Shifting the Risk

ohn Ortego, director of the Agriculture Department's National Finance Center (NFC), may have figured out a way to get a new software system to handle the payroll for nearly 500,000 federal employees without spending a penny up front. Ortego estimates it would cost him $30 million to $45 million to buy and install a system using a traditional acquisition. Instead, Ortego plans to use what he calls "share-in-success" contracting to entice a large software company to put up the money for the new software in return for a fee for each person successfully paid with it.

It's a risky venture. Ortego, who still is working out the legal and contractual aspects of his idea, concedes that over time he may pay the vendor far more than had he bought the system outright. But that doesn't bother him. "If they share in the risk, they should make a handsome profit," Ortego says. "If it doesn't work, they get nothing. They'll only be paid upon the success of our joint venture."

Ortego expects to be able to afford the vendor's fees by using the contract to expand his payroll business. He plans to offer the winning firm additional financial incentives to bring in new NFC payroll customers. In addition, he anticipates saving money by using a system that runs more efficiently-with less manual intervention-and needs less maintenance than his current mainframe-based system. "There are definitely going to be labor efficiencies under the new system," Ortego says. He hopes the expanded business will help him avoid staffing cuts.

In addition to sharing the potential benefits of the deal, Ortego and his private partner will share the costs should it fail. "If they can't make it work, they walk away with a major loss to their reputation and we walk away wounded," says Ortego. But unlike many large federal information technology projects, if this one fails, the cost won't be borne by NFC, its agency customers or taxpayers. "I [will have] suffered a major defeat, but I [will not have] asked my client to pay for that defeat," says Ortego.

Variously known as share-in-savings, shared-savings, value-based, transaction-based and shared-benefits contracting, the risk-sharing method calls on vendors to cover the up-front funding of a project in return for the promise of a share of the savings or additional benefits that result. Acquisition reformers would like to see it spread governmentwide. "In addition to reducing costs and relieving government [of] capital funding expenditures or major investments, share-in-savings acquisition has significant potential both to improve the performance of agency programs and to bring in new technology and new methods of doing business," says an April report by Acquisition Solutions Inc., a Chantilly, Va., consulting firm.

But the shared-savings approach is a seismic cultural shift away from the way agencies traditionally have bought services: by closely specifying the how and what of each contract and paying contractors to enact their plans. Agencies slowly are moving toward performance-based contracting-specifying only results, leaving companies free to devise how they achieve them, closely measuring performance, and basing rewards on meeting outcome goals. By adding incentives for performance exceeding what's expected and penalties for falling short, agencies are shifting even more risk to vendors.

But shared-savings deals go even further by reserving payment until the contractor produces tangible results. Ken Buck, special assistant to the commissioner of the General Services Administration's Federal Technology Service (FTS), calls the share-in-savings approach the epitome of performance-based contracting. "You get no reward unless you perform," Buck told an April forum sponsored by the Bethesda, Md., chapter of the Armed Forces Communications and Electronics Association (AFCEA). Buck is FTS' shared-savings evangelist, scouring agencies for projects to test how the approach works for information technology procurements. Among the candidates are two Defense Department data network consolidations intended to improve efficiency, thereby producing savings from which vendors would be paid.

Overcoming Mistrust

Demonstration projects are sorely needed if government buyers and vendors are to be persuaded to take the risks inherent in innovative incentive contracts. "Share-in-savings has had a hard time getting going because of not having good examples and [because of] some lack of faith," says Robert Woods, who heads the government sector solutions group of Affiliated Computer Systems Inc. (ACS), a technology services company. "The government doubts whether industry is really serious, and industry says, 'What if I spend the money and the government comes in and says ... I don't deserve the profit?' Someone has to take the leap and trust the other guy not to take advantage."

Shared-savings-type contracting already has taken root in a few pockets of federal activity. The Education Department, for example, pays ACS a fee for each loan serviced under the Federal Direct Student Loan Program. Contingency contracts requiring firms to invest time, labor and technology in return for a share of collections have become common in agencies that oversee federal loans. Agencies contract with private debt-collection firms, which are paid a percentage of the delinquent payments they bring in.

