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Title: Incentives for cooperative behaviour within supply chain networksin the automotive industry – A positive analysis of a project financeapproach in financing network-specific inventories

Henry Schäfer1 and Sebastian Baumann2

Table of contents

Abstract...................................................................................................................................................2

I. Supply chain networks in the automotive industry ........................................................................3

II. Supply chain networks – A stylised case .........................................................................................3

III. Link between the physical flow of goods and financial level in the supply chain network ............5

IV. Identification of exogenous risks and behavioural risks in supply chain networks ........................7

A. Network exogenous risks..............................................................................................................8

B. Network endogenous risks ...........................................................................................................9

C. Contextual factors determining the level of behavioural uncertainty in supply chain network10

V. Project finance approach in financing network-specific inventories and establishing a temporary

network governance .............................................................................................................................14

VI. Conclusion .....................................................................................................................................20

References ............................................................................................................................................22

1Prof. Dr. Henry Schäfer, University of Stuttgart, Institute of Business Administration,

Department III - Corporate Finance, Keplerstr. 17, D-70174 Stuttgart, Phone: +49 711 685 860 01Fax: +49 711 685 860 09, Email: h.schaefer@bwi.uni-stuttgart.de, Website: http://www.uni-stuttgart.de/finance2

Dr. Sebastian Baumann, Email: sebastianbaumann@gmx.net

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Abstract

The European automobile industry is characterised by dynamic restructuring processes.

Existing business models are permanently subject to changes. Disintegration, modularity,

outsourcing processes and the development of supplier parks are concepts adopted by

modern forms of industry collaboration in the automotive production chain. Tensions of

autonomy vs dependence, competition vs co-operation or stability vs flexibility are inherent in

the established organisational structures, which can be defined as supply chain networks.

Within automotive supply chain networks, parts and components manufacturers, system and

module suppliers, and original equipment manufacturers (OEMs) intensely rely on the

integrative role of logistics service providers (LSPs).

This paper examines the risk structures in automotive supply chain networks, with a focus on

the relationships between system and module suppliers, LSPs and the OEMs within

networks. This paper will argue that the incompleteness of the contractual relationships in

the network and existing asymmetries of information and power are sources of behavioural

risks, which are associated with the network-specific inventories (working capital). LSPs are

increasingly required to take over the ownership of the network-specific inventories and have

to finance the working capital. In this context, the risks associated with the working capital

have become visible and make it difficult to finance these network-specific inventories by

LSPs.

To institutionalise incentives explicitly within the network and to align interests of the network

members, project finance is considered to be an adequate approach. Project finance is

regarded as a financing technique as well as an organisational design which can promote

cooperative behaviour by various elements and procedures. This paper discusses how

incentives incorporated at the financial project level pass through to the project organisation

and affect the behaviour of project participants with respect to the supply chain network. The

resulting incentive structures will be analysed while examining the project finance structures.

In particular, it will be shown how these elements might influence the behaviour of the entire

supply chain network.

The paper will conclude that the project finance approach facilitates cooperative behaviour

between network members. Dynamic industries which permanently reconfigure their

production chains could especially make use of this approach to institutionalise temporary

supply chain networks through more formal project organisations and reduce opportunistic

behaviour.

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I. Supply chain networks in the automotive industry

Automotive supply chain networks with manufacturing processes locally distributed among

legally autonomous companies require a connecting and integrating function (see

Holweg/Miemczyk 2002, p. 175). In this context, logistics services become increasingly

important and take over significant functional responsibilities acting as network integrators. It

becomes evident that logistics takes over network-shaping functions, and provides “stable

flexibility” in supply structures (see Sydow/Möllering 2006, p. 8).

By analysing the services provided by LSPs in automotive supply chains, a successive

extension of the spectrum of logistics services can be recognised (see Zadek 2004, p. 16).

The service bundles provided by LSPs within supply networks are often referred to as

“contract logistics”. Contract logistics differs from standardised logistics services. The

services are specifically designed, integrating several functions and wider responsibilities of

the LSPs and are often founded on an existing long-term relationship between

manufacturers and LSPs. Besides various core logistics services, such as transport and

storage, the service bundles particularly include production-related services, for example,

product pre-assembly. The increasing complexity of the required logistics service within

supply networks reduces the possibility of standardisation. This in turn limits the possibility of

governing the relationship through complete contracts that cover all relevant contingencies

(see Schäfer 1995, p. 534).

In addition to the core logistics services, some services provided by the LSPs have direct

financial impact on the financial layer of the supply chain network. The ownership of

inventories, as well as trade financing (e.g. factoring), are services that might be provided

under the umbrella of contract logistics in the supply chain (see Hofmann 2009, p. 717). The

difficulties arising from the transfer of inventory ownership to the LSPs from a finance

perspective will be considered in more detail in the subsequent section.

