Construction sector failures pose a potential worry for lenders

Across England and Wales, nearly a fifth (19%) of all firms that went bust in the second quarter of 2022 were construction businesses. And in the year to the end of June, the number of construction sector insolvencies doubled (up 101%) compared to the previous 12 months – a far faster rate of growth than that seen in any other sector.

On the construction front line, most building firms and their subcontractor supply chains are SMEs with limited cash reserves and operating on thin margins that leave them exposed to adverse changes in business conditions.

But the exceptional circumstances of the past few years have put the sector through the wringer. While building work was allowed to continue – albeit under tight restrictions – during lockdown, many fragile firms became heavily reliant on government support like the furlough scheme to stay afloat.

With the safety nets now gone, hundreds of weak firms that survived largely thanks to government support and cheap credit are being driven to the edge by a toxic cocktail of rising interest rates, soaring prices for key building materials like steel, wood and bricks, and post-Brexit labour shortages that have sent wage bills soaring.

With demand for their services now starting to cool – new orders across the construction industry fell by 10.4% in the second quarter compared to the first three months of 2022 – the threat of further insolvencies is increasing.

Warning signs to watch for

While not all ABLs are active in the construction sector, the reluctance of high street lenders to lend in this space has made it an attractive target for some alternative lenders.

In the current environment, those intending to lend to a builder or subcontractor will naturally want to up their due diligence before agreeing finance. And for those whose loan book already includes building firms, there are a number of warning signs – many of which are unique to the construction sector – to watch for.

However, the underlying issues behind the red flags are not always clear-cut, and finding them often requires specialist expertise and an understanding of the complex web of contracts that underpins the construction industry.

Top tips

Lenders to the construction sector should:

Regularly review the borrower’s management accounts and forecasts: With the prices of some building materials increasing almost by the week, it’s vital that construction firms update their accounts frequently to capture changes in labour and material costs that could erode margin.

Double down on debtors: Review the borrower’s aged debtor report and investigate any late-paying clients. Distinguish between the ‘cannot pay’ and ‘will not pay’ debtors, and act accordingly.

Look down the supply chain too: Establish whether the borrower is paying its creditors on time. Construction firms typically rely on a host of specialist subcontractors and suppliers, and repeated failure to pay them on time may indicate a systemic cashflow issue.

Watch for slipping standards: Review the firm’s correspondence with its clients for any reports that the quality of its work is falling short, or delays are being incurred. Such issues could be a sign of mounting financial distress.

Read between the lines and compare with reality: Identify any inconsistencies between what the borrower says about its progress on a building project and reality. While discrepancies in what a borrower reports about cost and time overruns may have an innocent explanation, they could be an indicator that all is not well. Lenders should study progress reports carefully, challenge and investigate accordingly, and in some cases may want to arrange a site inspection.

Act promptly

Where a warning sign is detected, the use the ABL makes of this information is critical. The key question to answer is whether the issue is a temporary hiccough or a longer-term problem that requires intervention.

Above all, the key to managing the risk of a construction sector borrower becoming insolvent, and thus defaulting, is early engagement and then acting promptly and decisively. ABLs should put a laser focus on the builder’s cashflow and performance, while simultaneously putting a supporting arm around them to keep further problems at bay.

This is specialised work and, for most ABLs, seeking support from external professionals who are experienced in the construction sector is essential.

Mike Layne MRICS is Director of Asset Recovery at the national surveyors and property consultants Naismiths