Love me tender

The word "tender" is a vicious misnomer in the business context. Bidding for tenders is anything but "tender" - you don't know what price to use; you don't know whether you will win the bid; and you don't know whether you will make money.

Despite these difficulties, there are some companies - a small number, to be sure - that have learned that the only way to sustain margins in such businesses is to build in the full cost of the risk to the bid, and, if successful, to hedge out that risk at once.

The full cost of the risk is, of course, the price of an option to hedge the risk. In most tenders, there is a risk period - between the date of the bid and the date of opening the tender - during which the variable (say, the price of aluminum or copper or USD/INR) may move adversely. An at-the-money option would protect against this risk and provide opportunity gains if the market moved favourably - an ideal solution. Unfortunately, buying an option on the bid date would leave the company open to a cash loss if it lost the bid and the market moved adversely. Rather, it should add the option price to the forward cost for the estimated date of purchase to calculate the bid price.

Note that this is not foolproof - the option price may render the bid too expensive or, worse, the market may move more than the option price and the company could end up winning the bid but losing money. However, that's the occasional reality of the markets. Over a period of time, though, and assuming the business has reasonable margins, building in the option price as the cost of risk will provide both a good hit rate and steady profitability.

Unfortunately, many companies either do not fully understand the risks or, worse, choose to juggle with this formula in making the bid. Often, they are just nervous (less experienced) and feel that the option price does not protect them sufficiently, and so add some correction to it. These companies, unsurprisingly, have a pretty low hit rate.

More often, however, there are pressures from the sales side to reduce the bid price, with sophisticated arguments about negative correlations (between, say, aluminum and USD/INR), market views, and so on to buttress these pressures. While sales are, of course, the main goal, and pricing must respect this, it is important that there is a consistent, transparent process to determine just how much the theoretical price can be reduced.

One idea is to monitor the "over-correction" of lost bids. This is the difference between the bid price and the price on the date the tender is opened. We conducted such an analysis for a client and found that over a six-month period, their average over-correction was 11.1 per cent of the value of the bids lost. Part of this over-correction was because (in these cases) the market moved favourably - in other words, the price fell relative to the bid price - by an average of 1.7 per cent. Of course, the markets could move adversely as well, but even if they did (to the same degree), the over-correction was huge.

We used a safety factor of 50 per cent and set the maximum price reduction that could be permitted at half of the difference between the average over-correction and the average market movement; in this case, it worked out to 4.7 per cent. Again, let's be clear, this will not provide definitive protection - or, for that matter, a definite win. Nonetheless, having a transparent, replicable process that sets limits on pricing reductions makes the bidding process much more accountable.

Of course, making the bid is just the first part. If the bid is won (yay!) and is, say, in the money (double yay!), the treasury should simply hedge out the purchase and add the over-correction to its business margin (as the best companies do). Many companies, however, prefer to stay unhedged and try to manage the risk, but since very few of them have the discipline to avoid market views, this often ends up in tears.

The situation is much more difficult if the won bid is out of the money, or if the business has such excruciatingly tight margins and cannot build the full cost of risk into the bid without decimating their business volumes. Here, it is even more critical that risk management is run with a very tight stop-loss and disciplined hedging.

All in all, there is no one-size-fits-all recipe for tender pricing and risk management. However, staying away from market views and following a simple, transparent set of rules will, over time, enable companies to turn this "tough love" into "love me true".

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jamal@mecklai.com