Australia’s Building and Construction cash flow crunch
The construction industry is a significant driver of economic activity in Australia. It is Australia’s third largest industry, behind only mining and finance, and produces around 8 percent of our Gross Domestic Product. It comprises over 380,000 businesses nationwide and directly employs over one million people (around 9 percent of our total workforce).
The Building and Construction industry is also one of the toughest industries in Australia.
In FY19, Australia saw 1,515 companies in the construction sector enter external administration, an increase of 12 percent from FY18.
Despite the infrastructure spending boom, the Australian Bureau of Statistics reports the value of construction sector work completed in the June 19 quarter is 9.4 percent lower than the June 18 quarter and has been declining over the past 4 quarters.
Quite often, a project starts with a culture of quoting low on jobs to win the work combined with a false expectation that variations will provide additional margin. When a project is not delivered on budget and/or on time, developers and builders typically seek to claw back margin by disputing variations and claiming liquidated damages. The result being all parties in the payment chain (from head contractors to small subcontractors) being squeezed, not paid in full or at all, with subcontractors usually faring worst.
This problem is exacerbated when an entity in the payment chain enters a formal insolvency administration resulting in entities ‘down the chain’ not being paid.
With wafer thin margins, the profits of contractors are caught up within retention monies withheld, meaning that on a cash basis, the subcontractor is simply ‘covering its costs’ (or worse) until the retention monies are received 12 months following practical completion on a project.
We have been involved in many insolvencies of developers, builders and contractors in the building and construction industry and have seen this situation play out time and time again.
In our view the key reasons why builders and subcontractors fail include:
Taking on bigger projects and more risk with insufficient project controls
Developers and head contractors are generally more experienced, disciplined and sophisticated when dealing with and negotiating the original contract, contract variations and evidencing such variations. This often leaves builders and subcontractors in a situation where variations cost significant amounts as they are not able to evidence these additional claims.
Poor estimating and quoting at the front end of each project
In a competitive environment with extremely small margins, builders and contractors often find themselves in a situation where they need to win the next job in order to allow them to continue to pay their wages and meet their other fixed costs. This often results in jobs being quoted at a level that is not sustainable or profitable for the business, resulting in cash flow pressures.
Unpaid / slow paying progress claims, debtors and retentions
Slow payments are generally the result of disputes around cost to complete estimates (QS opinion is different) and non-approved variations claimed. The outcome being discounted progress claim payments, variations not approved and retentions lost. For builders and contractors, cash retentions should be avoided – bank guarantees should be provided where possible.
It is easier for a party to release a bank guarantee (a piece of paper in a drawer). Releasing a cash retention effects the payee’s cash flow (retentions aren’t held in trust accounts). If a counterparty can’t obtain a bank guarantee from their financier, this could be indicative of financial distress.
In a formal insolvency scenario, the enterprise value of builders and construction subcontractors evaporates following the appointment of an external administrator. This is because developers and builders will generally not deal with a company under external administration. Legally whilst the new ipso facto provisions prohibit counterparties terminating contracts by reason of insolvency, practically, there are other contractual breaches being relied on by developers and builders to terminate contracts. Even where a developer or builder elects to work with an external administrator, they can disrupt any sale of business process by refusing to assign works contracts to a purchaser.
Overall, it is generally easier for developers and builders to engage new contractors to complete works and seek to rely on the new contractors’ warranties. This does come at a significant cost and is then charged back as liquidated damages.
It is extremely difficult to realise debtor or retention amounts due after the appointment of an external administrator as counterparties typically claim defects have not been rectified and/or the insolvent builder/contractor is not able to fulfil its 10 year warranty obligations resulting in funds due withheld against unspecified liquidated damages.
The earlier a developer, builder or contractor with symptoms of financial distress in the building and construction sector engages with a restructuring expert, the more options are available to maximise enterprise value.