Similarly, a number of Defense agencies and the Veterans Affairs Department have engaged recovery auditors, who pore over payment records to find duplicate payments, overpayments, missed discounts and other errors. The auditors receive 20 percent of whatever the agencies collect from vendors. Some agencies also hire auditors to identify inefficient telecommunications configurations and improper billing in exchange for a percentage of money saved by correcting the problems.

Perhaps the best-known example of benefits-sharing contracting in government is operated by the Energy Department to help agencies install energy-saving devices. Energy's Federal Energy Management Program (FEMP) has crafted energy savings performance contracts under which energy service companies pick up all the up-front costs of identifying a facility's energy needs and then buying, installing, operating and maintaining energy-efficient equipment to cut energy bills. In return, the companies get a share of energy savings generated by the improvements during the contracts, which can last as long as 25 years.

Think Big

The energy contracts exemplify the most classic form of share-in-savings, in which development and operation of a project is funded by the contractor, who is paid-in part or in full-out of the savings generated by contract performance. A key to establishing such contracts is choosing the right projects, says Buck. "The potential benefits have to be exponentially larger than the costs incurred."

"Projects suitable for share-in-savings have to have big enough returns so they can fund the contractor and have benefits left over for the government," said former Office of Federal Procurement Policy administrator Steven Kelman at the AFCEA forum. "If the return on investment on a project is so low that the project can't pass the agency's capital planning process, it won't generate enough benefits for share-in-savings," said Kelman, who is now Weatherhead professor of public management at Harvard's John F. Kennedy School of Government.

Crafting such deals also requires solid baseline data about an activity's current costs and a reliable method for measuring the cost of operations after the process has been improved. Gathering baseline data is no small task, says Buck. "The baseline is the most important piece of any share-in-savings contract. The government is woefully poor in maintaining measurable baselines-in other words, in cost accounting to know what we're spending now," he says. But FTS is ready and available to help. "We will send in a benchmarking firm to validate or establish a baseline," Buck says. Kelman suggests that agencies' estimates need not be perfect "as long as government says how it's going to calculate costs for the baseline and then sticks to it post-award."

Not only do the agency and contractor have to see potential benefits before a shared-savings deal can work, but the parent department, Congress and the Office of Management and Budget must see gains as well. "Everybody has to get a cut: Program costs need to decrease, program people need an incentive, the agency needs an incentive, OMB has to show the budget decreases, Congress needs to show it has cut the budget, the contractor needs to make money," Chip Mather, senior vice president of Acquisition Solutions Inc., told AFCEA members.

Providing incentives for program people can be tricky, says Kevin Carroll, program executive officer for the Standard Army Management Information Systems Office at Fort Belvoir, Va. "Their biggest complaint is that they lose the [savings] money. The money is taken immediately from their budget and then they don't get [as much] savings as they expected, so program managers don't want to do it." Recognizing this problem, Rep. Dan Burton, R-Ind., has included agency incentives in a bill he introduced in May to mandate contingency-fee recovery auditing across government. The bill, HR 1827, permits agencies to reinvest 50 percent of funds recovered in improving staff capacity, information technology, financial management and other management areas. Another 25 percent can be returned to the programs from which overpayments originated and another quarter can go to funding the recovery audits.

Shared-savings backers strongly advise programs considering the approach to line up support at OMB and on Capitol Hill early. "I would never expect anyone involved in share-in-savings to proceed without consulting the Appropriations Committee," says Mark Brasher, former senior policy director of the House Government Reform Committee, who now runs Argo Public Enterprise Consulting. "If you've got the Appropriations Committee on board, you're not going to have problems." Buck says FTS is available to help agencies build relationships with the budget office and legislators.

No More Kabuki

OMB's procurement policy shop is also ready to support agencies' benefits-sharing efforts. Allen Brown, associate administrator for procurement innovation at OFPP, has appeared at several gatherings devoted to explaining the method. "OFPP is ready to work with you," he told the audience at a GSA-sponsored share-in-savings conference in January. Brown suggested three key conditions for agencies considering share-in-savings contracts.

