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The recent wave of high-profile builder insolvencies is further proof of what many have been saying for some time: The construction industry’s commercial payment model is broken. But while there is no shortage of people pointing out the inherent issues with the current process, putting forward a viable alternative appears to be far more challenging.
It’s clear that existing payment practices have the potential to place significant financial stress on builders. Working under fixed-price contracts on narrow margins, while simultaneously being required to tie up significant cash flow/assets in the form of security for the duration of the contract. Add to this the expectation that builders finance costs for site establishment and procurement of long lead time items with lengthy delays before reimbursement; are we really surprised that so many builders are struggling? And it’s not just the smaller players—publicly available trading information shows that the big end of town is also having to take on huge risks for relatively meagre returns.
Alternatively, there is no work for builders and subcontractors unless developers are prepared to take on these projects and they won’t do that unless they can make a dollar. To this end, developers are never going to pay a premium in terms of margin without something substantial in return and strict lending conditions mean fixed-price contracts are here to stay. They also can’t/won’t release funds without physical ownership of long lead time/unfixed plant and materials given that they have no visibility or control over where any payments made to their builder will actually be spent.
Whilst there is little doubt that the current model is flawed, there is clear logic behind the way builders are paid and it is unrealistic to expect the model to change without also changing the conditions and behaviours that led to its implementation.
Despite builders being required to operate under a range of checks and balances (due diligence/statutory declarations, et cetera), the fact that none of these processes provides developers or lenders with certainty, together with the unfortunate truth that some builders are willing to ‘misrepresent’ reality means that all builders (including the honest ones) are currently subject to the same risk-mitigating requirements and payment terms.
Even in markets where the government has mandated that project funds be ‘siloed’ into dedicated trust accounts with strict rules surrounding payment practices and the threat of penalties or fines for non-compliance, there is unlikely to be any meaningful change to builder payment processes for one key reason; project funds are still not secure. While positive in intent, any legislation that permits builders to withdraw project funds from these accounts legally (let alone the opportunity for the builder to access these funds outside the law) leaves developer/lender funds (and of course, subcontractor and supplier payments) exposed.
No developer appoints a builder believing they’re about to go under; however, too many have sustained losses despite long-standing relationships, great track records, extensive due diligence and a pile of signed ‘stat decs’ for anyone to seriously consider releasing vast sums of money in advance. So, as long as builders have the opportunity to misappropriate project funds, they will be paid in arrears.
When a builder submits a progress claim, they are not only asking to be reimbursed for costs incurred by their business but also on behalf of the consultants, subcontractors and suppliers who have performed work on and/or provided materials for the project—only a portion of the progress payment is actually the builder’s money.
Whilst admirable, the various trust account models that have been proposed to ‘fix’ this broken builder payment model all have one critical flaw—they still rely on ‘trust’;
Trust that the imposed ‘rules’ are understood by the builder, and
Trust that penalties for non-compliance with these rules are sufficient to ensure that all builders will operate within them at all times, even when doing so is to their personal detriment (that is, they are under extreme financial duress).
If this builder payment model is to change, we can’t rely on trust—we must know that the right thing will occur. For developers and lenders to ‘know’, adherence can’t be dependent on the builder being willing and able to follow the rules, there simply can’t be an option not to:
The builder must be prevented from accessing funds placed in the project trust account for any reason other than to pay the consultants, subcontractors and suppliers that have been verified as linked to that specific project regardless of their financial position or any potential advantage that doing so may yield.
The financier, developer and/or project manager must have both visibility over which entities have been nominated for payment and the ability to verify that all funds have reached the intended recipients before approving further claims.
The builder must only receive their entitlements when they honour the entitlements of those they accepted the funds on behalf of.
Under this model, not only is distributing project funds quickly and in full in everyone’s best interests at all times (a builder under cash flow pressure has even more incentive to move funds on quickly), there’s no practical option not to. Under these conditions, other builder payment models are possible.
