Over the past few years, interest rates have risen to levels not seen since the early 2000s. As a result, project finance costs have become a substantial component of any construction project utilizing debt financing.
To minimize costs, owners (or project equity stakeholders) are seeking ways to provide sources of debt performance security that allow them to offer their best interest rates. Even a single-notch upgrade in a lender’s project finance credit rating can have a much bigger impact in today’s marketplace than in the low-interest rate marketplace. The credit spreads are much wider than they were five years ago. Thus, project owners are focusing more on satisfying their lenders’ need for strong project performance security from their construction contractor partner.
From a contractor’s perspective, they do not want excessive performance security straining their balance sheets. But project owners want stronger performance security to release their lender’s best finance terms, and “stronger” means the performance security needs to be bigger or more liquid in its ability to respond to the contractor’s failure to complete the project. Wise contractors will raise their construction pricing when asked for stronger or more liquid performance security, thus increasing the cost of the project for the owner. Ultimately, all three project stakeholders, the owner, the contractor, and the lender, need to find the ideal balance of performance security to minimize constraints on the contractor’s balance sheet, while giving the lender strong enough performance security to allow them to offer their best interest rates.
When the ideal balance between contractor and lender needs is achieved, the best construction costs and project finance costs will combine to create the best overall project cost. To achieve this ideal balance, you need to have a strong knowledge of the inventory of various performance securities available to the construction contractor and further knowledge of the impact of these performance securities on the contractor’s balance sheet, as well as the lender’s appetite for said security when it comes to security strength.
From a high-level perspective, the following table should provide you with a good starting point when it comes to some of the tools that can be utilized when structuring a project’s performance security:
Tool |
Coverage |
Impact on Contractor Balance Sheet |
Lender’s Liquidity Rating |
|---|---|---|---|
Parental Company Guarantee (PCG) |
Guarantee by a parent company of a contractor's performance under its contract with its client, where the contractor is a subsidiary of the parent company. |
Low |
Low |
Performance Bond (North American) |
|
Low-Medium |
Medium |
Adjudication Bond (Often Used in UK) |
|
Medium |
High |
Subcontractor Default Insurance (SDI) |
|
Low |
High |
Letter of Credit |
|
Very High |
Very High |
Demand Bond or Liquid Surety |
|
Medium-High |
High to Very High |
Hybrid Bond (Liquid Surety and North American) |
|
Medium-High |
Very High (Liquid) Medium (Cond.) |
Surety-Backed Letter of Credit |
|
Medium-High |
Very High |
Final Takeaway
Everyone hopes that the low-interest rate environment of the past 15 to 20 years will return. Until it does, project stakeholders need to become more familiar with the spectrum of performance security solutions available to secure contractor performance. Stakeholders should not only familiarize themselves with these solutions but also know how each stakeholder perceives these security solutions and their impact on each stakeholder’s pricing. To achieve the best cost for constructing a built environment asset, in today’s higher interest rate economy, you need to find the ideal balance when it comes to performance security.
Questions? Contact:
David Bowcott
Managing Director, NFP Construction and Infrastructure Group
416.566.5973 | david.bowcott@nfp.com