Stuart Wigley outlines why there are a disproportionate amount of construction-based businesses going into insolvency as well as what we can do to tackle the issue in this RICS Journal entry.
More than 300 construction firms became insolvent in November – accounting for 15% of all insolvencies in England and Wales, according to Insolvency Service statistics.
This took the total number of construction firms becoming insolvent over the previous 12 months to 4,102. While this figure shows a 6.3% decrease compared to the figure for 2023, which was 4,380, this still marks a 27.5% increase on the 2019 figure of 3,217 – and, in fact, it means that more than 11 construction firms are becoming insolvent every day.
Construction’s contribution to UK GDP is 6.4%, and in this context the fact that the sector represents 15% of insolvencies suggests it is disproportionately affected by firms going out of business.
Sector vulnerable to financial distress
These statistics record organisations that have gone insolvent. However, the Red Flag Alert report, published by consultancy Begbies Traynor Group in October, offers commentary on those businesses that have yet to become insolvent but still face financial challenges.
The report concludes the sectors that are experiencing the highest numbers of companies in critical financial distress include both construction and real estate and property services.
It goes on to highlight that ‘the construction sector in particular continues to struggle with the legacy of high materials and labour inflation[,] which have led to some high-profile insolvencies recently’. This is a trend that it expects to continue, as the September collapse of construction firm ISG attests.
However, there are practical measures the sector can take to prepare for challenging circumstances.
Procurement must avoid lowest-cost approach
One such measure is that, when procuring works, employers should aim to appoint the most appropriate contractor rather than the one offering the lowest cost.
This process starts with reviewing the key objectives for a project to select the most appropriate form of procurement. Risk should be allocated fairly between the contracting parties, and documentation must be consistent and unambiguous, clearly describing the extent and scope of works required.
For example, my employer Baily Garner is increasingly seeing the use of two-stage tendering, pre-construction service agreements and enabling works contracts, which can offer greater assurance when it comes to agreeing the value of the main contract sum.
Before either tendering or entering into the main contract, the employer should review the project risks to ascertain whether these can be effectively addressed and mitigated. This strategy focuses on collaborating with the project team to achieve the right price to enter into the contract.
The development of this risk-mitigation strategy starts with a discussion among those commissioning the project, ascertaining their appetite for risk, as well as their attitude to programme and cost certainty at the time the contractor is appointed.
The feedback obtained should shape the approach to work on the project, and the strategy will continue to be refined and defined as and when other parties are appointed and join the project team.
‘Employers should appoint the most appropriate contractor rather than the one offering the lowest cost’
Early action can reduce risk for main contractor
As the consultant working on behalf of clients, Baily Garner has used several approaches to improve cost and programme certainty while allocating risk.
One approach is the removal and diversion of existing services, and thus risk, on a site ahead of contractor selection. This prevents disruption to the main contractor and enables those tendering to price the project effectively, reducing the likely number of caveats and provisional sum allowances.
Another approach is demolition of existing buildings and removal of ground obstructions, including foundations, ahead of the main contract to limit potential delay. Similarly, building on land where hazardous ground conditions are likely presents a clear risk to programme and cost, so we have developed a remediation strategy and implemented this in advance of main contractor procurement to offer greater assurance.
Agreeing and implementing party wall agreements at an early stage also helps clearly to define the scope of any works, and identify any potential impact on the method and sequence.
Any obligations or works resulting from the party wall agreement can then either be undertaken, reviewed and completed as part of an enabling package of works, or included in tender documents for the main contract works, providing clarity for all parties.
Finally, we have also commissioned further reports and surveys associated with design development and coordination to investigate and interrogate risks, enabling these to be priced with more certainty.
Risk items that are on the critical path, can be packaged up into an enabling works contract, so called, as they are assisting with the delivery on a forthcoming management works contract. These enabling works are frequently let using a JCT Minor Works Building Contract or JCT Intermediate Building Contract.
An example of the type of works included in such a contract could be demolition works of an existing building. Delays on an enabling works contract are likely to be accommodated more cost-effectively under a more modest-sized contract rather than a much larger and complicated main works contract.
