Construction Finance: untapped potential for receivables finance 

The construction sector is a significant part of the global economy. According to the EU Commission, it provides 18 million direct jobs and contributes to about 9% of the EU's GDP. The Growth Opportunities in the Global Construction Industry Report predicts the global construction industry will reach an estimated $10.5 trillion by 2023.   

While the global economy remains clouded by a surge in inflation and supply chain bottlenecks, a study published by Oxford Economics in September of 2021 forecasts a bright future for the construction sector. Growth (4.4%) is expected to be faster than the manufacturing or service sectors as the industry will lead global economic recovery over the medium term and reach $15.2 trillion by 2030.  

The industry downed tools for some time in 2020 and global construction outputs decreased by 4.6%, however activity resumed quickly as the sector adapted to new ways of working. Global outputs would increase by 6.9% in 2021 and are forecasted to increase again in 2022 (5.4%). Taking into account some changes in position, the UK, Germany and France will remain in the top 10 construction markets in 2030. The US and China will remain the clear leaders, yet the emerging markets will continue to grow. 

Of the top 10 markets to lead the construction sector until 2030, half are relatively high credit risk (or below their long-term trend), and four are average risk (or have stable performance). According to Atradius Construction Industry Trends reports for 2021, it is worth noting that of the residential, non-residential and civil engineering subsectors, the performance forecast can vary with the bulk of the subsectors experiencing stable growth. In the US, the second-largest market, the credit risk in the sector is considered favourable, and the performance across residential and civil engineering subsectors is above its long-term trend. 

Payment performance varies from country to country. According to the same report, payments take from 60 days in countries like Germany, and over 200 days in Italy and China, with public bodies, often being the worst offenders for poor payment performance. Consequently, there is considerable pressure on the working capital of smaller contractors, and receivables finance could have a crucial role in assisting these businesses facing cash flow issues.  

The receivables finance community has traditionally avoided the construction sector due to the perceived risks regarding the quality of the debt - performance risk is often the primary reason for not funding the receivables of construction businesses. Additionally, construction projects can be complex, with numerous sub-contractors engaged in fulfilling the obligations undertaken. Contracts may span several months, or even years, with staged billing against an overall contract value. Variations to contracts, discounts, special taxation rules and retentions can muddy the waters of the collectable debt. 

As with any form of receivables finance, the key is to understand the nature of the debt being funded. Construction projects will be governed by a contract, stating the contractor’s obligations, the contract value, retentions, and payment conditions. Lenders must understand the overall contractual position. Value-added tax adds complexity as (depending upon the country and type of construction) the receivables are often net of VAT, although payments will include VAT. 

Sub-contractors' applications for payment against the overall contract value are generally approved by a third party (a quantity surveyor or equivalent) that will issue a payment certificate upon which the customer will make payment. There may well be a discrepancy, with the sub-contractor overstating the work completed against the contractual value. Tracking the cumulative position of billing against the contract value is key to controlling the risk, as is the management of payment certificates to understanding the approver's view of the work completed and thus the legitimate billing to date. 

Of course, the initial contract may change over time, with variations to contract value, both up and down, due to changes to the scope of the project. These need to be approved by the 3rd party, creating another opportunity for discrepancies to appear. Naturally, counterclaims (disputes) could arise, which would reduce the collateral value and the chance of recouping collections against advances. 

Traditional rules around ineligibility or disapprovals of the receivables can still be applied to reduce funding when rules are breached, for example, age disapproval. In addition, lenders can apply construction-specific rules for situations such as when the sub-contractor states more work completed than approved or when the overall work completed exceeds a certain percentage of the total contract value. Advance rates can also be reduced - potentially on a contract-by-contract basis - to increase funding reserves. 

The many complexities and nuances can create challenges in establishing the true financial and risk position. Processes can be administratively heavy and lacking in controls and visibility of the risks (particularly if lenders attempt to do this off system with spreadsheets and manual workarounds). Or worse, lenders ignore the complexities and risks, funding the receivables as if they were like any other commercial invoice. 

Flexible and capable of scaling efficiently, the technology exists today to unlock this key market opportunity - supporting the funding for the construction sector while mitigating risk. Technology can address the challenges and complexities associated with the sector, through features such as self-service options for sub-contractors, automated fees, special risk rules, bad debt protection, management of payment certificates, and the ability to track the overall contract value. 

By building a better understanding of the construction sector, the receivables finance industry can use market-ready technology as a business differentiator, a revenue generator, and to support economic growth.


Article written by: Kevin Day & Iain Gomersall

First appeared: TRF News

Image Cred: Isabella Mendes