II. Supply chain networks – A stylised case

In the context of the automotive industry, the previously described structures can be

characterised as supply chain networks. In particular, the form of cooperation between the

system suppliers, LSPs and the car manufacturer are close, collaborative relationships.

Before we analyse the relationships of the supply chain network in more detail, we introduce

a stylised case that describes an idealised automotive supply chain network. In this case, we

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limit the number of network participants to reduce complexity in further discussion. Figure 1

below outlines the network members and their relationships.

Figure 1: Stylised supply chain network

Further, the analysis will focus on the series-production phase of the automotive product life

cycle. The antecedent product development processes and the subsequent phase of spare

parts supply are characterised by network structures as well, but the network settings vary

between the life cycle phases significantly. The physical manufacturing process and the flow

of materials require different network structures, resulting in different risk profiles. Within the

product life cycle, the configuration of the network in the series-production phase is linked to

the antecedent phase of product development. From an operational perspective, the setting

up of the supply chain network through the “make or buy” decisions and the selection of

suppliers are critical to the strength, vitality and success of the supply chain.

The LSP takes over the responsibility of the security of supply in the manufacturing process

of the network. Besides physical processes (e.g. transportation and storage), the LSP’s

responsibilities include administrative management services, like inventory management,

and planning and procurement services based on the production schedules provided by the

OEM.

In this stylised case, the OEM is responsible for the design of the network and the selection

of suppliers and service providers. The system suppliers are responsible for the availability

and quality of complex modules/systems. Typically, such a network design, with distributed

responsibilities among all involved parties, is characterised by a reciprocal dependence and

low degree of substitutability. A high degree of specialisation of each network participant, the

Parts andcomponentsupplier 1

Automotive supply chain network

Series-production phase

LSP OEMParts andcomponentsupplier n

Moduleand systemsupplier 1

Moduleand systemsupplier n

• Productionplanning

• Networkdesign

• Selection ofsupplier&serviceprovider

• Transportation• Inventory

management• Pre-assembly• Just-in-

sequencedelivery

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need for two-way communication processes (information flow) and integrated supply chain

processes (flow of goods) lead to high interdependence.

The stylised case should serve as a framework in the following discussion to illustrate the

lines of argument.

III. Link between the physical flow of goods and financial level in

the supply chain network

Recent research in the area of supply chain pays increasingly more attention to the financial

aspects and the potential of optimisation (see Timme/Williams-Timme 2000; Hofmann 2005;

Hofmann 2009; Stemmler/Seuring 2003). The financial flow builds the counterpart of the flow

of goods. This means that network structures determine the flow of funds and the levels of

financial resources required within the network. Identifying the connection between financial

and physical flows helps us to understand that disturbances in the flow of goods affect the

financial layer and the financing requirements of network parties as well. Vice versa, the way

of raising finance and likely restrictions in raising capital affect the operational level of the

supply chain network. For example, liquidity problems of a single supplier in the supply chain

network result in a disruption in the flow of goods and affect the entire network.

Analogous to the motives for holding cash, the level of net working capital held by each

network member can be linked to the transaction motive and precautionary motive.

Maintaining reserves can be considered a general approach to managing risks, which

manifest themselves in fluctuations in demand (see Corbett 2001, p. 487; Chopra/Sodhi

2004, p. 54). Thus, financial resources tied up in the net working capital are a risk buffer,

which compensates the volatility in physical flows and cash flows in the supply chain

network.

In the supply chain network, the provision of net working capital (net working capital =

inventories + receivables – payables)3 determines the financing requirements of individual

network members and is a risk management instrument to ease physical and financial flows

in the network. From an individual network member’s perspective, the net working capital

itself is associated with risks. Conflicts in interests across the network and individual

3The paper focuses on the discussion predominantly on inventories (physical working capital) as part of the

working capital. However, we emphasise that especially in this context, the net financial working capital(receivables minus payables) could result in a significant financing requirement, depending on the paymentterms agreed upon within the individual supply relationships. The risks of the financial working capital aredifferent compared with inventories. The counterparty credit risk is the most significant risk associated withtrade receivables.

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interests become obvious. The trade-off between process risks at a network level and

inventory risks at an individual company level illustrates the conflict between network

interests and individual interests. The term process risk refers to risks that relate to the

physical processes (production and logistics) and manifest themselves as process

interruptions. At the financial level, they affect the cash conversion cycles in the supply chain

network and lead to fluctuations in cash flow. In contrast, inventory risks are usually borne by

the temporary owner of the inventories. The risk level of inventories depends on the degree

of specificity. Inventory risks can be split into three drivers: the value of the products,

obsolescence and the demand and supply fluctuations (see Chopra/Sodhi 2004, p. 58).

While the risk of obsolescence is determined by technological aspects, supply and demand

fluctuations are, to a large extent, driven by upstream and downstream companies in the

supply chain. The recoverability of inventories is determined by the fungibility of the

products, which in turn is not only heavily dependent on the specificity of the inventories, but

is also determined by quality characteristics of individual product components. Thus, the

inventory risk is also influenced by upstream and downstream network companies.

