This is the catchy headline of the 2016 Farmer Review of the UK Construction Market which is aptly summarised in the report's executive summary;
the UK’s construction industry faces ‘inexorable decline’ unless longstanding problems are addressed. In particular, the review highlights the sector’s dysfunctional training model, its lack of innovation and collaboration, and its non-existent research and development (R&D) culture. It finds that high levels of cost inflation, driven by labour shortages, have caused numerous housing schemes to stall as their costs have risen prohibitively.
A lot of the emphasis of the findings are around the need for the market to adapt towards the 'manufactured' development of buildings via 'modern methods of construction' ('MMC'). However, my view is that the issues run far deeper into the culture of the UK construction industry, and three years on from the Farmer Report, limited progress has been made outside of the development of specific MMC initiatives.
What follows is my personal views on the construction market and why now is a very interesting point in the cycle for Main Contractors, despite little positive progress against the recommendations within the Farmer Review.
Why is is the financial model so high risk?
As Main Contractors generally no longer directly deliver any of the on-site works, they are in reality an arbitrage businesses which take a disproportionate amount of risk for very low margins. They do this in return for cash flow by acting as a financial 'insurance' solution for clients / funders via a fixed price contract secured against the perceived value of their balance sheets. Whilst most ‘insurance‘ type businesses have limited operational complexity (and high, risked priced margins) the same is not true for Main Contractors. Design & Build contract obligations require them to design, procure and coordinate the construction of a building within a finite timescale. If they fail to deliver against this timescale then they are penalised under the contract with liquidated damages.
In addition to all this, they must then recruit from a very limited talent pool across the entire industry, and new entrants must pay disproportionate salaries to attract reasonable people. This has led to a very transient workforce across the various trades and white collar roles.
Why do people do it?
Many would disagree with me on the widespread fragilities of the sector, and talk about how they only undertake 'negotiated' contracts. However, in my experience these are incredibly rare and often are negotiated by contract savvy clients meaning that they are not necessarily any more financially rewarding than tendered contracts, and certainly no less risky.
When I became involved in the industry the poster child was Carillion and the Tier 1 teetering on the edge of decline was Balfour Beattie. Fast forward five-years and Carillion is now in liquidation, Balfour Beattie is the new benchmark and Leo Quinn heralded as a saviour. To me this really demonstrates that all Main Contractors are only ever a few decisions (or hires) away from initiating a sequence of events that exponentially increases the risk of failure at a point in the future.
So is the industry doomed?
That depends on your perspective. The barriers to entry are very low and when executed correctly, at the right point in the cycle, construction activities are highly cash generative. With this fact, those that are fortunate with their timing are able to take cash out of high risk main contracting activities and deploy it into lower risk markets. In most cases this ends up being property development by leveraging their expertise in construction delivery. McAlpine would be the grandfather of this model and recent entrants are those such as McLaren who diversified into property at the correct point in the market cycle. There is however a very, very long list of casualties where businesses have got this wrong.
Within the Main Contracting business in isolation, there are also opportunities to make substantial returns at certain points in the cycle, but this should not be confused with creating a stable long-term business. These opportunities exist for those with fixed price contracts, over a duration that means they are not fully procured on contract execution, and subcontractor prices fall. I.e the main contractor is on a fixed price with its customer but it can procure subcontractors for a cheaper price due to a market change.
For this reason, I think that the UK main contracting operations of Balfour Beattie, Morgan Sindall, Kier, etc... are likely to have a profitable spell on the assumption they have flushed out all the bad news / contracts through the public markets already.
What must change for progress to be made?
In my relatively brief involvement in Main Contracting, I was overwhelmed by the mistrust shown towards contractors. I entered the industry from a ’professional’ background where your opinions and advice are met with a level of trust and respect. However, in construction you are immediately treated with suspicion and as a supplier who should know its place in the development process - right at the bottom!
Why is this, and why does the construction industry allow itself to be treated in this way? I certainly met many far more capable and intelligent people in construction than any other industry I have been in, with no exception, but their opinions are not treated with the same level of importance or credibility as the army of consultants that get involved in any construction project - large or small.
When you look at the development process there are really only three parties which take risk. The Funder. The Developer. The Contractor. If you then look at any development, every party is procured around (and against) the main contractor. Developers and Funders appoint an army of consultants to advise them on every aspect of the scheme, whilst they take no risk, and allow them to act as a buffer between the only other party actually taking any risk in their scheme. This culture is the product of years of malpractice, by both developers and contractors, but in its current setup the Main Contracting market cannot, and will not, ever break the cycle it is in.
To Conclude
For any progress to be made my observations from direct experience in the industry are as follows;
Main Contractors should form a proper professional body (no different to lawyers, accountants, surveyors, etc...) to give the industry a professional 'chartered' voice in the development process.
The JCT suite of contracts are a sham if they are amended disproportionately in favour of one party. The whole contractual set-up of the industry needs substantial revision, starting with the large blue chip contractors, this change should be imposed on clients from the industry as a whole.
Supply chain should be required by law to insure their debts on every contract. The cost will be priced into contract sums and serves to protect the industry as a whole, and mitigate financial risks for all parties in insolvency scenarios.
There is a lot of noise around training and apprentices needed to fix the industry. Whilst this may be true for specialist trades I see this more as bringing people into a flawed model unless the structure and culture of the main contracting market is changed first. In addition, how does the industry expect to attract 'professionals' into an sector with no proper professional body or credibility associated with it...
MMC could lead this change but would result in the failure of many of the current UK Main Contractors as they are not sufficiently capitalised to morph into quasi manufacturing businesses.
Main Contractors with strong order-books, particularly in public infrastructure works, could be set for a profitable period if legacy issues have been dealt with.
Oliver Hutley
11 October 2019