First, agencies should vigorously share information with vendors before letting a contract. "The kabuki dance of the past won't work," he said. He recommended that agencies use a phased competitive approach to identify real contenders early in the selection process. "You need to let the contractors do due diligence so they can't say they didn't know [the extent of the requirement] later." Second, agencies should maintain competition through the life of shared-savings arrangements to spur innovation and verify that the contractor's share of savings is fair. Finally, Brown said agencies should carefully craft partnerships with contractors, especially for mission-essential services. "If you are expecting a company to come in and find a problem and propose a solution, it's going to need a lot of resources. You're going to expect the company to keep operations going even if the benefits are not there at first," Brown said.

"The challenge is taking a government that isn't used to [shared-savings deals] and a company that is and making sure you educate each other on expectations," says Karol Burt, regional vice president for business development of Oracle Service Industries. Oracle is one of the firms talking with NFC's Ortego about the prospective payroll software deal. "The buyer's biggest risk is vague specifications," Burt adds.

Kelman, who is advising Andersen Consulting on the NFC deal, says another big risk for both buyers and vendors is estimating the size of the pool of potential benefits in a share-in-savings deal. He fears that even after performing due diligence, vendors will be unwilling to commit to a firm percentage of benefits until after contracts are written. Kelman says agencies should push reluctant bidders to identify the additional information they need in order to set their share of benefits up front, as opposed to waiting until the contract has been awarded.

Relieving Sticker Shock

Much of the appeal of shared-savings contracting comes in shifting the early investment to contractors. But agencies still may need some funding to go forward. The 1906 Anti-Deficiency Act requires agencies entering contracts to have on hand enough funds to cover first-year contract costs and the estimated cost of terminating the deal early. Termination costs could produce sticker shock for agencies considering testing the risk-sharing waters, says Kelman. "The requirement to fund termination liability could be a barrier to agencies' willingness to do share-in-savings contracting," Kelman says.

Special laws relieve Anti-Deficiency Act concerns for benefits-sharing contracts in debt collection and energy. There may be ways around the funding problem for other shared-savings contracts as well. "One idea would be to ask offerors to bid their termination liability costs and they might not bid as much," Kelman says. Shared-savings boosters also are trying to determine whether agencies could waive their ability to terminate contracts for convenience in order to get shared-savings deals into place. In addition, FTS may be willing to help agencies come up with a modest amount of funding to cover termination costs on IT shared-savings contracts.

"We are working to figure out if there is a way to use our IT fund to support agencies that might not have first-year termination costs," says Buck. "It's a low risk to us because if we have a winner, it's not going to be terminated in the first year." The 1996 Clinger-Cohen information technology reform law encouraged share-in-savings deals by authorizing two pilot tests of shared-savings contracts for IT projects. Buck and others are searching for pilot test candidates.

Despite the remaining challenges, support for share-in-savings contracting is higher than it has ever been within the Clinton administration and Congress. In October, Rep. Stephen Horn, R-Calif., chairman of the House Government Reform Subcommittee on Government Management, Information and Technology, urged GSA to take the lead in promoting share-in-savings contracting in the government. Speaking at GSA's January forum, Rep. Tom Davis, R-Va., endorsed GSA's efforts to promote the concept. Industry appears ready to experiment as well. For example, leading human resources and payroll software firms Oracle and SAP are enthusiastic backers of Ortego's share-in-success concept. "Oracle is 100 percent behind it," says Burt. "We're going to be aggressive," says Russ Goodrich, director of federal sales for SAP Public Sector and Education Inc.

"The big picture about share-in-savings contracting is that it increases the chances for government projects to be successful," says Kelman. In April, he noted that "right now, looking at IT systems, there's an enormous failure rate. It's not like the current system is working fine. From the government's perspective, share-in-savings is less risky because we're not paying unless we get the performance."