Net working capital and inventories are often objects of negotiation in the supply chain

network. In a conflict of interests within the network, the interests and objective of individual

supply chain network members are to reduce their individual net working capital

requirements and the tied-up capital. Individual network members cutting back inventory

levels to reduce financing requirements is one option to optimise the situation from an

individual perspective, but it increases the vulnerability of the physical supply process. The

alternative option, the transfer of net working capital to other network member firms, is an

individual reaction that minimises the financial requirements from the perspective of the

individual company, while containing an acceptable level of process risk. The transfer of net

working capital and the associated risk and financing requirements between upstream and

downstream members in the network are possible due to the different levels of negotiation

power among the network members (see Jüttner et al 2003, p. 198; Maloni/Benton 2000, p.

50).

As already outlined, the LSP is more and more integrated in the sense of an active network

manager. With the increase of responsibilities of LSPs within the supply chain network, it is

understandable that OEMs and system suppliers will try to transfer inventories to a certain

extent to LSPs as well (see Stenzel 2003, p. 145; Hofmann 2009, p. 724).

The transfer of ownership of network-specific inventories to an LSP is only possible if the

financing can be arranged. But without additional precautions, the financial viability of the

transfer of net working capital and the specific risks remain in question. To assess the

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financial feasibility, a detailed analysis of the risks associated with the specific inventories in

the supply chain network is essential. Therefore, this should be carried out in the next

section. We will focus on the situation of ownership transfer of network-specific inventories to

the LSP and analyse related problems in the network.

IV. Identification of exogenous risks and behavioural risks in

supply chain networks

The roles and relationships of the individual companies within the network can be structured

and analysed by means of the principal-agent theory. Endogenous risks arise in the context

of highly specific delegation relationships between network members. These could be

analysed by assuming a bilateral interaction similar to a principal-agent relationship (e.g.

supplier as agent and the OEM as principal). Principal-agent problems are caused by two

elements – firstly, an existing conflict of interests due to divergent goals between principal

and agent, and secondly, an asymmetric distribution of information (see Eisenhardt 1989, p.

58). In such a delegation relationship, the outcome for the principal is dependent on the

characteristics and/or behaviour of the agents (e.g. the suppliers’ capabilities, effort and

diligence in producing parts for the OEM). Thus, behavioural risks, which are analysed by

applying the principal-agent theory framework, are network-endogenous risks because these

risks emerge within the network and imply dependencies between network members. In

contrast, exogenous risks, cannot be influenced by network members and originate outside

of the network.

Figure 2 below illustrates the definition in the context of the stylised case. For example,

market risks can be described as exogenous as well as endogenous risks. The OEM could

partly influence the market risk relating to the end product through marketing activities. For

example, sales can increase or demand fluctuations can be smoothed by sales or pricing

strategies. On the other hand, the commodity price risk, which impacts the network from the

supplier side, is predominantly characterised by an exogenous nature due to the market

structure. It is not possible to influence this risk.

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Figure 2: Risk areas in the automotive network

Within the network, the transmission of risks can be facilitated and the level of risks can be

intensified by the behaviour of individual network members. In the context of supply chain

management, a frequently analysed and discussed phenomenon is described as the

“bullwhip” effect (see Lee et al 1997). This effect could be characterised as partly

endogenous and partly exogenous, i.e. the behaviour in the supply chain amplifies the

impact of demand fluctuations. The bullwhip effect is a combination of stochastic exogenous

risks and behavioural reactions of individual supply chain members.

A. Network exogenous risks

Risks emerging outside the reference system, which affect the entire supply chain network,

can be regarded as non-influenceable by network participants. For instance, market price

risks are, to a large extent, non-influenceable when the respective market is sufficiently

competitive. In the context of global supply chain networks, in particular currency, interest

rate and commodity price risks matter, which can cause fluctuations in the financial flows

without an appropriate financial risk management (see Schäfer/Frank 2006, p. 448). Price

risks which arise in (complete) markets either directly or indirectly affect individual

businesses in the network. Market risks emerging in either end-product markets or

commodity markets can be relevant for the entire network.

The consideration of exogenous risks is also important for the assessment of behavioural

risks. The principal-agent problem occurs only in presence of exogenous risks. In observing

Module and systemsupplier 1

Module and systemsupplier n

LSP OEM

Endogenous risks

Partly exogenous and endogenous risks

Exogenous risks

exogenous causes:e.g. enconomicrisk, currency risks

Commoditymarket risks

Parts and componentsupplier 1

Automotive supply chain network

Parts and componentsupplier n

Marketrisk

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outcomes in a delegation relationship, insofar that these are observable, the principal is not

able to conclude to what extent the result is caused by the agent’s individual behaviour or by

other exogenous factors.