Furthermore, once these types of early-stage risk have been mitigated, the development opportunity would be more attractive for potential contractors, maximising participation in any tender exercise.
Financial assurance proves hard to come by
Another difficulty faced in the sector is that contractors are finding it increasingly challenging to provide the performance bonds that many employers require, with organisations reportedly withdrawing from the surety bond market or tightening their underwriting acceptance criteria.
Nevertheless, bonds are just one of the kinds of assurance that contractors can provide, with others including warranties, guarantees and project bank accounts. Indeed, the latter is now an integral part of the JCT documentation used in many standard forms of contract.
Some clients have indicated that, to mitigate their risk, retention should be significantly increased from the typical 3% and 5% commonly used in building contracts to three times as much; that is, between 10% to 15%.
However, this would affect cash flow and harm construction companies’ ability to finance projects precisely when market conditions mean that the flow of money is particularly important.
Furthermore, these levels would be contrary to The Reporting on Payment Practices and Performance (Amendment) (No. 2) Regulations 2024, which aim to simplify and improve payment and retention practices.
Given the frailties of the construction sector, overly onerous contract amendments may well hinder organisations wanting to take part in procurement exercises, at just the time when participation by well-managed, financially sound organisations is required.
Advances no solution to cash-flow issues
Problems achieving the forecast cash flow are a great indicator of a lack of productivity on site, and sometimes symptomatic of financial distress in the supply chain and the progress of projects.
Client organisations in these cases may therefore find themselves approached to help cash flow by making additional payments for work not yet completed. Such on-account payments or forward funding are not a long-term solution to short-term cash-flow issues, though, and should be carefully considered.
For example, in March 2024 ISG made payments to a subcontractor in an attempt to save it from administration, pumping £300,000 into a glazing and facade specialist only for it to collapse. ISG itself collapsed six months later.
Payment should be integrated with inspection
Clients may think modern methods of construction (MMC) provide an answer. MMC are thought to accelerate build times, lower costs, improve quality and energy efficiency, reduce waste and minimise disruption to surrounding areas, in comparison to traditional building methods, with controlled factory production and reduced work on site.
However, a number of high-profile modular providers have recently gone insolvent, including well-known names such as Caledonian Modular, Ilke Homes and L&G Modular.
Combined with these insolvencies is the risk associated with the payment arrangements for such projects, where a deposit may be required in advance of component manufacture to secure a production slot in the factory. Such expenditure is earlier compared to traditional projects, where payments tend to reflect construction work in progress on site.
Protecting employers’ interests in the money being spent on projects will also include ensuring that it is paid in accordance with the contract provisions. It is essential as part of this for work in progress to be valued in accordance with the building contract provisions, and confirm these meet the requirements of the design and specification.
Paying for work that meets the specification and quality required by the contract documents is clearly a risk-mitigation measure, and conversely means not paying for work that does not comply or that may subsequently require removal and replacement.
Close collaboration between those inspecting and checking quality and those who certify payments will therefore be the best way to ensure work fulfils the contractual requirements.
To do so, contractors also need to record and obtain the required consents and approvals. Therefore, in addition to competence and project management abilities, they also need good administrative and knowledge-gathering skills.
This means that, when payments are made, there will be greater confidence that works have been carried out to the required standards, and that the records obtained accurately reflect the status of project and contribute to the golden thread of building safety information.
‘Close collaboration between those inspecting and checking quality and those who certify payments will be the best way to ensure work fulfils the contractual requirements’
Collaboration and preparation will help sector through
The reasons for the continued fragility of the sector and its sensitivities to price increases are well documented, occurring as a result of the impacts of entering into fixed-price contracts, followed by a period of high inflation combined with the increases in interest rates and a shrinking labour force.
The challenge, then, is how to collaborate with contractors to get the best out of the resources available and achieve the quality outputs required at an acceptable price.
The solvency of organisations in the industry is likely to remain threatened over the coming months due to continued labour shortages, cost pressures and low margins, with corresponding disruption to the professional and personal lives of many. If those in the industry are well prepared, though, they will be able to increase the likelihood of better outcomes.
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