This is the second of a series of quarterly blog posts on the subject of alliance contracting and looks at the painshare and gainshare provisions that are key to a number of alliancing contracts. It examines the payment principles under an alliance contract, looking at the various factors that must be taken into account in agreeing these, such as the respective positions of each party, how these can be aligned and how service providers can be sufficiently incentivised.
Alliance Contracting Principles
The principles underlying alliance contracts include:
- Aligning the interests of all parties involved.
- A no-disputes culture.
- Good faith obligations.
- Joint management structure.
- Transparency of information and costs.
These characteristics are straightforward enough, but how do they become a reality? What drives the contracting parties to sign up to this collaborative culture?
Arguably, the philosophy behind alliance contracting is underpinned by a risk and reward compensation regime. This means that the parties equitably share in the financial “gain” of a project’s success or the financial “pain” of a project’s underachievement. All parties to the contract therefore have a shared interest in the overall success of the project.
This “painshare/gainshare” payment model aims to foster a win:win, lose:lose mind set. All stakeholders win or lose as the case may be. The joint financial incentive for a project to reach clearly defined goals fuels the collective approach central to alliance contracting.
Risk in “traditional” contracts compared with risk in alliance contracts
In a traditional approach to contracting for services, a contract will generally be initiated by a commissioner setting out what it requires. A service provider (or a number of service providers) will then tender its solution and propose a price for delivering it. The final price agreed will be the result of each party’s assessment of the risks involved in achieving the final solution.
In projects where the provision of services is more complicated and the level of risk is difficult to anticipate, service providers typically tend to include a “risk value” in their initial quotes. As a result, many fixed price contracts involve service providers increasing their initial price in order to offset the perceived level of risk.
Alliance contracts aim to address this issue. They are premised upon combining the strengths of each party in order to respond to the complexities of a project. The parties sign up to this arrangement on the basis that they will share the financial impact of the ultimate outcome. The alliance parties therefore have an aligned financial interest in driving a project towards success.
How are payment provisions structured in alliance contracts?
In this type of contract, the price proposed by a service provider for delivering a solution is not part of the commissioner’s selection process. Instead, the idea is that commissioners will choose service providers based on their level of knowledge and expertise. Rather than being paid a fixed price for the provision of services, the parties’ financial rewards depend on the performance of the whole project.
Typical payment provisions in alliance contracts include:
- Reimbursing all of the service provider’s direct costs, on the basis that costs are open and transparent. There is no incentive to cut corners to make a bit of additional profit.
- Contributing to the service provider’s corporate overheads.
- A risk and reward compensation model that rewards the parties based on overall project performance. The better the performance the more money the service provider receives. This is a crucial point in terms of incentivising a service provider.
The alliance members will set performance indicators. These are often agreed outcomes, whether it is delivery of certain standards or delivery on time, and there will be a focus upon the project delivering these defined and overarching goals. Only once these outcomes have been achieved can the alliance members benefit from a financial bonus. The parties to the alliance may set aside funds at the inception of the project in order to reward the alliance parties for exceeding the performance indicators. On the other hand, if the alliance parties do not achieve the pre-agreed outcomes then they will share the financial burden. In so doing it encourages a high performance culture.
By way of example, payment provisions in an alliance contract could look like this:
1 Each service provider accepts that no matter what act, event, circumstance or degree of difficulty is encountered in performing the alliance works, the service provider’s entitlement to payment from the commissioner is limited to:
1.1 Reimbursable costs [actual cost of the work];
1.2 Fee [contribution to the service provider’s overheads and profits];
1.3 Amounts determined by the commissioner under the risk/reward regime;
1.4 Amounts which the commissioner is liable to indemnify the service provider under this agreement; and
1.5 [applicable taxes etc].
The risk and reward regime or painshare/gainshare mechanism used will vary from contract to contract. Often it will involve a percentage split of savings (gain) or overspend (pain) between the commissioner and service provider against, for example, target costs. A 50:50 split of any gain or pain will obviously be the most simple, but frequently parties will provide for more complex arrangements designed to incentivise certain behaviours.
Gainshare mechanisms are frequently included in outsourcing contracts, requiring service providers to provide continuous improvement to effect efficiencies, innovation and/or transformation in relation to services and/or technology. Such changes may potentially reduce the fees payable to the service provider, and are therefore incentivised by the prospect of a share in the financial benefit to the project.
Practical benefits of the painshare/gainshare payment model
An obvious benefit for service providers is that the risks are shared between the alliance parties. This decreased level of risk renders alliance contracts an attractive proposition for service providers, and commissioners should feel the benefit. For example, more service providers may be inclined to tender for projects as a result of shared risk exposure, and commissioners will therefore have a wider choice of parties with whom to form an alliance and a wider pool of expertise to utilise in reaching their ultimate goal.
Potential dangers of shared liability exposure
Despite the clear advantages, parties should be aware of the potential difficulties with alliance contracting. It would appear that this type of agreement is best suited to situations where the service providers are of a similar size. If there is one dominant service provider in an alliance, this may impact upon the impartiality of important decisions. The management of an alliance contract can also become difficult in situations where a large number of parties are involved.
Furthermore, the “painshare” aspect of an alliance contract may act to discourage service providers from full engagement with a project. In a traditional contract, service providers will be exposed to the full extent of the risk. However, in an alliance contract, the consequences of a poor result with be shared amongst the parties to the alliance. This may result in service providers failing to allocate their strongest resources to an alliance contract, choosing instead to designate their best performers to projects with a higher risk exposure.
Commissioners therefore need to ensure that the risk and reward regime includes sufficient “gains” to eradicate potential complacency in service providers as a result of reduced risk.
The next post in this series considers the no-blame/no-fault culture of alliance contracts, in which the parties agree not to litigate if a problem arises.
