During the recession, many contractors put their own money into schemes to keep themselves in work. But why, with new orders finally coming through, is this business model still proving so attractive?
In 2009, less than a year into the recession that the industry is only now coming out of, construction firm Mace signed a deal with Robinson Asset Management to refurbish the Great Northern Hotel at King’s Cross, London. What was unusual about that deal was that, as well as being the design-and-build contractor for the £22m project, Mace was, for the first time, a co-investor in the scheme. It was a case of the construction management firm, which had already turned its hand to fixed-price contracting as the recession began to bite, realising that it might have to go even further to help clients get schemes off the ground.
And Mace was not alone. The recession saw an increasing number of clients approach their contractors to see if they could help finance schemes that suddenly couldn’t get funding in the post-Lehman Brothers world. Prime examples include Shepherd Construction’s decision in 2009 to invest millions in teaming up with development manager Sovereign Land and US pension fund Area to buy the £210m Trinity Walk shopping centre scheme in Wakefield, West Yorkshire. This was after it had collapsed into administration owing Shepherd £15.5m when the Irish bank funding it walked away.
However, this was one industry trend that many thought would disappear with the recent turnaround in prospects, with new orders now rising at their fastest rate for over six years. It might come as some surprise, therefore, that Mace is just one of a number of construction firms looking to expand this part of its business, to become a much bigger part of its work overall. So what is driving the resurgent interest in this model? And what are the risks for contractors that go down this route?
Merged model
Contractors work on a business model that generates large amounts of cash at a relatively low margin through the careful management of contracts with subcontractors and on-site build risks. But as soon as a contractor invests in a project it is working on, it effectively becomes either a bank or a developer - very different business models that involve investment of cash for potentially high future returns.
Twenty years ago, it was common for the biggest firms in the industry to retain both parts to their businesses, seeing an opportunity to invest the cash generated by contracting in development. But in the period up to the start of the recession, many of these firms demerged these potentially conflicting capabilities, because of concerns that the two types of business required such different skills sets, capital structures, risk profiles and focus as to be incompatible.
But with the recession came the call to return to the fray. Stefan Friedhoff, head of construction at Lloyds Bank, says: “Many of the bigger players have been approached by their clients and asked to take on development risk. Where the clients haven’t been able to secure finance, they will try and push that requirement down to main contractors.”
Lloyds has been taking advantage of the cheap money available under the government’s Funding for Lending scheme (FLS), to offer lending specifically to contractors looking to finance development work. Friedhoff says most of the UK’s top 10 contractors have taken up products using cheap FLS funding, with £100m of Lloyds money used to restart stalled developments by three separate contractors.
Contractor Kier is unusual, both in having consistently retained a property arm, and in having gone public earlier this year with the news that it was taking up £30m of Lloyds finance under its FLS product. Haydn Mursell, group finance director at Kier, says the money is being used for both its mainstream property work and also for what it calls “construction finance” - enabling projects that have stalled because the client is unable to secure funds.
Where the clients haven’t been able to secure finance, they will try and push that requirement down to main contractors
Stefan friedhoff, Lloyds
“It was part of our raison d’être for bringing in the FLS funding,” Mursell says. “
If the client is being offered a price that makes the scheme unviable but we can come in with our sub 4% cost of borrowing and suddenly make it viable, then that’s useful.”
In such situations, main contractors can potentially help in a number of ways, all of them predicated on their ability to access relatively cheap finance because of the size of their balance sheet. Contractors can finance projects in the form of cash loans or, more commonly, through funding the “work in progress” on a construction scheme.
This means, in effect, paying the subcontractors but not asking the client
to be paid until much later. Often, where cash flow is the problem holding a client back, this ability to fund the work in progress means no cash payment is necessary.
The final option is for a contractor to take an equity stake in a scheme as an investor - meaning it becomes a fully fledged part of the development consortium behind the project.
Risks and opportunities
For a construction business, the prime benefit of this is, of course, not the profit from the development itself, but the ability to secure work for itself as a contractor - and ideally at a preferential rate. Mursell says: “Inevitably there would be a price attached to the increased risk we’d be taking on. That’s the position as we open negotiations, but every scheme is different.”
But there are dangers. Will Shirley, analyst at Liberum Capital, says: “Contracting and development require different skill sets and therefore different people. In addition, development ties up capital whereas most contracting businesses operate with very low, or even no, capital employed. There are potential conflicts of interest, particularly when the developer is working in partnership. However, these conflicts can be managed and there are also potential efficiencies. With the right controls and the right people there is no reason that a joint model cannot work well.”
