How Venture protects projects against contractor insolvency

The construction market is battling long-term inflation increases, supply-chain troubles, along with legacies of Covid, Brexit and the Grenfell tragedy, which means that contractors are increasingly facing challenges that lead to insolvency. So how can Project Managers structure protective mechanisms to safeguard investors’ projects from the financial woes of suppliers? Ben Kearns explores the steps put in place by the Venture Projects team, as reported by Property Week.

Construction has been blighted by insolvency over the past few years. In the year to August 2023, the number of construction firms entering insolvency reached 4,263, the highest number of any sector in England and Wales, according to the Insolvency Service. In 2022, the construction industry experienced 4,143 company insolvencies across England and Wales. This accounted for 19% of all company insolvencies, according to the Office for National Statistics (ONS).

The figures are not reassuring for commercial property investors looking to commit to large-scale development or deep retrofit projects. Main and specialist subcontractors have found themselves pinched between fixed prices agreed months or years ago, and rising material, energy and labour costs, leading to erosion of profits.

Challenging trading conditions have squeezed contractors’ profit margins, with build costs having increased by 15% in 2022, compared to 24.5% in 2021, according to the latest UK construction material prices, released by the Department for Business, Energy and Industrial Strategy in February 2023. To put this into context, construction costs normally rise around 3% – 5% on average per year. For example, in 2019 there was a 1% decrease in construction costs for the entire year, followed by a 5% increase in costs for 2020.

Meanwhile, materials costs have risen 43% in two years, while labour costs are up by nearly 10%, according to The Building Cost Information Service. Data from the ONS points to even faster rates of inflation for energy-intensive, or high-demand building materials. Legacy issues relating to cladding schemes can further place main contractors’ performance under pressure, which can result in notices to appoint administrators, and subsequent insolvency.

How to structure protective mechanisms

Establishing a project in a robust position at the outset will help defend against the threat of supplier insolvency, so it’s wise to put safeguards in place at the very beginning. For example, the introduce payment terms, ensuring that a balance is available to ensure swift payments supporting the main contractor’s cashflow to their own supply chains. Or collateral warranties, which create a contractual link between the third party and the contractor, which sits alongside the underlying contract, and grants rights to a third party which can be relied upon.

Further protective mechanisms, such as the introduction of performance bonds typically at 10% of the contract value, including Association of British Insurers (ABI) standard terms or on-demand arrangements, can give confidence to investors. Meanwhile, assessing the bonding capacity of contractors can give an indication of the insurance markets’ confidence of their stability and performance longevity.

Making diligent financial checks can also help protect a project. No matter how well-established the contractor’s business may seem, the threat of a project collapsing due to a contractor outside of your project is real. Therefore, a detailed understanding of the contractor’s wider business and legacy challenges must be explored and understood in order to assess the degree of their reliance or exposure.

In addition, consider a Parent Company Guarantee (PCG), which is a guarantee given by one contracting party’s ultimate or intermediate holding company in favour of the other contracting party to secure the performance of that party’s obligations under the contract.

What do early signs of financial distress look like?

Staying alert to signs of financial distress in contractors can mean that losses are mitigated against as early as possible.

Warning signs can include:

  • Sub-contractors reducing labour and material levels to meet their minimum obligations, while not overly exposing their business to main contractor cash flow contraction.
  • Payments not being made to sub-contractors within the contractor’s own supply chain.
  • Sudden departures of key team members and senior managers.
  • Overvaluing works and uncharacteristic chasing of payments.
  • Requests for additional payments outside of contractor entitlement.
  • Knowledge in the market of a contractor’s oversights slowing or associated sub-contractor payment issues.

Ultimately, using publicly available searches of the Companies Court insolvency records will confirm in real time the extent to which a particular entity is subject to insolvency proceedings – including the moratorium process (a new insolvency procedure intended to give struggling businesses a temporary breathing space to implement a rescue plan) under the 2020 Corporate Insolvency and Governance Act. This, along with regular credit checks and Companies House alerts, will provide financial and legal information to give an early warning on a potential or actual insolvency, and provide critical time to plan how to respond to it.

How to recover the project following contractor insolvency

If the worst happens, and the project is hit by contractor insolvency, project recovery will be the default position. The status of works on site will be critical to a recovery strategy, where maintaining relationships with supply chain members will be key, and direct payments can be considered. In the build-up, issuing pay-less notices may be necessary to protect the Employer’s position, particularly where works are not progressing in a regular and diligent manner.

As a result of the main contractor’s insolvency, variations may be required to the project to reduce build time or make savings and get the project back on track. This is where the construction management process, which can allow trade contractors to recommence work on your site at the earliest opportunity, may be an appropriate course of action to provide stability to the project and mitigate overall programme delay that may otherwise emerge from retendering a project.

Third-party testing and inspection, including the potential for abortive works will likely be required to enable new main contractor warranties to be established to enable institutional-type arrangements for future purchasers.

Project managers should lead clients through the process of claim management with insurance providers, and also foster close working relationships with legal advisors and administrators or insolvency practitioners.

Case study: Coburg St, Portsmouth

The £10m Stanley Studios development, which consists of 123 student apartments across 11 storeys on Coburg Street in Portsmouth, was completed in July 2023. It’s an example of high-quality purpose-built student accommodation (PBSA) being brought onto the market. The building was designed by gdl architecture, for client developers Glenmore Group of Companies, while Workman’s Venture Projects team was the project manager and employer’s agent.

In month eight of a 17-month programme the main contractor became insolvent. This meant the Venture Projects team needed to swiftly put into place the protective measures they had set out at the start of the project.

Led by Ben Kearns, Partner in the team, Venture managed the performance bond claim, engaged directly with sub-contractors to maintain elements of progress, and mitigated the programme of works.

Their next step was to reframe the contract, identify a separate contractor to complete the works, and to re-appoint the sub-contractors. Within 14 weeks, the Venture team had negotiated and let the contract to a new main contractor and created a new contract with an appropriate warranty wrapper.

The building is now complete, including air-source heat pumps, all-electric heating systems and PV arrays, along with a BREEAM ‘Very Good’ rating, as reported by Property Week. What’s more, its developers invested in submetering systems to ensure that occupier energy data can be collected in real time.

Looking ahead

While construction company insolvencies have been rising, there are signs that build cost inflation is now beginning to ease. The same ONS construction data points to 20% price declines for some key building materials such as concrete, steel, and timber over the past 12 months, for example, following price surges in 2021 and 2022. However, it’s smart to ensure that projects are protected against contractor insolvency from the very beginning.

A shorter version of this article first appeared in Property Week.

By Ben Kearns, Partner and Head of Venture.