• Louise Stewart, CEO at ProjectPay


• 16.08.2022 03:45 pm
#payments

As one of the largest global sectors, construction is also one of the most parochial and complex. It also lacks diversity, which has also contributed to it being stuck with outdated systems and processes. That’s particularly true regarding payments, one of the largest challenges being the dysfunctional working capital situation created by a lack of liquidity on projects. 

The contractual chain counterparty risk of relying on payments being passed on from main contractors to subcontractors, then subcontractors to sub-subcontractors, often creates levels six deep on large projects. Frequently, this is coupled with main contractors misusing funds to finance working capital on other projects or spending on unrelated expenses instead of paying their subcontractors for work completed. 

The result? Chronic, frequently late, short or cancelled payments to subcontractors. If the main contractor collapses, unable to make up the shortfall of funds that they have spent elsewhere, projects and supply chains are adversely affected in unison. Subcontractors and project owners are then unable to obtain payments that are overdue to them from the liquidator, leaving project owners out-of-pocket and subcontractors unable to receive their entitled payments.

Global governments have attempted to use legislation to right this wrong with limited success. Canada and parts of the USA have led efforts so far in legislating statutory trusts. So, when a contractor collects payments for work done by their subcontractors, that money is deemed held in the trust to be passed onto the subcontractors and not be used for any other purpose. Should the contractor misuse the money, criminal charges apply for theft. If a contractor collapses, there is protection from a liquidator’s attempts to seize the money to pay themselves and secured creditors rather than subcontractors.

Unfortunately, without transparent digital payment processes, this is impossible to enforce as it becomes apparent after a collapse that proper accounting records have not been in place to determine what money belongs to who. 

Canada is now considering the use of Project Bank Accounts (PBAs), an instrument enforcing ringfencing of money per project belonging to subcontractors alongside statutory trusts. However, the use of PBAs in the UK and Australia has shown that they are ineffective, only addressing the final step in the payment process, not the request through approval process most fraught with delays and disputes. Not being connected to a digital payment process makes enforcement of legislation difficult. 

Main contractors have aggressively lobbied against the use of PBAs and statutory trusts, complaining that they tie up their free working capital (the money they received that subcontractors are entitled to). 

Creating legislation to enforce ethical, fair payments in the sector is critical. But it’s clear that to solve the payment problems in construction supply chains, the sector must move to a collaborative, digital payment process. It should be one that creates new, low-risk opportunities to fund the working capital gap for the entire sector – while supporting legislation and enforcement.

The working capital need is most urgent for small business subcontractors who represent 98% of the industry. Many lack access to affordable working capital because of the sector’s notorious payment problems. Therefore, traditional lenders like banks don’t have the risk appetite to fund them with high insolvency rates.

We’ve seen many outsiders identify this huge opportunity. They are typically from finance or consulting backgrounds with no experience in the construction sector, but are very good at sales. They attempt to use blunt financial instruments to address the liquidity problem in supply chains without addressing the underlying cause and dysfunction 

These outsiders often worsen Ponzi payment behaviours in the sector, ‘robbing Peter to pay Paul’ on projects where they can generate the best return using unethical financial instruments. All while using money belonging to subcontractors – withholding it to profit from them in return for releasing their payments. 

These financial instruments (including supply chain finance, invoice financing, and invoice discounting) are developed to benefit large main contractors at the expense of subcontractors, adding further complexity and disfunction to the payment process. 

Let’s start with invoice discounting, also called marketplaces. Conceptually, the main contractor deploys their surplus working capital to pay subcontractors early. The problem is main contractors with surplus capital are extremely rare - the sector’s main issue is liquidity. Hence why main contractors misuse money owned by subcontractors as working capital, creating a further vicious cycle of main contractors using money that belongs to subcontractors for their works completed.

Yet it gets worse; the subcontractor must then bid on the marketplace against other subcontractors, offering the biggest discount to get paid their own money being withheld by the main contractor for a profit. 

They must offer a discount for early payment once work is already done, and the main contractor has already been paid from the client - yet the subcontractor is carrying all costs and has been the one completing the work. 

Once the limited surplus funds run out, everyone else misses out. It doesn’t get more unethical than that. These platforms give full power to the main contractor, robbing subcontractors of their automatic right to prompt payment, and requiring the subcontractor to pay for prompt payment so that the main contractor can profit.

Subcontractors aren’t aware that these marketplace platforms are risk rating them without their permission, running company checks on their financial viability, and impacting their ability to get early payment. Yet research and history show the biggest risk is the main contractor’s misuse of funds and risk of financial collapse, resulting in no payment to subcontractors. Nonetheless, some of these platforms claim to be ‘subcontractor payment platforms’ and should be reported to the industry regulator for deceptive, misleading conduct. 

Greenshill has shown how unethical supply chain finance is; it’s astounding that some still try to justify its use. Supply chain finance is not fit for purpose in construction. It enables large main contractors to delay payments, using a financial instrument instead to pay their subcontractors while forcing the subcontractor to use this instrument forced onto them. It encourages main contractor Ponzi behaviours including misuse of money, enabling main contractors to hide their true financial position on balance sheets. It’s no coincidence that many main contractors that used supply chain finance have collapsed. 

Invoice financing can benefit other sectors, but it does not work in construction.

Main contractors and subcontractors can also sell their invoices to a finance company that will pay them up to 80% of their value immediately. The company collects payment from the client when due. But why would a main contractor or subcontractor want to finance an invoice when essentially, they are being paid money that isn’t all theirs to retain? 

In the likely event of main contractor insolvency, the invoice financing company can’t recover payment on the financed invoice from the main contractor. The subcontractor must pay back the full amount, leaving the subcontractor faced with magnified losses because they paid for invoice finance, yet are back to the situation of no payment for work completed. 

It’s bewildering why investors keep lining up to invest in these high-risk, unethical instruments which encourage poor payment behaviours and don’t solve the underlying cause of the sector’s payment dysfunction.

To fix the sector’s payment problems, the underlying cause of this dysfunction must be resolved. Technology platforms with new models for deployment of working capital and liquidity are now being developed. They transform the management of working capital, removing the insolvency risk and Ponzi payment behaviours while providing payment certainty for all. They will provide much-needed, overdue disruption to the sector – securing livelihoods and helping the industry thrive.

They remove the industry’s contagion to misuse money due to subcontractors and Ponzi payment behaviours. With these risks removed, external debt capital can be used to fund digital project wallets against logged invoice approvals pending payment. This solves the working capital gap that statutory trusts and PBAs create – the reason they are resisted by main contractors. 

With insolvency risk also removed, debt providers will be prepared to take on payment risk on qualified projects, providing access to embedded finance for an immediate, guaranteed payment option to all levels of the supply chain. This provides a substantially reduced cost of capital, with contractors paying a small transaction fee on their share of the money, providing a seamless, end-to-end digital payment process. 

This new digital, on-demand way of deploying capital to supply chains substantially reduces the cost of capital and project costs, also eradicating unethical financial instruments pushed onto the supply chain. 

Everyone in the supply chain should pay their own costs for capital on payments that are theirs to retain. No one wants to pay for credit when the funds are not theirs to retain, but must still be passed onto subcontractors entitled to the money. 

With everyone fairly paying the share of capital, costs are reduced for everyone, and projects can be delivered more cost-effectively - and without the payment risks, the sector continues to struggle with to create an environment where productivity can thrive.