Construction leaders must collaborate to avoid financial failure
In an analysis piece exclusive to Construction Week, AESG's Saeed Al Abbar outlines the practices that are essential to maintaining a healthy construction supply chain
In an analysis piece exclusive to Construction Week, AESG's Saeed Al Abbar outlines the practices that are essential to maintaining a healthy construction supply chain.
I have often written and spoken of my optimism for the construction sector and the great strides being taken in innovation, quality, and sustainability.
These are certainly key trends in the industry, and the rate of change and progress that we are witnessing is truly phenomenal. I strongly believe that as a sector, we have some of the best and brightest minds at work, who can truly achieve phenomenal results.
However, as a global industry, in order to actually achieve the potential of which we are capable, we need to also ensure that we have created the right business environment for creativity and innovation to thrive.
Over the past few years, the construction industry has faced significant challenges. News of write-downs, losses and, more recently, liquidations, have sent shockwaves through the global construction sector. This has far-reaching consequences, both in terms of jobs lost, and also in the stifling of progress.
It is important for us, as an industry, to take a hard look at the business of construction, and ensure we create the right environment in which the firms and individuals can thrive, so that we can achieve our lofty goals of innovation, quality, and sustainability.
In recent years, through my position as managing director of AESG, I have been fortunate enough to be involved in some of notable success stories within the Middle East. I have also had the opportunity to see first-hand the various struggles that some in the industry are facing. This experience has revealed to me the issues that we need to collectively address.
The first of these is financial reporting. When speaking to an accountant recently, he was shocked to learn that we managed our accounts predominantly based on actual cash flows, and not billings, as if such a practice was so primitive as to have no place in the modern world.
I strongly believe in the old adage of not counting your chickens before they hatch, and this is no more applicable than when applied to cash flows in the construction sector, where disputes and delayed payments are commonplace.
Reporting billings before they are paid is also not the worst of it. Many firms in construction report revenues from uncertified work or variation orders.
Of course, while there is a need within a complex industry such as ours to report more indicators than purely cash flow, it is also important not to overlook this one very important metric.
This is would mean the boards and shareholders of construction firms have greater insights into the health of the business. In addition, being held more accountable to the actual cash flow of the business would create greater motivation for construction firms to review their cash position more effectively.
To make matters worse, focussing on metrics other than cash flow motivates firms to take business decisions that are conducive to positive reporting, but not necessarily to the medium- or long-term health of the business. A simple trawl through data on the London Stock Exchange shows a number of instances over the past decade when, just prior to entering liquidation or bankruptcy, a construction firm reported not insignificant profits in its previous year’s financial statements.
I do not profess to be an expert in the complexities of accounting – particularly in the intricate world of construction – but throughout my career, I have seen a number of firms fail despite the fact their recent financial reporting showed very positive results. This begs the question, do we need to rethink how financial reporting is carried out in the sector?
Predatory pricing is another challenge to look out for. In a business where contractors often operate on single-digit margins, one would not expect to see double-digit variances in tender prices from competing construction firms. This is often the case, however, and in extreme cases, the lowest bidder has been 20-30% below the competition.
While some great progress has been made through value engineering and construction efficiency, such variances are often either symptomatic of the contractor having mispriced the project – meaning that they will struggle to deliver to the required quality and programme as they attempt to mitigate losses as construction progresses – or it could mean that the contractor has deliberately priced very low to secure the project and boost their reported order book, or to receive the mobilisation cash advance to satisfy creditors that may be knocking on their door.
These actions in competitive tendering have resulted in predatory pricing, where all too often on construction tenders, there is at least one firm submitting a price at a negative margin, which in turn drags prices down throughout the sector.
This practice is not isolated to the main contractor either – it cascades through to sub-contractors, and is also evident in the consultancy sector. This has created a sort of race to the bottom for the industry, and needs to be addressed, otherwise we will continue to see projects – as well as the firms delivering those projects – fail.
Moreover, it is common place for clients to assign a main contractor or consultant the liability for the full extent of the design or construction of a project. Essentially, the client assigns risk to the party best equipped to manage that risk. In turn, to protect their liability, the main contractor or consultant will seek to make their sub-contractors and sub-trades legally responsible to the full extent for their elements of work, which is perfectly reasonable.
