How could the accountancy profession address the major risks inherent in the construction sector? Mike Thompson and Rudy Klein from the SEC call for a proactive approach.

The recent profit warning from Kier, one of the UK’s largest construction contractors, has highlighted the continuing frailty of the construction industry’s finances. Within a year, the value of Kier’s shares has dropped by almost 85%. Kier’s underlying operating profit will be £25m lower than its forecast figure for the financial year to the end of June 2019. This is in addition to another write down of £25m that was announced in March 2019.

This follows Carillion’s collapse over 18 months ago and the events that took Interserve into administration on 15 March 2019, including a debt to equity swap. On behalf of the Official Receiver, PwC is still trying to work out Carillion’s total liabilities. Current estimates have put the total net liabilities for the whole of the Carillion Group at between £12 and £15 billion.

Research carried out by University College London for BEIS over six years ago found that the large tier 1 construction companies were net receivers of trade credit whereas tier 2 contractors were net providers of trade credit. In other words, the large firms had become reliant on their supply chains as a major source of financing.

According to ‘UK Construction: An Economic Analysis of the Sector’, Department for Business, Innovation & Skills, July 2013: “The undercapitalisation of tier one contractors and their reliance on business models generating negative need for working capital may in practice be as decisive as industry attitudes to risk and business models of risk transfer in determining whether intended changes to procurement and forms of payment (milestone payments, performance-based contracting) will be taken up by the industry, and with what effect on competition.”

Carillion’s business model – described in evidence to the House of Commons Business Select Committee by its interim CEO Keith Cochrane as “asset-light” – was focussed on a carefully managed manipulation of its supply chain’s cash.

An article by Gill Plimmer in the ‘Financial Times’ on 2 December 2018 was headed “UK contractors have bankrupt business models says vetting group”. In the article, the chief executive of Company Watch is reported as saying: “Our analysis points to the conclusion that the business model adopted by the major listed players in the [construction] industry is essentially bankrupt.”

Against this background, there has been severe criticism of the accountancy profession for being, as some have claimed, “asleep at the wheel” while these construction giants fell further into financial crisis.

Getting the risk/reward balance right

Construction has always been a high-risk business but, for a long time, it  was undertaken by firms with substantial balance sheets, often supported by house-building operations. The asset-light balance-sheet model referred to by Keith Cochrane was developed as house-building operations were split from construction in the early 1990s. At the same time, the outsourcing of long-term maintenance activity provided a rich new source of business for these companies who thought they could run maintenance contracts at the same gross margin as mainstream construction; this has proved impossible time and again.

Recently, a long list of large companies have failed, most of them being taken over by slightly stronger companies. Companies such as Amey, Mowlem, Alfred McAlpine, Taylor Woodrow and many smaller maintenance specialists morphed into the larger groups that we have come to know. The business model remained flawed and, now that there are few takeover options left, the companies are being shown in their true light.

Increasingly complex supply chain finance schemes have been put in place to conserve the precious cash that is so lacking in these large construction companies, but eventually, with unsustainably low margins on the work and with no balance sheet buffers, the doors have to close.

The largest UK construction firms outsource most of their work to subcontractors and suppliers. The overwhelming majority of these are SMEs; most do not possess the means to protect themselves against late payments or underpayments, delays to the release of retention monies and upstream insolvencies. At this juncture, it should be noted that payments to tier 1 contractors are not at risk when working for the public sector; public bodies do not go into insolvency. This doesn’t apply to firms in the supply chain.

With regard to insolvency risk, access to the trade credit insurance market is frequently no longer possible for most firms and, even if it were,  such insurance can be withdrawn in the middle of a contract from which the sub-contractor cannot extract itself. Trade credit insurers have been spooked by high-profile insolvencies and, more particularly, by the opaqueness and unreliability of the declared figures in company balance sheets.

An opportunity to join the conversation

Given this state of affairs, there is now an opportunity for the Construction and Real Estate Community, to join a debate that includes addressing the risks of the current business model and seeking to reduce those risks by promoting policies which massively strengthen the financing model without having to increase margins on contracts by huge amounts. There should be:

• Support for mandating project bank accounts (PBAs) for all public sector works. PBAs enable all suppliers to be paid simultaneously from one ring-fenced pot without monies having to cascade through the different layers of contracting. The funds are held by the client at all times and released to the supply chain without passing through the bank accounts of the major contractors. Monies go direct to the supply chain with each part taking its share when due. They are already in broad use by several areas of the government and are rapidly being mandated in the devolved regions.
• Support for legislation to protect retention monies. These monies are withheld as security for payments due and, as such, belong to the firm from whom they were deducted. However, as they are retained until the very end of the contract period, they are most at risk of loss through insolvency. Research published by the government in October 2017 indicated that £7.8bn worth of cash retentions had been unpaid across the construction sector over a three-year period ending in 2016. There already exists a Private Member’s Bill, the Construction (Retention Deposit Schemes) Bill, which aims to protect cash retentions by requiring that they are held in a ring-fenced scheme.
• Encouraging construction companies to publish in their accounts the amounts held by way of retention monies.
• Support for amending the Public Contracts Regulations 2015 to mandate 30-day payments on all public sector construction contracts and sub-contracts. At present, the Regulations only require public bodies to ensure that 30-day payment clauses are included in supply chain contracts but this has not been enforced.

The future of the UK’s construction industry is wholly dependent upon viable and collaborative supply chains that continue to add value through investment in training and apprenticeships, and in upgrading skills and technologies that will help the industry move into the digital age. All this rests upon fundamental changes to the industry’s payment processes so that the obstacles to unimpeded cash flow are removed. The accountancy profession has an important role to play.

About the authors

Mike Thompson BA FCA
Mike has worked in the construction industry for 25 years as both FD and MD of medium-size and large electrical engineering companies. He is a board member of the Specialist Engineering Contractors’ (SEC) Group which represents the largest value sector in UK construction. 

Rudi Klein
Rudi is CEO of the SEC Group and a barrister specialising in construction law.