B. Network endogenous risks

The majority of theoretical models analyses behavioural risks considering explicit formal

contractual relationships. In the context of supply chain networks, it could be argued that

relational contracts could also form the basis of the relationships. These intentionally

incomplete contract relationships, which are a combination of formal contracts with implicit

norms of behaviour, should provide higher flexibility for adjusting to a changing environment.

Therefore, opportunistic behaviour in the context of relational contracts relates to the breach

of implicit norms of behaviour (see Wathne/Heide 2000, p. 40). Four types of such

behaviour-related risks can occur.

1. The risk of adverse selection in the supply chain network could appear in the

configuration of the project network. Only after the network has started its operation

will the true capabilities of the network partners be revealed. In the selection process

of the network partners, certain information about the capabilities of individual

network members is important (see Zsidisin/Ellram 2003, p. 16).

2. After closing of the contract, the risk of moral hazard may occur in different forms in

supply chain networks. The flow of information is important for coordination in the

supply chain, but has an inherent problem of hidden information. Transparency – in

terms of providing information in the network among all network members – is

necessary to promote the agility of the network and eliminate inefficiencies. The

deliberate miscommunication and disruption of the information flow (cheating) with

regard to expected demand and information about stock levels can become a

problem. OEMs are able to indirectly build up “buffer stocks” at their supplier level to

avoid shortages of supply. Such a miscommunication may partly be in response to

difficulties encountered in the past in terms of timely delivery. To avoid process

interruptions, higher demands could be communicated deliberately.

3. Another form of moral hazard is caused by hidden action of the network members,

which negatively influences the entire network. For example, the use of

malfunctioning parts or the reduction of material qualities might cause a brand and

image damage throughout the life cycle of a series, and any necessary recalls and

the associated cost of exchanging defective parts may reduce the profitability of the

entire network. Also, process interruptions caused by negligent behaviour of

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individual network members can have negative consequences for the entire network

(see Chopra/Sodhi 2004, p. 54). This results in fluctuations in the inventory levels,

and as the cash conversion cycle is affected, the process interruption translates into

increased fluctuation in cash flows as well. This in turn can cause significant liquidity

problems.

4. The risk of hold-up primarily depends on the specificity of investments made

unilaterally. One-sided, specific investments create unilateral dependence (see

Schäfer 2004, p. 266). For instance, a supplier might be exposed to a hold-up in

annual renegotiations due to its very specific production facilities, which can hardly

be used in other supply relationships. The OEM might insist on a price reduction by

threatening to not renew the contract (see Hallikas/Virolainen 2004, p. 51).

An important difference between the two risk categories (endogenous and exogenous) that

needs to be considered relates to the instruments and approaches which are available to

mitigate these risks. In contrast to exogenous risks, endogenous risks are not marketable

and, therefore, cannot be hedged through market-traded financial instruments (see Froot et

al 1993, p. 1650). This means that individual network participants are not able to hedge their

network cash flow against idiosyncratic risks. As discussed earlier, fluctuations in financial

flows (cash flow) and the associated financing requirements (net working capital) in supply

chain networks occur due to the connectedness of cash flows and physical flows of goods.

Additional financing costs or opportunity costs occur under the assumption that the

fluctuations caused by behavioural risks in the network need to be compensated either by

raising additional external debt (e.g. through an increase in the available working capital

facilities) or by limiting the flexibility of undertaking other advantageous investments. In

addition, the behavioural risks manifest themselves in the value of network-specific assets

(physical working capital). Their value is determined directly through qualitative properties,

which are due to the complementary nature of services and product components influenced

by other network parties. The value is indirectly driven by the convertibility of these assets

into cash, which in turn depends on the existence and persistence of the specific network.

C. Contextual factors determining the level of behavioural

uncertainty in supply chain network

In the above section, we analysed types and characteristics of behavioural risks

(endogenous risks) within network relationships in the automotive industry and their financial

impact. In the following section, reasons for the existence of behavioural risks in the network

should be analysed in more detail. The determining factors identified here are related to the

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stylised case and focus on logistics services within the supply chain network and its impact

on the financeability of the working capital.

The importance of inventories for the entire network has already been discussed earlier. The

LSP which is intended to take over the ownership of these network-specific resources and

which should guarantee the availability of required parts and components in the

manufacturing process in the network is exposed to the process risk as well as the inventory

risk, which could be affected by opportunistic behaviour of all other network participants.

Unconsciously or consciously, distorted supply and demand information from upstream and

downstream network members might cause unnecessarily high inventory levels, which

require additional financing. At the same time, the entire network is exposed to the risk of

insufficient stock levels that might cause interruption in the production processes, when the

owner of these network-specific stocks tries to improve its profits through inventory

reduction.

With reference to the net working capital to be financed by an LSP in the stylised case

presented earlier and by considering contextual factors that promote behavioural

uncertainty, the following assessment of the risk-determining factors can be made. Here, the

determinants from the perspective of the inventory owner and also from the perspective of

the remaining network participants are analysed.

