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What can borrowers do?
Borrowers have started mapping their exposures to cladding, in addition to ongoing inflationary pressures, to their forecast models where the impact on financial covenants and ultimately liquidity can be modelled. Once borrowers have modelled through the implications and stress-tested across different scenarios, they are starting to proactively engage with their lenders where any requests for amendments are needed.
One area of potential amendments are covenants. A typical financial covenant in the construction sector is the tangible net worth covenant. This metric is impacted by the level of provisions, with tangible net worth deteriorating as provisions increase. If a covenant reset is required, borrowers should consider at what level and for which periods a reset is being requested. From a going-concern perspective, the auditor will look forward on a twelve-month basis and will need to see that the borrower can comply with its covenants during the entire period.
For larger borrowers or issuers with multi-tiered capital structures, including instruments such as private placements, supply chain financing, and bonding and surety instruments, borrowers and lenders should be alert to any cross-default risk and the potential need to seek consent from a diverse set of stakeholders. Being proactive, by designing a credible proposal in advance, maximises the likelihood of a successful outcome, allowing management teams to focus on running the business in what is an increasingly volatile environment.
What can lenders and other financial stakeholders do?
Beyond understanding the actual level of exposure to cladding claims at a more granular level, lenders should be asking their borrowers to model through the potential impact on headroom under different scenarios. These could be modelled on a high case, low case, and medium case, taking into account current cost pressures and labour shortages and, also mitigating actions such as supply chain support and possible insurance claims.
Some firms will have sufficient headroom in their facilities to withstand the cash pay out of provisions. Other firms will not have this advantage. Understanding the timing and payment profile relating to such provisions is important. Lenders should also consider which borrowers are more vulnerable to pressure from customers higher up in the supply chain, as borrowers seek to mitigate exposures.
Appreciating the difference between covenants, such as tangible net worth or interest cover, which are profit and loss driven, versus cash-based covenants, such as minimum liquidity, is important to establish at the outset. The two will not necessarily converge in the short-term or tell the same story.
How we can help
We provide financial advisory and coordination support to companies, lenders and surety providers in discussions between stakeholders, concerning funding requirements, financial covenants and multi-party solutions.
We are working with companies and their lenders to help them manage the process of communicating to stakeholders and being on the front foot. Clarity of communication, illustrating the ask of stakeholders and presenting credible action plans are essential to navigating this difficult period.
We also provide services to employers regarding the economic viability of tendering companies for new construction contracts. In our assessment, we consider the company's provisions, including cladding, and their headroom position.
