How to Handle Due Diligence Gaps in Builder Reliability

There’s no doubt that current market conditions have placed significant financial stress on builders; the Australian Constructors Association is reporting that building firms are entering administration at twice the rate of other industries with over 50 per cent of large contractors currently fitting the technical definition for insolvency.

Whilst we certainly empathise with builders given what has been a tough few years (we’re also actively working to change construction payment processes to improve builder liquidity), we can’t help but wonder—if these firms really are in such desperate financial trouble, how do they continue to be awarded new contracts?

More checks, same result 

Recent, high-profile insolvencies have made many developers and lenders nervous, leading to ever-increasing scrutiny on builder finances.

Whilst no developer would appoint a builder they believe is at risk of going under, many have sustained losses despite them reaching a position of ‘comfort’ through extensive due diligence (DD) checks.

When did it start to go wrong? 

Are we to believe that all these builders’ finances only started to decline post their most recent contract award? Or, were they already in trouble when bidding for those final contracts and in need of new ‘donor’ projects so they could continue trading?

Whether intentional or not, it’s clear that some builders are misrepresenting their true financial position to manipulate the tender assessment process. The question is why doesn’t DD pick this up?

No matter how thorough your due diligence process, there will always be gaps

Due diligence looks at a range of very specific numbers and 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.

You might also consider the source of supplied financial information and the context under which they’re sharing it; you could argue that there’s even greater incentive to ‘appear’ strong when you’re not, given that you need the cash injection that comes with that new contract. 

Besides the numbers, 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 (if any) discernible signs to the external observer; projects are being completed and subbies are being paid.

Due diligence might turn up some history of late payments but, 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 make the builder accountable for them

You can (and should) keep auditing balance sheets, work in progress/cost to complete, builder track records—these are all sensible checks to undertake before awarding a contract. But let’s get to the point—what are you actually trying to learn?

We’d argue that it all boils down to answering 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 and 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.

But what if we reverse the dynamic of the DD process? What if we were able to shift the onus on to the builder to ‘prove’ the answer was yes via their actions.

What if we asked the builder 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 their bank statements say or how creative they’ve been with their accounting; are they truly in a position to take on a contract under which there is no opportunity to ‘borrow’ subcontractor/supplier entitlements?

Can they really finish off existing commitments without using money from this project? If the answer isn’t yes, they really can’t take the project. 

So, how can a developer or lender transfer accountability to their builder? By mandating that their project be run under IPEX as a condition of winning the contract.

Builder response tells you all you need to know

Let’s be honest, builders will never love IPEX but the ‘good ones’, those who are already doing the right thing, have no issue with working this way (and why would they—IPEX doesn’t change anything—everyone including the builder gets what they’re entitled to).

If anything, IPEX only strengthens the position of a financially secure builder in any commercial negotiation; in our experience, acceptance to the overarching concept is typically straightforward, with discussions quickly shifting to how it’s to be implemented and what they can get in return.

We have, however, encountered a small handful of builders who have met the request for IPEX with immediate hostility and 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 phase one: there are two phases to reducing your insolvency risk

Due diligence is limited and always will be; while extending checks may provide 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.

To truly reduce your insolvency risk, you’ll need to:

• Appoint a builder who is financially secure, and

• Protect funds against any potential builder cash flow issues for the duration of the build.

To find out how you can achieve both, talk to IPEX.

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.