The types of factors and their assessment are summarised in Table 1. It also indicates how

much the company which owns inventories is exposed to opportunistic behaviour of the

network participants. In particular, the nature of these provided services, which depends on

the integration of two external factors – the physical assets (flow of goods) and the flow of

information – increases the risks of adverse selection and moral hazard. The high degree of

plasticity and the knowledge and information asymmetry with respect to upstream and

downstream processes and technologies increase behavioural uncertainty. Furthermore,

due to the specificity of the provided logistics services, one-sided dependency manifests

itself in the network and, thus, raises the risk of hold-up for the LSP.

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Perspective

Factorsthat intensifybehavioural risks

Inventory owner – LSP Remaining network participants

Exogenous risk

Demand and supplyfluctuations

Supply shortages caused by suppliersand fluctuations in demand on the

customer side are partly exogenous.Thus, clear conclusions on the

behaviour of the remaining networkparticipants are not possible.

Supply shortages can be caused bythe inventory owner through

negligence. Exogenous risks limit theability to make judgements on effort

levels.

Conflict of interests

Independent corporateobjectives

Major objective: Reduction in inventorylevels to reduce financing

requirements.

Major objective: High availabilityprovided by inventory owners of the

complementary parts and componentsto ensure a smooth manufacturing

process in the network.

Plasticity

Service-related input factors(management resources,

tangible/intangible externalfactors)

Manipulation of information aboutdemand (“Cheating”) as an intangibleexternal factor can lead to excessive

inventory levels to ensure securitysupply.

Parts and components as externalfactors are, in general, less plastic, butthere exists the risk of hidden quality

reductions.

Management resources required tomanage inventory are plastic.

Observability

Autonomy reducesobservability and increases

information asymmetries

Behaviour of the network companiescannot be observed directly.

Behaviour of the inventory ownercannot be observed directly.

Interdependence

Mutual behaviouraldependencies in connection

with exogenous risk

The network’s outcome is dependent on the behaviour of all network actors.Additionally, network-exogenous factors affect the outcome. Conclusions about

actual behaviour can be difficult.

Knowledge

Specialisation of networkmembers increases the

degree of knowledgeasymmetries

The inventory owner can evaluate thebusiness processes and technologiesused by other network companies andidentify critical factors only to a limited

extent.

The OEM has specific know-howregarding the entire product

architecture, supply companies only inrespect of their affiliated supplier

network.

Specificity

Ex ante idiosyncraticinvestments

Bundle of services customised to thenetwork as well as inventories havehigh degree of network specificity.

Network processes and interfaceshave sunk costs character, but

compared to capital tied up in specificinventories, the amount is relatively

low.

Reputation Reputation depends on the transaction history in a specific case. Because of theinnovative character of this form of cooperation, reputation is low.

Power imbalances Taking over the ownership of networkinventories results in asymmetry of

power due to the specificity.

Some companies have a strongerposition in terms of power than othersin the network. For instance, the OEM

is able to control market access orsome system suppliers control critical

resources.

Table 1: Summary of the factors that intensify behavioural uncertainty with reference to thesituation of inventory transfer to the LSP in the automotive supply chain network

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In the stylised supply network, the risk of opportunistic behaviour is higher than in market-

based transactions (e.g. commodity markets). Thus, to stabilise the expectations of the

participants involved in the network, from a risk-management perspective, incentive-

compatible institutions and mechanisms of control become important.

The problem and the need for “network governance”, which has a stabilising effect on the

entire network to reduce endogenous risks, were also identified by Straubhaar/Theurl (2005,

p. 48): “(...) various kinds of information asymmetries regarding the partners’ characteristics

and behaviour that might endanger the inner structure of the cooperation. (...) the

establishment of stabilizing mechanisms is crucial.” In scientific theory any form of

organisation is regarded as an approach to deal with the uncertainty and associated risk

behaviours. However, in the context of this work, we emphasise the view that any form of

cooperation is characterised by behavioural risks. “(...) ‘industrial partnership’, like any other

form of cooperative action, is of course vulnerable to opportunistic behaviour by any one of

the ‘partners’” (Friedberg/Neuville 1999, p. 67).

Because of information asymmetry and incompleteness of contractual arrangements within

the supply chain network, additional mechanisms to stabilise cooperation relationships

become important, which enable the coordination of activities and allow for the resolution of

conflicts in the network.

The institutionalisation of a network in a centralised form of governance is another way to

increase the stability of the network: “(...) the presence of private governments (or

‘authorities’ as distinct from ‘hierarchies’) as a core element in the architecture of hybrid

organizations (...). One major characteristic of these devices is that they pair the autonomy

of partners with the transfer of subclasses of decisions to a distinct entity in charge of

coordinating their action” (Menard 2004, p. 366). The project financing approach may be

regarded as such a centralised network institution, which is characterised by a formal

contractual structure and, in addition, is empowered through providing access to financial

resources.

