Following a number of well-publicised builder insolvencies, there has been a shift in the market regarding builder due diligence. From something that used to be considered ‘nice-to-have’, extensive pre-contract builder due diligence is now considered a must.
The construction industry as a whole is facing challenges on multiple fronts: record rainfall (NSW and QLD); lagging COVID-19 related supply chain effects; the current labour and materials cost inflation; all of which are impacting builders’ margins. Even more concerning is the fact that many projects are subject to contracts entered into 12+ months ago, which could limit the ability to transfer or re-price these risks.
ASIC Insolvency Statistics
To highlight the importance of builder due diligence in the current market, let’s firstly take a look at the historical insolvency numbers and trends.
Source 1: ASIC Insolvency Statistics
Predominantly due to Government support, total insolvencies are 43% down from the FY20 peak and have still not reverted to pre-COVID-19 levels. We believe total insolvencies hit their ‘floor’ in FY22, with early signs in July and August 2022 indicating a rise in FY23.
Despite this, FY22 construction insolvencies have risen 19% from FY21, and the proportion of total insolvencies is also rising:
Source 2 ASIC Insolvency Statistics
For FY22, construction related insolvencies made up 26% of total insolvency numbers, steadily increasing year on year from FY18, where they were 17% of the total. Based off the current issues being faced in the construction industry, this trend is likely to continue through FY23.
What should Prudent Developers and Lenders do?
Newpoint has completed 30+ distressed construction projects and from our experience the increase to cost to complete is 30-40%, highlighting the importance of prevention over cure.
Due diligence requirements should be tailored to take into account the contract being entered into, the nature, size and situation of the builder.
A good place to start is by considering the following:
- Non-financial analysis:
- What does the industry think of the builder?
- Nature, structure and experience of the builder.
- Disputes or litigation.
- Any previous insolvency events of the builder.
- Historical financial analysis:
- What level of cash reserves are held compared to turnover?
- Does the builder retain or distribute profits?
- Creditor and debtor ageing compared to contract terms.
- Are retention trust accounts complying?
- Are ATO lodgements up to date?
- Consider off balance sheet or contingent liabilities (defects).
- Forecast financial analysis: the key to understanding builder viability
- Analyse and sensitise forecast cash flow.
- What contract revenue is secured and how are margins performing?
- Are any projects running at a loss and how will this impact the business?
- It’s important to update this assessment regularly (at least annually) and undertake regular site visits to identify any on-site issues.
Bespoke Due Diligence v Credit Scoring
The risk in the construction industry changes daily, and whilst credit scoring may highlight trends in historical financial performance, it can miss the impact of market changes specifically related to a builder’s circumstances.
Whilst credit scoring has evolved over the years, we do not believe that it is a substitute for bespoke due diligence. Credit scoring focuses on the historical performance of the builder (payment defaults, historical financial analysis etc.). In order to understand the financial strength of a builder you must have an understanding of its forecast cash flow and forward workbook and how the builder is responding to the current circumstances, (e.g. weather, inflation, statutory changes). Historical financials only paint half the picture.
Newpoint – What we do
With vast experience in the Australian construction insolvency market, Newpoint is well positioned to provide due diligence reviews of builders for stakeholders on all sides of the transaction. This construction insolvency background gives Newpoint an understanding of the challenges builders currently face, and also the ability to identify key areas of concern which often lead to insolvency events for builders.
Rather than reacting to builder issues via formal insolvency appointments, preventative risk measures will identify the red flags prior to awarding contracts to (potentially) struggling builders.
Originally featured in The Urban Developer.