Construction Industry Profit Margins 500×374

Profit Warnings in Construction industry: Is it time to get rid of Retentions?

Not only the collapse of Carillion but official records show that big industry names including Interserve, Mitie, Balfour Beatty, Laing O’Rourke and Costain have all fallen on troubled times in the last few years due to losses made on major projects with Mace providing one of the few good news stories with their pre-tax profits doubling to £23m in 2017 as its problem jobs wound down. This does point to endemic structural problems within the construction industry.

Construction sector firms to issue profit warnings since the start of 2016 include:

Consultancy firm Ernst & Young shows that profit warnings in Q4 of 2017 hit the highest levels for two years. A total of 81 UK companies issued profit warnings in the last three months of 2017 – the highest quarterly total since Q4 2015. EY say that FTSE support services filed the most warnings in 2017 out of any sector with 42 during the year. 

According to the EY report, 30% of all profit warnings in 2017 cited cost and competitive pressures, compared to 16% in 2016. Contract uncertainties also continued in 2017, with 25% of companies citing delays or cancellations .”

Can getting rid of Retentions help make the Construction industry more profitable?

Aside from structural issues such as sterling rate, availability of construction resources and quality of tender proposals and project execution; one area that can also be considered is the hidden role that “Retentions” play.

Retention is a term referring to the percentage of payment held back from a construction contract. In this way they offer “insurance” to construction clients in the case that contractors do not complete work or return to fix defects by:

1.     Incentivising timely completion of work, and act as a warranty against poor quality work

2.     Encouraging contractors to return to fix any defects:

3.     Provide a source of funds for works required to fix defects in the event that the contractor did not return to rectify these. Retention monies withheld can be further used for another purpose by the client/main contractor such as to fund working capital.

Sounds good…What’s the problem with Retentions then?

Research conducted by Pye Tait (2017) estimated that the value of retentions held in the UK construction sector as a whole in the course of a year of approximately £4.5 billion (in 2015 prices). In the same study it was identified a number of issues associated with the practice, including frequent late and non-payment of retention monies, retention money lost due to insolvency, increased project costs, and weakened supply chain relationships. There is qualitative evidence that contractors increase tender prices to offset the retention.

How retentions affect tender prices (contractor views)*

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Impacts of having retentions held (perspectives of tier 1 contractors)*

*Source: Department for Business, Energy & Industrial Strategy (BEIS) Paper 2017

The number of negative impacts of retentions for contractors and the sector as a whole. In particular, the cascade system of payment in the industry, and the fact that an insolvency further up the supply chain can cause that cascade to stop, can make exposure to insolvency particularly acute to a participant further down the supply chain. 

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What’s the alternative to Retentions?

Although the Prompt Payment Code and Construction Supply Chain Payment Charter contains an explicit commitment to remove retentions by 2025, it is a voluntary initiative which will work incrementally. So what’s the alternative to Retentions?

There are a wide range of mechanisms which could potentially be used in place of retentions in the construction sector:

·         Retention “Caps”

·         Project Bank Accounts (PBAs);

·         Retention bonds;

·         Performance bonds;

·         Escrow stakeholder accounts;

·         Warranties/guarantee;

·         Parent company guarantees; and

·         Retentions held in trust

Each of these options have a different impact on contractor/sub-contractor cash flow depending if money is withheld. In the case of Performance and Retention bonds there will be upfront costs to set up the bond (1-10% of bond value typically 5% of contract value). Tender prices may be increased to offset the costs of the retention bond, making overall costs of construction works higher. In the case of Escrow accounts, money is ring-fenced and protected in case of insolvency of the client or main contractor however many not offer sufficient insurance against defects. Whereas warranties/guarantees offers better protection against latent defects and lasts longer than the typical defects liability period.

Retention deposit schemes do not currently exist in the UK but has some advantages in theory. The advantage for contractors and clients disputes about the operation, amount and timing of the release of retentions payments will be dealt with by existing dispute resolution processes. Other advantages such as the potential for automated release of payment and offering no client/main contractor incentive to hold on to the retention monies (i.e. unjustified late payment) as the money cannot be used for any other purpose. Finally retention money is ring-fenced and protected in case of insolvency of client/main contractor