Given the restrictions that this type of framework places on the use of project funds, one might assume that builders would resist—not so. ‘Good’ builders are also dealing with the fallout of insolvency; the issues of some causing all to be tarred with the same brush.
Enhancing the effectiveness of existing risk mitigation processes only strengthens the position of any financially secure builder, creating an environment in which many of the adverse consequences associated with the current payment model (issues publicly voiced by numerous builder associations as key reasons for builder distress) may be avoidable:
Removing the ability for a builder to use project funds to pay bills linked to another project (or themselves) deters those already in financial difficulty from bidding.
There is no motivation for a builder with existing cash flow issues to attempt to ‘buy’ a project operating under this type of payment framework (even if they win, they can’t access the money to cover their shortfall). This leaves only financially sound bidders in the race, leveling the playing field and reducing the potential for a ‘race to the bottom’.
Any builder willing to operate with transparency and accept limitations over how they manage project funds is essentially ‘proving’ their financial health.
Agreeing to work within this type of payment framework essentially confirms what standard due diligence can’t: that the builder has no need to divert funds to other projects. Whilst this clearly differentiates their bid from those unwilling to work this way, it may even help to justify a premium in terms of margin. Many developers are prepared to pay a premium for a high-profile builder as a form of protection against insolvency—what is visibility and control over how project funds are managed worth?
If the builder can only pay approved entities and can’t access funds themselves, do they still need to be paid in arrears?
Under the above model, we are already seeing the additional visibility and control satisfy multiple developers to the point of releasing a percentage of the head contract payment in advance for site establishment costs/long lead time materials, helping builders to reach a cash positive position far earlier in the project.
Reducing the risk of non-payment to subcontractors and suppliers helps build trust.
Builders who facilitate these secure payment conditions instil trust with subcontractor and supplier partners, with the reduced risk having the potential to encourage more favourable pricing/terms to the builder. The ability to attract subcontractors is a huge benefit to any builder in this current market.
Builders who legitimately face cost escalations mid-project have a greater chance of successful renegotiation.
Whilst renegotiating previously agreed terms is never pleasant, it is sometimes necessary. Transparency can only help builders that find themselves in a difficult position to prove that their request is genuine, increasing their chances of securing the funds they need.
So, who loses out of all this? Additional security and transparency does disadvantage one group: builders that are misrepresenting their true financial position to manipulate the tender assessment and due diligence processes. These builders will quickly withdraw their interest in any project running under this type of framework; they’ll need to seek contracts that allow funds to be ‘borrowed’ if they are to keep trading.
Will that mean some of these builders go under faster? Probably. But the truth is that many of these businesses are already insolvent; allowing them to continue trading just places new projects and more subcontractors/suppliers at risk.
Whilst there are multiple factors influencing every negotiation and acceptable terms in one setting may be impractical in another, true security of funds is essential to any alternate, sustainable, builder payment model. In practice, a secure, transparent payment environment is little more than an extension of currently accepted due diligence and stat dec processes, making it difficult to justify any real objection to working this way, particularly when under this model, ‘good’ builders can ask for something in return.
IPEX is an online payment platform that secures funds intended for a project, protecting developers, subcontractors and suppliers in the event of builder insolvency. IPEX software integrates with a dedicated construction project bank account to ensure that progress payments are used only to pay approved subcontractors and suppliers linked to that specific project. IPEX provides developers and lenders with visibility over who has been paid and when, without sharing a builders’ commercially sensitive information*.
Whilst IPEX clearly erodes much of the nervousness amongst developers and lenders created by multiple, high-profile builder insolvencies, equally, we see IPEX as a tool with the potential to deliver financially solid, well managed builders with the more favourable payment conditions they’ve long been appealing for.
*There are 2 IPEX developer portal configuration options with multiple additional variables impacting level of security and transparency; final implementation model to be agreed between lender, developer and builder
The Urban Developer is proud to partner with IPEX to deliver this article to you. In doing so, we can continue to publish our daily news, information, insights and opinion to you, our valued readers.