Kier itself is looking to grow its overall property business, which has a £1.5bn work pipeline, but admits that construction finance specifically is only ever likely to be a “modest” part of its £238m property arm. Mursell says the firm has three or four schemes worth in the region of £10m funded in this way. “As the economy improves, the demand for that kind of funding will, we hope, decrease. You have to assume it will become a less frequent event.”
But if the improving market does reduce demand for construction finance specifically, there are other opportunities. Morgan Sindall, Wates and Willmott Dixon have all been seeing an expanding role for » » funding development, with Willmott Dixon’s Regen arm now having more than 500 homes under construction, and a pipeline of a further 2,000 over the next decade, and Morgan Sindall betting its future success on the expansion of its own investment and regeneration arms.
Steve Trusler, strategy director at Wates Living Space, says that despite the recovery in the private residential sector, cuts to government funding for social housing mean that associations and councils are looking for innovative ways to get regeneration schemes off the ground with minimal or zero grant. The firm has invested £1m to take a 20% stake in a start-up called QSH, which has been set up to find ways to tackle this very issue, with models relying significantly on contractor finance.
The banks have lost so much money they’ve become massively
over-cautious, so unless a scheme is an absolute slam-dunk they’re not interested
david grover, mace
To this end Wates is building 65 private sale homes as developer with Orbit housing association, part of the 350-home first phase of the £128m Erith Park regeneration scheme in south-east London. It is working in a similar way at 75-home Drake’s Place in Aylesbury.
Trusler says: “More and more we have to be a proactive partner, willing to take open market sales risk, and willing to use our financial capital to fund certain projects.
“Organisations like ours aren’t banks, but as part of a portfolio of services, and if it helps customers in certain situations, then we’re increasingly looking to do this. We’re very much at the start of this kind of activity.”
A reassuring presence
Mace, having dipped its toe in the water at the Great Northern Hotel, is being even more ambitious. It has set up an investment business, run by investment chief operating officer David Grover, that currently provides 2% of the firm’s turnover. But with £500m of its own schemes under construction, it is looking to grow this business to 10% of the group turnover by the end of the decade.
Why? Firstly, Grover says that while the economy has picked up, banks’ attitude to development finance remains very cautious. Mace’s 645-home scheme with the Greater London Authority (GLA), Hadley Homes and housing association L&Q at Greenwich Square (see box) has been hugely successful, with just eight units remaining to be sold. But all of the major high street banks turned it down as too risky, even with half of the homes pre-sold. He says: “The banks have lost so much money they’ve become massively over-cautious, so unless a scheme is an absolute slam-dunk they’re not getting up and getting interested.”
But clearly the firm sees more potential in the model than merely as a response to subdued bank lending. Grover says that for public authorities interested in getting regeneration schemes off the ground, having a contractor as part of the development consortium offers huge reassurance. This is because it is clearly going to be in the interest of the consortium to build the scheme out rather than land-bank it, given that the construction firm will make much of its return from the build phase.
In addition, the presence of a builder in the development consortium means the construction side is incentivised to provide a realistic price and deliver the scheme on budget. “As we’re building it,” Grover says, “we know it’s going to be built, [and] we’re not going to mess it up.”
It is partly this reassurance over delivery that has won Mace its latest commission - the £200m build-to-rent scheme with Essential Land at Newington Butts near Elephant & Castle, also marketed by the GLA.
Grover says Mace will consider both equity investments and loans to projects - it has already loaned in the region of £200m to schemes. As an investor-developer it is bidding on a pipeline of a further £1bn of work, making Grover’s motivation clear. “At the moment it is not a plan for us to hold land, or grow a property portfolio. This is about helping the construction group grow.”
Increasingly, for those with the confidence to manage the risks and the balance sheet to borrow cheaply, financing development is becoming not just a last resort, but a central way of doing business.
Greenwich Square: homes without banks
A consortium comprising Mace and Hadley Homes was selected by the London HCA and its public sector partners to transform the site of the former Greenwich District Hospital into 645 homes in June 2011. The deal saw Mace take the majority equity stake in the £215m Heart of East Greenwich development, which it renamed Greenwich Square. With major high street banks rejecting the chance to lend to the scheme, Mace helped bring in new lenders Urban Exposure and its partners Topland and LaSalle Investment Management to provide debt. David Grover, chief operating officer at Mace Investment, says their involvement meant the consortium was not required to make as many forward sales in order to draw down the funding as lenders will commonly ask for. This enabled it to keep its commitment to the GLA to sell the homes to Londoners, rather than market them overseas to investors. The consortium brought in housing association L&Q to take control of the 314-home affordable housing element. Grover says that now only six units of those marketed remain unsold, with the town houses and maisonettes yet to go to market. Grover says: “I think the HCA got confidence from the security of the Mace name being involved and from their point of view Mace de-risked delivery of the scheme.”
This article was published in print with the headline “Spend Money To Make Money”
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