In the light of the behavioural risk associated with the working capital, in particular, the

network-specific inventories, the question arises as to how the companies can finance their

operations when they are embedded in such supply networks and to what extent could

network-specific financing structures in the form of project finance arrangement facilitate

both the provision of financial resources and the formation of institutional arrangements that

stabilise behavioural expectations within the network.

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V. Project finance approach in financing network-specific

inventories and establishing a temporary network governance

In contrast to the traditional corporate finance approach, which builds upon the corporate

portfolio of assets and associated risks, the project financing approach focuses on a specific

single asset, which is embedded in a transactional relationship with various parties (e.g.

suppliers, offtaker and operator).

In setting up project financing arrangements, organisational elements also become

important. In view of the separate and legally independent nature of the project company,

which is financed in the ideal case without rights of recourse to the sponsors (equity

providers or shareholders), the main task in setting up project financing arrangements is

implementing organisational and contractual arrangements that result in stable and

predictable cash flows available to capital providers. Particularly, cash flows available for

debt services and for appropriate dividend payments to the equity providers need to be

secured.

Lenders rely on the cash-flow generated by the collateral (“cash flow-based”) and/or on the

value of the project assets (“asset-based”) as the source of repayment and as security for

the loan. In the context of the specific inventories, the use of the assets as collateral is

limited because of the high specificity of the network assets, as there are no secondary

markets in which these assets can be liquidated if there is a default. The future cash flows

are the main sources of repayment. In the context of the supply network, the stabilisation of

cash flows means that the flow of funds and the cash conversion cycles within the network

need to be maintained by appropriate institutions that foster predictability of network

behaviour and project cash flows as well.

The project company takes over a central position in the supply chain network. It becomes

the central counterparty, which means that cash flows induced by operational supply and

service contracts are directed to the central project company.

The cash flow directed to the project company is influenced by various risks which we have

already discussed earlier in this paper, and which could either have an endogenous or

exogenous source. With reference to these two risk categories, particular institutions are

established to identify, control and reduce them in project financing arrangements.

Figure 3 below presents the project financing structure and illustrates the role of the project

company in the supply network.

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Figure 3: Project finance approach in the automotive supply chain network

The neutrality of the project company is advantageous for the principal-agent relationship in

the supply chain network, especially because the capital providers of the project company do

not have a conflict of interest with the network as a whole. The dominating interest is not

influenced by one network participant in particular. To secure the repayment of the

outstanding loans, they have an interest in continuing network operations and going

concern of the network, which is not overruled by other interests.

In the context of supply chain networks, it is possible through the central positioning of the

project company to establish incentive and control mechanisms for the entire network in

aligning the individual interests of the network members. In contrast, when financing is

provided in the form of traditional corporate financing approaches, individual network

members might dominate the interests of others. As the project finance approach focuses on

the transaction relationships in the network, the capital providers themselves become part of

the network and get the opportunity to analyse the risk structures in the underlying business

processes and build up network-specific knowledge.

The primary organisational design elements in project financing are contractual

arrangements and, therefore, the project financing is often referred to as “contract finance”.

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To establish appropriate incentive structures to reduce risk in the project company, a

selective integration of network members as equity providers is possible. Therefore, we see

that project financing is more than just a financing technique; it also constitutes an

organisational design for the network, which is only made possible through these special

financial arrangements.

The following discussion of procedural and structural elements of the project financing in the

context of network structures is conceptual in nature. We will outline the main elements of

project financing arrangement and their positive effects on the supply chain network.

Baumann (2008, p. 146) provides a comprehensive discussion of the theoretical foundations

that support the argumentation outlined in this paper.

Reduction of information asymmetry ex ante

Information asymmetry ex ante, i.e. before any contracts are closed, exists among the

network participants at an operational level as well as between the network as a whole and

the capital providers. Three procedural elements of the project financing approach reduce

this information asymmetry and, thus, mitigate the risk of adverse selection.

1. Reduction of knowledge asymmetries: Financial intermediaries (particularly outside

investors) themselves become part of the network. More than in traditional corporate finance

approaches, capital providers have to acquire sufficient knowledge to take over in the

structuring phase; also in the subsequent operational phase or in default/restructuring

situations, they play an active role. The knowledge is necessary to properly process

information and interpret data and information in decision-making processes (see Baumann

2008, p. 162). The analysis of the stylised case shows that the lenders’ knowledge about

industry models, critical success factors and risk structures of the automotive and logistics

sector is important during both the design and operational phase of the network.

Intermediaries with significant experience in project financing of either production facilities in

the automotive industry or logistics asset might be well positioned to transfer existing

knowledge into this related area of application.

2. Direct acquisition of information (see Stiglitz 2000, p. 1452): The intense project

analysis, including prefeasibility and feasibility studies, technical, commercial and legal

project appraisals prepared by third parties (see Yescombe 2002) in the planning and

structuring phase primarily reduce information asymmetries between the network companies

and capital providers (see Baumann 2008, p. 159). The autonomy of the network members

(LSPs, OEMs and suppliers) limits the access to information, if not disclosed voluntarily. The

financial intermediary has a stronger position to force network members to disclose

17

information ex ante, because he provides a significant proportion of financial resources and

may refuse to grant loans.

