Construction is a volatile industry, with exceptionally high failure rates and financial risk. This is not only true in financially troubled times. A recovering or growth economy can also spell trouble for construction industry participants. Construction financial managers (“CFMs”), and others in the industry, would be well-served to be mindful of the unique risks in the construction business.
Some of these unique risks can be devastating to construction industry participants. As the construction industry is heating up, and the number of new projects is on the rise, it’s a good idea for CFMs to pay special attention to the risks, and protect their company in the coming year.
Fast growth can turn into a cash crunch
Everybody wants the economy to grow. The growth in business opportunities presented by a growing economy is a welcome change from the recent stagnation in the construction industry.
After all, a rising tide raises all ships, right? In construction, however, it’s not all rosy news. Subcontractor failure is three times more likely in a recovering economy than it is during an economic downturn, but why?
Subcontractor failure is three times more likely in a recovering economy than it is during an economic downturn, but why?
The easiest explanation is that the failed business ran out of cash.
In the construction industry, subcontractors are generally expected or required to float substantial project costs. This is due to the unique nature of the construction payment chain — the subcontractors must pay for the materials they use, the laborers they employ, deal with retainage withholdings, and then wait to be paid by the parties at the top of the chain. For companies that are not already swimming in cash, this system of construction payment can be deadly if many projects are ongoing.
Getting the required capital may be difficult or impossible
The construction payment process is difficult for companies without significant cash reserves. This can be a problem in a couple of different ways. Not only can the large capital requirements and messy payment process lead to construction company failure after working on a project, many companies may be unable to even get the necessary capital to start work.
Since the construction industry, especially subcontracting, is such a risky and cash-hungry business, it is very difficult to get capital from traditional banking sources. This is especially problematic, and even more true, in a recovering/growth economy. Lenders are shying away from construction investments now than ever, and this causes problems. Given the above discussion of failure rates, it’s no wonder it’s difficult for subcontractors to secure capital, but the result is that these companies are unable to get capital affordably. So when lender funding is required, construction participants find themselves required to pay exorbitant associated costs.
Changing project types can create confusion regarding available protection — or limit available protection
Public-Private Partnership construction projects, commonly referred to as P3 Projects, are rapidly gaining popularity in the construction industry. In fact, President Obama just recently took steps to expand the market for P3 transportation projects. This national trend means that it’s likely construction companies will be encountering many more P3 Projects soon.
While the underlying construction tasks performed on a P3 Project will be the same as those on any other project, the regulations, contractual obligations, and legal rights available for protection may be very different. P3 projects are not a new project type, they are generally classified, for the purposes of remaining in a secured position, as “actually” either private or public in nature. If the underlying project is private in nature, the security availability is generally the same as any other private project – mechanics liens. If the underlying project is public in nature, the security availability is generally the same as any other private project – bond claims.
Just because the underlying nature of the project has been determined, does not mean that a potential claimant may relax, however. If a mechanics lien is an appropriate remedy to secure payment, there is a separate question on P3 projects as to what interest the mechanics lien may attach, if any. It’s unfortunate, but in some instances, this project type can leave project participants with no ability to secure their extensions of credit, making the financially turbulent construction industry even more difficult.
Pay attention and be careful to protect your business from these risks
The construction industry is a difficult industry with high failure rates and quite a bit of financial risk. These issues do not go away when the construction economy is growing, and in some cases, can even expand in such a scenario. Therefore, prudent parties in the construction industry, should keep these unique risks presented by the construction business in mind, no matter what the current position of their company. By spending a little bit of time thoughtfully and truthfully analyzing your business’s susceptibility to the three risks outlined above, your company will be better prepared to thrive in the coming year.