultation then PBR schemes have to achieve volume which is also necessary to measure the statistical significance of the reoffending reduction. This means the cash-flow deficit for most PBR schemes will amount to £ millions. Even larger organisations may find they have limited investment (because their lenders may see this as riskier [both in terms of reputation and delivery risk] than most other investments). Further thought on incentivising PBR is needed alongside options to off-set cash-flow deficits to ensure a level playing field of organisations involved in PBR service solutions.

      2. In advance of the PBR market competitions all organisations need to seriously consider their hunger to get into PBR schemes. This is prudent planning and something the government needs to listen to or risk a lack of investment into the Transforming Rehabilitation plans. Shifting risk onto the shoulders of providers who may not have: a) the credentials to deliver, b) the cash-flow to meet the lag between costs and income, and c) the experience to manage the data to prove their delivery, needs careful thought. To effectively compete for the full array of future business opportunities all investors/providers should consider now:
      • how much appetite they have for PBR principles/mechanisms – how many (if any) schemes can they realistically afford to take on?
      • what arrangements (Special Purpose Vehicles) they may wish to arrange to manage the risks?
      • which partners in the commercial, public or voluntary sector should work together locally under what terms of reference?
      • and, what degree of risk are they wanting to take on for what contract gain? – this includes a legal opinion if they can in fact introduce such PBR risks.
      It would seem sensible to offer legal and development support to do this.

      3. What lessons have been taken from the PBR-like process introduced at the DWP regarding the Work Programme which requires sustained/1 year proof of access into employment before full payment is made to agencies. Many of the large prime organisations and nearly all of the smaller voluntary/charitable organisations in supply chains have struggled to make this payment mechanism work? The smaller organisations may not been protected in cash-flow terms with regard to the PBR risks and some have had to withdraw. Similar arrangements in CJS should be avoided and arrangements put in place to improve delivery and supply-chain protection.

      4. It is most likely PBR will be applied in the main to reoffending rate reduction. This makes a) resettlement from prison a natural target for PBR mechanisms, and b) compliance with community orders equally a likely area to focus on. Both would places Probation Trust offender management skills in high demand in such projects to deliver rehabilitation. What is the governments view on this to enable effect use of skilled staff in the SPVs and other vehicles created. Would it be sensible to especially support Probation Trusts to take part in forming stand alone SPVs which can take transfer of staff and effectively compete in the PBR market with clear water between the residual role of higher risk offenders?

      5. PBR is essentially about contract risk assessment. A rate of reoffending reduction is chosen against a historical baseline or a control group. What is the government’s preferred method and is the statistical data available to allow accurate counterfactuals?

      6. One of the main risks in PBR is setting the ambition right. Commissioners want a significant change, providers need to be clear their service model and interventions will deliver the agreed target which should be based on prudence, evidence and ‘what works’ interventions. Is there a clear library of evidence which can be accessed to assist in scheme design to given assurances on delivery? Also if schemes do not deliver what is the sanction process to stop them and recommission?

      7. Measuring the agreed (offending reduction) PBR change has to be done with very defined metrics. Most reoffending reduction is based on a binary metric which simply means not being convicted of an offence within 1 year of leaving prison. If reoffending does not happen then payment is made at a set unit rate for the extra offenders who do not reoffend against the baseline/control numbers. Payment is made approximately 18 months after success of non-reoffending based on court statistics (via PNC data proxy). Metrics can be based on frequency or severity of offending reduction but this is not as preferred by the MoJ, however this metric can show distance travelled by the offender. Is a binary method the only real metric that will be acceptable?

      8. It is important that the structure of all PBR schemes is inclusive of the whole cohort of offenders it is seeking to work with to reduce offending. Anything less opens the possibility of ‘cherry-picking’ entrants into a service to create success whilst actually not dealing with the offenders with the greatest needs who offend the most. Is this a principle the government will adopt?

      1. LW
        Thanks very much for taking the time to comment in such a helpful way. I think you summarise the main challenges of the Justice PbR model very accurately.

        I’m particularly interested in the mainstream community interventions contracts where I think new providers will find it very difficult to improve substantially on current re-offending rates – although they may be able to compete on price.

        Thanks for your interest.

      2. Dear LW,

        Thank you very much for your considered response. You raise a number of very good points, many of which we are planning to address in subsequent blog posts. For now I would like to share a few thoughts directly in response to your comment.

        1. While the government has shown commitment to stimulating the social investment market to address short-term cash-flow issues in the voluntary sector (Results Fund, Investment and Contract Readiness Fund), other moves have gone in the opposite direction (likely contract size for probation services >£10m?), putting in question the commitment to creating a level playing field. If PbR is to take off at the scales indicated, a lot more capital needs to be attracted into this market to fill in the cash-flow hole you talk about. Apart from large corporate primes, only a handful of voluntary organisations are likely to be able to attract investment (as in the Peterborough pilot). Unless smaller players can articulate a convincing investment case they are likely to have to rely on subcontracting with corporates arrangements to take part in service delivery.

        2. Some support is available from independent providers (click here for a list from the Cabinet Office) that is mostly aimed at social organisations. Most notably there is grant funding available to social ventures (which includes “businesses delivering social value”) for contract readiness support through the Investment and Contract Readiness Fund. We would like to encourage our readers to send us any additional relevant links that we can publish here. Finally, as a support provider ourselves, we welcome any enquiries (http://www.aylesburypartnerships.com).

        3. I understand that less of the risk will be passed to providers on probation contracts, compared to the DWP Work Programme which is almost 100% PbR. We will see when the details emerge. Nonetheless if exploitation by prime contractors, some of whom have passed on much of the risk to smaller organisations in the Work Programme, is not addressed, subcontractors need to look hard at their contract terms and refuse to sign agreements that leave them exposed.

        4. This is a really important point. Probation Trusts must be allowed to contribute to PbR delivery in the areas they will no longer be responsible for in a statutory capacity. I hope a suitable and fair mechanism can be found.

        5. The fact that interventions will be tendered nationwide means that finding meaningful control groups is hard and unfair (why should some offenders benefit and not others?). This leaves the historical baseline method that cannot account for outside factors that affect the whole country (economic and demographic developments, changes in police practice etc.). Providers will inevitably be taking on a lot of these risks that they have no control over – a clear weakness in the commissioning process.

        6. There is an inherent paradox in PbR contracting: It is supposed to stimulate innovation and reward the most cost-effective interventions over time. At the same time it is used as a short-term cost-saving measure and cannot afford to fail. The implementation will inevitably compromise between the fundamental principles and the current politics. My belief is that over time a robust process based on suitable measures will evolve, helped in part by the availability of cheaper and better data capture and analysis tools, resulting in significant public service improvements.

        7. My sense is that we absolutely have to move to more sophisticated measures over time if we want to create the right incentives and stimulate innovation that really works. I would be disappointed to see the binary method prevail, especially in the long-term.

        8. Cherry-picking is a real threat to the credibility of PbR contracting as a whole. Suitable mechanisms to prevent or punish the practice need to form part of any contract to ensure the original goals can be achieved.

        Holger Westphely

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