3. Self-selection (see Stiglitz 2000, p. 1452): With respect to contractual relationships at

the operational level in the network, the influence of intermediaries is comparable to a

screening mechanism4 and leads to the separation of a pooled market. The lenders make

their capital provision dependent on the fulfilment of certain terms and conditions

(“conditions precedent”), which include contractual risk sharing among the various

stakeholders in the network. The allocation of risk in a particular area of responsibility is

established through various contracts supply, operation, and purchase agreements. For

example, in requesting special contract clauses, for instance, performance guarantees or

minimum offtake obligations, risks can be allocated within the network. The provision of

financial resources by the lenders linked to certain contractual structures form an offer of a

project finance arrangement which the network may choose. The effect is comparable to a

screening mechanism. Project members will only accept risks if they have the capability to

manage them or if they have better information to assess the allocated risk as less

significant. Through the risk allocation process, when the project participants accept the risk

ownership, information about the capabilities of project participants or about the level of risks

is revealed. In addition, the financeability as a “standalone” project basically signals its

viability to all project participants (see Baumann 2008, p. 163).

Reduction of behavioural uncertainty ex post

To mitigate the behavioural uncertainty ex post, i.e. after the contracts are in force, in project

financing arrangements procedural and structural elements work together. The risk of moral

hazard as a type of behavioural uncertainty, which is based on an information asymmetry in

connection with conflicts of interests, is reduced by the following elements.

1. Active monitoring: Debt and equity providers engaged in the project financing of the

supply chain network take over the role of an “active monitor”5. As a result of the central

position of the project company, which concentrates the flow of goods and the financial flows

in the supply network, endogenous and exogenous risks affecting the financial level become

transparent more quickly. The incentive to undertake active monitoring results from the risks

4Under the signalling approach, the better-informed party (agent) takes the initiative to reveal information,

while screening is initiated by the less-informed party (the principal) to disclose additional information (seeMilgrom/Roberts 1992, p. 154; Stiglitz 2000, p. 1452).5

The distinction between active and passive (speculative) monitoring refers to Tirole (2006, p. 27). Activemonitoring has a prospective and active character and the monitor intends to influence the corporate strategyand to implement decisions based on the gathered information. In contrast, passive (speculative) monitoring isperformed in retrospective, which relates primarily to activities in the past. The information obtained can becharacterised generally as a value-neutral.

18

of project loan in connection with its illiquidity. Because of the limited availability of

secondary markets for highly specific loans and a high concentration of debt provider, the

liquidity of the project finance loan is relatively low. Moreover, because the loan is not fully

secured by the collateral (the network-specific inventories) and the value of the collateral can

be influenced by the behaviour of network participants, the incentive to actively monitor the

network increases (see Baumann 2008, p. 170).

2. Influence and sanctions: Taking over an “active” role through monitoring requires the

possibility to control, which is given in the case of equity due to the decision rights assigned.

However, often the decision rights of the equity holder can only be exercised under certain

constraints to mitigate the conflict between equity and debt provider. The lenders protect

themselves by contractual clauses established in the loan agreement (“covenant”) and

enforce their rights to control the project company in any event that might deteriorate their

position and the recoverability of the project loan. Particularly, to increase the credibility of

the sanctions, certain precautionary measures in the event of a default are established.

Thus, safeguards that result in an increase in default costs for the network and allow for a

liquidation of the loan without losses can be established. The examples are compensation

payments, guarantees and put options in case of early termination of the project by default.

In the event of a default, there is also a possibility to gather additional information and

promote the reduction of asymmetric information ex post, as the analysis of causes is

necessary to make the most favourable decision regarding the continuation (with or without

restructuring) or liquidation (see Baumann 2008, p. 175).

3. High leverage: A high level of debt reduces the “free cash flow” within the network

and, thus, also reduces the operational discretion of the project participants in relation to the

project company. For instance, supply network disruptions impact the cash flow of the

project company and may cause problems to service debt. The resulting negative effects of

a high level of debt – e.g. the underinvestment problem (see Stulz 1990), asset substitution

problem (see Myers 1977), the costs of financial distress (see Myers 1984; Wruck 1990) –

can be mitigated by the “standalone” character and by adopting contractual arrangements

that limit discretion of network participants (see Baumann 2008, p. 198).

4. Concentrated ownership: Renegotiation situations with the debt holders, including the

network participants, are likely to occur. Thus, the choice of a highly concentrated debt

ownership structure is favourable due to the reduced costs of renegotiation. This also

establishes an incentive to engage in active monitoring. In addition, free-rider problems in

monitoring activities are reduced (see Baumann 2008, p. 216). The concentration of equity

ownership is often stipulated by debt providers. On the one hand, equity acts as collateral,

19

and on the other hand, the concentrated equity owner has a greater incentive to monitor the

network (see Baumann 2008, p. 213). In the supply chain network, a high concentration of

both equity and debt provider is favourable and supports the effectiveness of the network

governance established with the project company.

