Only the builder knows their true financial position; why should developers and lenders be forced to guess?
By Paul Reid, Head of Strategy and Operations at IPEX.
There’s no doubt that current market conditions have placed significant financial stress on builders. The Australian Constructors Association reports that building firms are entering administration at twice the rate of other industries and over 50% of large contractors fit the technical definition for insolvency. Whilst it’s hard not to empathise with builders after what has been an extremely challenging period, it begs the question: if these companies actually are in significant financial trouble, how do they keep winning new contracts?
More checks, same result
After a spate of high-profile insolvencies recently, developers are concerned. As a result scrutiny on builder finances is increasing.Whilst no developer would appoint a builder they believe is at risk of going under, many have sustained losses despite reaching a position of ‘comfort’ through extensive due diligence checks.
Are we to believe that these builders’ finances only started to decline following their most recent contract award or, are some builders misrepresenting their true financial position to manipulate the tender assessment process? And if so, why doesn’t due diligence pick this up?
No matter how thorough your due diligence process, there will always be gaps
Due diligence looks at a range of specific numbers & ratios that, although important, do not necessarily provide any indication of the builders’ actual current financial position. Due diligence checks are historical, representative of a ‘point in time’ only and rarely provide any real insight into any looming cash shortfalls.
Numbers aside, delivery records also play a key role. However, even these can be misleading – it’s entirely possible for a builder to operate under a ‘Ponzi’ type cycle for years with few discernible signs; they’re completing projects and subbies are being paid (even if a little late at times). Overall, their delivery track record can be solid – it’s just that their projects are being delivered with other developers’ money.
You can’t close due diligence ‘gaps’, but you can shift responsibility for them
Of course, you should keep auditing balance sheets, work in progress & builder track records before awarding a contract. But what are you trying to learn? We’d argue that it boils down to one simple question: does this builder have the financial capability to fulfil all their contractual obligations?
Due diligence in its current form places the onus on the developer and lender; it’s their responsibility to review all available documentation & satisfy themselves that the answer to this question is yes. If the information they are basing this decision on is out of date, incorrect, incomplete or worse still, fraudulent, they bear the consequences.
What if we could shift the onus onto the builder to ‘prove’ the answer was yes by asking this question instead: are you willing to accept this contract under the condition that all progress payments are ‘ring fenced’ to this project?
Now the builder has a decision to make; it doesn’t matter what due diligence suggests – are they truly in a position to finish off existing commitments without using money from this project? If the answer isn’t yes, they really can’t take the project.
How can a developer transfer accountability for due diligence gaps onto their builder? By mandating that their project be run under IPEX.
Builder response tells you all you need to know
Whilst IPEX does place limitations on how builders can use funds, it doesn’t really change anything for those who are already doing the right thing – everyone, including the builder, still gets what they’re entitled to. In our experience, acceptance is typically straightforward, with discussions quickly shifting to how it’s to be implemented & what they can get in return.
There have been a small handful of builders that met the request for IPEX with immediate threats to withdraw from the project; we can only imagine each had ‘grand’ plans for the initial progress payments and whilst it may be a coincidence, each has since entered administration.
Due diligence is only part one: There are two phases to reducing your insolvency risk
While extending due diligence checks may provide due diligence additional comfort, you can never be certain. And even if available resources appear sufficient at the time of contract award, no audit can forecast factors that may negatively impact a project linked to your builder during the construction of your project.
Construction needs a reset. An industry that tolerates insolvent businesses continuing to trade by ‘buying’ new donor projects at cut rates is unsustainable. With vast sums of money at stake, those funding projects are constantly seeking to better protect their investment. Builders that choose to embrace the enhanced transparency & offer greater security can clearly differentiate themselves from those in trouble & will be rewarded with more contracts & better payment terms.