Construction Risk In Project Finance

Overview of Construction Risk In Project Finance

Construction risk in project finance is a significant project finance risk to which the project is exposed from the commencement of construction through completion, performance testing, and turnover to operations. Until turned over to operations and begins generating revenue the Project Company will not be able to repay or even service project loans.

The success or failure of the project depends entirely on completing construction on time, on budget, and in accordance with the quality and performance standards specified in the contract documents. Until then the project will remain subject to construction risk.

Construction risk is not a single broad risk, but a number of separate dependent and independent project finance risks that must each be identified, assessed, allocated, and managed.

Contractor Risk

Construction cost overruns and completion delays are the most visible construction risks in project finance, but they are not the most significant. The principal construction risk in any project financing is contractor risk. While excessive construction costs and completion delays are construction risks to take seriously, construction risks stemming from the contractor dwarf all other construction risk exposures.

The contractor you engage to build your project is the linchpin upon which the success or failure of your project rests. It is vitally important to choose the right contractor for your project. Never lose sight of the fact that the right contractor is not necessarily the lowest bidder. Too often, inexperienced project sponsors choose a contractor based on price alone, with little regard for the dozens of other factors that must be considered.

Project sponsors are more inclined to engage the wrong contractor when the project’s financial modeling indicates that the project may not be viable. Desperate to get the deal done, they convince themselves that all they have to do is get the project financing approved and everything will be fine. Cost quickly becomes the only criteria for selecting a contractor. Because construction costs represent the vast majority of project costs, when confronted by construction cost estimates that exceed the project financial modeling, project sponsors often explore lower-cost contractors, which all too often results in engaging the wrong contactor and exposing the project to a myriad of contractor risks.

Mitigating Contractor Risk

As with all forms of project finance risk, Global Trade Funding works closely with project sponsors to mitigate and manage contractor risk. During underwriting, we scrutinize potential contractors, analyze their experience with similar projects, their reputation in the field, their backlog of other projects, and their financial wherewithal.

To the extent possible we transfer construction risk to the contractor and away from the project company, investors, and lenders. Our primary means of shifting construction risk to the contractor is through the use of a turnkey construction contract. A turnkey contract essentially locks the contractor into building the project according to the plans, completing construction by a specified date for a fixed contract price. The project company need then only turn the key when construction is finished.

The construction contract documents we create also deploy additional mechanisms to ensure compliance with schedules and budgets including performance bonuses for contractors who meet certain performance goals, liquidated damages, and penalty clauses.

Construction Cost Risk

Every Project Company wants construction to come in under budget. Unfortunately, that’s not very common, while construction cost overruns are. Construction cost overruns also pose a very real threat to the success and even viability of the project. Construction cost risk stems from a number of different factors that must be accounted for because factors that cause construction cost overruns can sink the project. Some of the most common causes of construction cost risks are:

1. Poorly designed or drafted building plans can cause budgeting errors.
2. Inflation can cause increasing commodity and building material costs.
3. An inadequate supply of labor can cause construction labor costs to increase.
4. An unqualified contractor or a contractor that bids too low can cause extensive change orders.
5. A poorly written construction contract can expose the Project Company to tremendous cost overruns.
6. An inexperienced project sponsor is often tempted to budget too tightly to make a deal work.
7. Project location could cause materials and labor to become unavailable or drive the costs of transportation to unsustainable levels.
8. Natural disasters can cause a spike in building materials costs.

Mitigating Construction Cost Risk

There are numerous solutions or mitigants to these risk exposures. Rather than address the countless permutations for mitigating the risk of construction cost overruns, we just address the simplest and smartest methods of mitigating these risks. The clearest path to mitigating all of these risks is:

1. The contractor has more of an impact on the budget than any other member of the deal team. It is imperative that the project sponsor engage an experienced, reputable, financially solid contractor.
2. Enter into a well-drafted, turnkey construction contract or, better still an EPC Contract.
3. Require the contractor to post a payment and performance bond as a condition of the contract.
4. Draft a construction contract that provides financial incentives to the contractor for exemplary performance.
5. Make sure your construction contract provides for liquidated damages.
6. Prepare a construction budget that provides for reasonable contingencies.
7. Adequately insure the construction period with builder’s risk insurance that insures all construction risk and insures the builder’s profit in the event of loss.
8. Have the building plans, construction specifications and construction site reviewed by independent consultants to ensure the budget is achievable.
9. To the greatest extent possible transfer all of the design, engineering, procurement and construction risk to the contractor via a well-written turnkey construction contract or preferably an EPC Contract.

Completion Delay Risk

Again, on-time and under budget is what every Project Company strives for, it’s just not very often achieved. Many of the same exposures that can cause cost overruns can cause scheduling overruns.

1. Building plans that are poorly drafted can cause schedule errors and extensions.
2. An inadequate supply of labor can cause an extended construction schedule.
3. An unqualified contractor or a contractor that bids too low can cause extensive change orders or delays to attempt to achieve cost savings.
4. A poorly written construction contract can expose the project company to tremendous schedule change orders.
5. An inexperienced project sponsor is often tempted to schedule too tightly to make a deal work.
6. Project location could cause unavailability of materials and labor as well as additional transportation time.
7. Natural disasters in any location can cause a delay in the delivery of building materials.

Mitigating Completion Delay Risk

Just as there were with construction risk there are numerous methods of mitigating construction schedule exposures. Rather than address the countless permutations for mitigating the risk of construction schedule delays, we just address the simplest and smartest methods of mitigating these risks. The clearest path to mitigating all of these risks is:

1. Choose an experienced, reputable, financially solid contractor.
2. Enter into a well-drafted, turnkey construction contract or, better still an EPC Contract.
3. Require the contractor to post a payment and performance bond as a condition of the contract.
4. Provide financial incentives to the contractor for ahead of schedule performance.
5. Provide liquidated damages in the construction contract in the event of delays.
6. Have the plans, specifications, and building site reviewed by independent consultants to ensure the schedule is achievable.
7. Transfer all of the design, procurement, and construction risk to the contractor via an EPC Contract with a firm completion date.

Allocating Construction Risk

Just as important as identifying and assessing project finance risk is allocating those risks to the project participants or stakeholders who are best suited to manage the risks. Thus, allocating project finance risk is one of the most effective and cost-effective forms of risk mitigation.

If stakeholders are responsible for project risks they are not suited to manage, the entire project finance structure is at risk. Therefore, the crux of every project financing is the proper allocation of risk. It is also often the most difficult part of project financing. The most significant characteristic of project finance is the art of minimizing and apportioning risk among the various participants and stakeholders.

How are the risks in project financing allocated? The principal instruments for allocating the risks and rewards of a project financing are the voluminous project finance documents, specifically the contracts that are created between the project company and other stakeholders. While often the most time-consuming and expensive documents to create, efficient risk allocation is essential for making projects financeable and critical for maximizing performance.