5. Equity ownership: Considering the operational network structures, the further

integration of certain network participants as equity providers to the project company can

contribute to an alignment of the interests in the network. Through the higher capital

investment, the individual network member internalises the costs of its own behaviour in

case of opportunistic actions. The possible conflict between the shareholders in “joint

ownership” structures can be mitigated by increasing transparency, monitoring and limiting

the scope of discretion. In particular, if some network members like the OEM or the LSP

have significant influence on the financial performance of the project company (e.g. through

the accuracy of demand forecasts or the effort in managing the network logistics), equity

participation is an appropriate instrument to align interests (see Baumann 2008, p. 220).

6. Covenants: Integrating performance metrics in financial contracts as covenants can

establish an early warning system, indicating problems or misbehaviour of individual network

members. Furthermore, in the event of non-compliance with covenants (technical default),

the lenders can enforce control rights that are defined in the project loan agreement. Those

control rights give lenders, in terms of active monitoring, the possibility to sanction and to

influence. In addition, the covenants limit flexibility directly through prescribing exact

investment and operational policies. Any material activities which are beyond the discretion

defined in the contracts require an agreement with the lenders (see Baumann 2008, p. 234).

Mitigating the hold-up risk

In the third area of behavioural conflicts, the hold-up, which can occur in renegotiation

between the lenders and the network as well as among different network members, the

following elements are important.

1. Event of a default: The hold-up, which means the obvious failure to comply with

explicit or implicit rules in the network (e.g. price reduction or increases, refusal to deliver or

offtake), inevitably causes the default of the project company by the breach of covenants or

liquidity shortages due to the high leverage. Through the precautionary measures put in

place by the lender, which allow the liquidation of the project loan in the event of a default,

without dramatic losses, the sanction becomes credible (see Baumann 2008, p. 179).

20

2. Equity ownership: Partial equity ownership can be interpreted as a credible signal

that the particular party does not exploit its bargaining power ex post (see Baumann 2008, p.

228 and p. 256). Network members that have a strong bargaining power in negotiations, like

the OEM in the supply chain network, might put equity at stake to signal their cooperative

behaviour.

It is important to recognise that the procedural and structural elements of the project

financing approach have a complementary effect in the network.

However, positive effects are not the only results of project financing structures. In addition

to higher administrative costs associated with the setting up of the network, the collateral as

security against the project loan inherits tension. Through a fully secured project loan, the

lenders achieve a better negotiating position in the network, because in case of any

irregularities they will have the opportunity to terminate and liquidate the project early. But in

turn, through a fully secured loan, the incentive to carry out intensive monitoring activities is

reduced. Assuming that the value of the collateral cannot be influenced by the network

members, the incentive to monitor can completely disappear. The effect which is desirable

cannot be determined in general. In practice, the problem is far less important because a

complete collateralisation of debt is often not possible and, therefore, monitoring procedures

need to be established. In this context, debt agreements including covenants are important

as these also create information obligations for project participants and information rights of

the lender.

VI. Conclusion

The risk structures in the stylised study case, in which the transfer of inventory ownership to

the LSP was considered, raised concerns that due to the LSP exposure to behavioural risks

in the supply network, the LSP might not be able to accept this role without appropriate

safeguards and without network governance that protects its vulnerable position in the

network. Because of these risk structures, raising finance to fund this new business venture

from the perspective of the LSP is difficult. Project financing arrangement to finance network-

specific working capital of the supply chain network was discussed and regarded as an

instrument to institutionalise network governance that aligns interests of the supplier, the

OEM and the LSPs and promotes cooperative behaviour.

The active role of financial intermediaries (debt provider), who engage in the early phase of

the project as “network designers” and later in a sense as “network supervisor”, could have

21

been illustrated in the discussion of procedural elements that are associated with the role of

the lenders in project financing arrangements. Because of the major objective to establish

the networks as a viable “standalone” business, the lenders require a powerful security

package that includes operational contracts, which allocate risks (endogenous and

exogenous) between network members effectively. The dominating interest of the debt

providers is to maintain steady operations in the supply network through the entire period of

the loan repayment, which is in line with the network’s interest. Through the financing

structures, the discretion of the network participants will be reduced and diverging interests

will become aligned. The intended integration of individual network participants as risk

owners, either directly through equity participation or through the provision of collateral, is a

central element, which can reduce imbalances of power and risk ownership in the supply

chain. In the operating phase, the monitoring function in combination with extensive control

rights and possibilities of sanctions build elements of network governance, which

incorporates incentives for cooperative behaviour and which can cope with behavioural risks

that arise in the network.

22

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