The issue arises, however, in the application of back-to-back clauses to payments – also referred to as ‘pay when paid’ – whereby the main contractor is not liable to pay sub-contractors until they are in turn paid by the employer. While main contractors have a need to manage the risk of non-payment or delayed payment by the employer, such clauses can often result in significant challenges for the supply chain and, in turn, the project.
The risk of non-payment is borne by the entire supply chain, despite the majority of the supply chain not being in a contractual position to manage that risk.
Take, for instance, a drywall contractor. It will be responsible for only a small portion of the project, but is exposed to the full risk associated with the main contractor not being paid, which may be as a result of failures of other parties in the project and have nothing to do with the unfortunate drywall contractor’s own actions.
This has created a contractual risk arrangement, whereby parties that may be responsible for less than 1% of the project scope will take on the payment liability for the entirety of the project. Not only is this arrangement somewhat inequitable, but it also demotivates the better performing sub-contractors, as they see their payments being withheld for matters outside their control.
Additionally, less scrupulous contractors have been found to use the guise and lack of transparency associated with back-to-back payment clauses to manage their own cash flow by not paying sub-contractors, or making only partial payments, even though they have been paid in full.
Back-to-back payment clauses have directly resulted in a number of very good sub-contractors in the Middle East market going out of business, which, in turn, impacts the market and the ability to deliver innovation and quality.
In the UK, the practice of implementing ‘pay when paid’ clauses has been outlawed under the UK Construction Act. This is not to say that the practice should be completely abolished in all markets, as main contractors may argue that they cannot bear the risk of non-payment by the employer for the entire supply chain.
Numerous contract mechanisms are available to better protect all parties, however, and to create greater transparency to ensure that those parties that deliver their work and obligations do get paid equitably.
Ultimately, it is the employer that suffers if the supply chain of their project is not paid. So, a number of employers in the market have implemented safeguarding mechanisms on their projects, and it may be appropriate to consider a more widespread adoption of such practices if we are to create the right environment for sub-contractors to perform.
Another point to bear in mind: there is a very good reason that people say cash is king. In construction, a firm that runs at a loss is likely to fail, whereas a firm that runs at negative cash flow will definitely fail. I find it perplexing that some clients take steps to squeeze the supply of cash to their appointed contractor, which affects the project’s supply chain in turn, resulting in inevitable failures.
A client appoints a contractor to build their project, and in essence, they are responsible for the delivery of the client’s investment. If they fail, the client also fails. It is flippant to disconnect the contractor’s failure from that of the client. I have seen first-hand instances where, due to squeezed cash flow, a main contractor or major sub-contractor has not been able to deliver. In these cases, it is the client that ends up footing the bill in the form of delays and cost overruns associated with appointing others to complete the project.
Contractors take on significant risk while working on construction projects, with significant outlays from the start. Even if the client has maintained regular payments, the contractor will often be in a negative cash position to the order of 20-30% when the various securities – such as advance payment guarantees, performance bonds, and retention – are taken into account.
In essence, contractors are being asked to take on double-digit risk for single-digit margins, and that is in the best-case scenario of timely payments. Therefore, a clear message for clients and developers is to maintain cash flows and payment schedules to their contractor, to in turn keep the supply chain healthy.
While it cannot be said that ensuring regular payments guarantees project success, I would argue that starving the supply chain of cash flow will guarantee project failure. It is that important.
As stated earlier, I am very optimistic for our sector, and strongly believe in the progress taking place in the regional industry, particularly around innovation and sustainability in construction. However, we must, as an industry, inwardly reflect and recognise that certain issues exist that need to be tackled effectively.
There is no single point of blame for these issues. It is a challenge that we need to collectively own, and we can only overcome it by working together. We need to collaborate in order to create business environments where everyone succeeds – the client, the contractor, and the entire supply chain.
If we are able to achieve this, we will create a win-win-win outcome that will not only help to ensure that the industry stays strong, but will also guarantee we create a built environment that we can be proud of handing over to future generations.