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Dissolving the stigma of insolvency

3 Oct 14 You might not be surprised that fewer construction firms are failing these days, but you may well be surprised by the reasons. Steve Parker, a partner with insolvency specialist Opus Restructuring, explains all.

The construction sector has long been the biggest contributor to business failures in the UK, even though its contribution as a proportion of all insolvencies has fallen from 20% in 2009 to a slightly more modest 16% last year.

Its dominance of the statistics reflects the under-capitalisation of so many smaller contractors, the abusive relationships between main contractors and their suppliers that has been endemic for decades, widespread late payment practices and - most of all - the paper-thin profit margins endured by all involved in the building trade. If the Top 100 contractors can only earn 1.49% on their combined turnover of £61bn, what chance for the tens of thousands of smaller companies without their big brothers’ bargaining power?

The signs are certainly not good. The SME Risk Index published by insurer Zurich reveals that 12% of UK SMEs had considered closing down in the second quarter of 2014, while 25% had been forced by market conditions to lower their prices. Credit insurer Simply Business released equally worrying research last month showing that 52% of SMEs have less than two weeks’ cash reserves and 20% have no cash reserves at all. If anything, construction SMEs are likely to be the negative outliers in such samples because of the high financial risk business model in the sector and the sudden upward surge in material and labour costs in recent months.

Nevertheless, the latest insolvency statistics look encouraging at first sight. Insolvency Service figures show that construction failures have fallen dramatically from a peak of 7,122 in 2009 to only 4,219 in 2013, a drop of 41%. The improvement has continued in the first quarter of 2014, with a further drop of 13% when compared to a year earlier.

Strangely, this is completely at odds with insolvency trends over the past 50 years, which show that the peak for failures occurs between 12 and 18 months after a recession ends and growth becomes established. The reason for the historical pattern is counter-intuitive; increased activity levels mean that contractors need more working capital just at the time when lenders are at their most risk averse after the spike in bad debts they suffered during the downturn.

Construction activity has been growing strongly for over a year, so by now we should be seeing increasing numbers of companies overtrading their way towards the financial cliff edge. Instead, the exact reverse is happening. The reasons for this are complex and some are unusual, heralding a fundamental change in the way that stakeholders and insolvency professionals are dealing with businesses struggling with their finances.

There’s little doubt that the banks are far more reticent about instigating enforcement action against borrowers than previously, so that one of the traditional triggers for formal insolvency is much diminished. This is not to say that the banks are anxious to lend, but the development of innovative new financial markets such as crowd funding has helped construction business access the extra resources that they need as sales and activity levels rise.

This is good news because smaller construction firms have never found it easy to borrow from traditional sources such as the banks or invoice discounters. The draconian terms in construction contracts,

wafer-thin profit margins, a high incidence of payment disputes and delays, as well as an often unhealthy reliance on one or two clients all militate against normal funding arrangements.

On the other hand, pressure on government finances from the deficit reduction strategy has made government agencies, particularly HMRC, more hard-nosed about collecting debts in the construction sector (about which anecdotally it has always had an ambivalent attitude because of past scandals over subcontractor tax schemes). Suppliers and their credit insurers are also far more sophisticated in assessing credit risk and managing downside risk than in the past, having been burnt so badly in the recession. The result is tight control of credit limits and much less tolerance when cash flow problems do occur.

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Whatever factors are at play, the reality is that many fewer construction businesses are going through an insolvency process. But it must be very doubtful that fewer are experiencing financial difficulties.

Figures from Company Watch show that the number of companies in the sector with negative balance sheets where their liabilities were greater than their assets had risen from 11,821 in 2008 to 26,076 last year, a staggering 221% rise. Their combined financial deficit rose from £1.7bn to £5.4bn, an even bigger increase of over 300%. It’s possible that this zombie army of the corporate walking dead may have diminished since last year, but the fall is unlikely to have been significant.

Formal insolvency has always been a great destroyer of value; construction cases are amongst the worst for all the same reasons that inhibit bank lending, most notably the impact on part-completed contracts where novation is often fraught with difficulty in the face of an all-powerful main contractor or client. The alternative of a consensual solution, avoiding the costs and stigma of an administration or liquidation, has always been preferable.

Now there is a clear change of attitude within the insolvency profession, led by firms who have seen the light and now actively seek to push directors and their advisers down the informal route unless they have been brought in so late that this option is no longer available.

Better still, insolvency firms are moving away from the blank cheque model of setting their fees on the basis of sky-high hourly rates; instead many are increasingly willing to fix their fees at the outset, giving some degree of certainty to the stakeholders.

The last positive change sweeping through the insolvency world is greater transparency and accountability; pragmatic firms no longer hide behind the rather sketchy disclosure requirements imposed on them by insolvency legislation, preferring to have an open dialogue with directors, employees and creditors as the rescue process unfolds.

This is not before time; the government has at last reacted to media revelations about the extraordinary fees charged on some high-profile insolvencies and the very poor outcomes for ordinary unsecured creditors. Launching consultation earlier this year on far-reaching proposals for changing the UK insolvency regime, Jenny Willott, minister responsible for insolvency at the Department for Business, Innovation & Skills said: “we need to make sure that creditors are getting a fair deal and not losing out through excessive charges by practitioners”.

So struggling construction companies can look forward to a far more positive and cost-conscious approach towards their problems; their creditors can expect a more open dialogue with restructuring professionals trying to rescue them and save as many of the jobs connected to them as possible. However, the quid pro quo is that expert help must be sought as early as is possible, otherwise it might still end in the doom and despondency of liquidation.

This is an edited version of an article that first appeared in the September 2014 issue of The Construction Index magazine. You can read the full issue online at: http://epublishing.theconstructionindex.co.uk/magazine/september2014.  

To receive your own printed copy every month, in traditional paper format, you can subscribe by going to http://www.theconstructionindex.co.uk/magazine and scrolling donw the page or dialling 0845 128 9700 on a telephone.

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