Why sureties critical to on time project execution

Construction is a risky business and even capable and well-established contractors can potentially fail. Vikash Khandelwal, CEO of Srei-CBL Guarantees Joint Venture explains why sureties is a wise idea in providing financial security.

As per the recent economic survey released in January’2018, India will require US $4.5 trillion till 2040 in the infrastructure sector. This investment will go towards to development of fresh infrastructure to cater to the ever-increasing need as well as up gradation of the existing infrastructure spread across roads, railways, shipping, power, oil and gas, housing, renewable energy, urban infrastructure, urban transport etc. The plans as announced by the Government of India are indeed ambitious.

However, despite its pivotal importance to the country and its economy, infrastructure sector faces a number of inherent challenges which if not addressed threatens to derail the huge thrust by the Government of India. Amongst the various challenges which include issues related to land acquisition, environmental clearances, availability of credit, lack of coordination between various government agencies, mechanism for dispute redressal etc., the timeliness of the completion of projects and the resultant cost overruns have had significant economic as well as political impact as they reduce the efficiency of available economic resources thus limiting the competitiveness and the growth potential of the entire economy.

As per the recent data released by MOSPI for central sector projects, an average of 27.86 per cent of the total projects are delayed with an average delay/time overrun of 43.98 months. Almost 25 per cent of the projects have an average cost overrun of 94.37 per cent of the original estimated cost.

Such chronic delays have pushed infrastructure companies into working capital cycles, which are amongst the longest in the world, exerting pressure on cash flows thereby resulting in higher debt and lower returns. According to the finance ministry’s mid-year report, private sector infrastructure companies across the board are all over indebted. Therefore, even if the government initiates new projects or expedites approval, the situation for many of these companies will continue to be dire. They may not be able to muster up the resources to undertake these projects.

Given the current state of the Indian infrastructure industry, India in its own interest should move quickly towards adopting globally accepted best practices of having sureties issue guarantees to address the increasing needs of the sector.

Construction is a risky business and even capable and well-established contractors can potentially fail. A report by Biz Miner held the contractor failure rate at 21.72 per cent. According to another study conducted by the Canadian Centre for economic analysis, a non-bonded construction enterprise is 10 times more likely to become insolvent than bonded companies. This serves to illustrate the effectiveness of the surety risk selection process in ensuring that only qualified firms are permitted to undertake public work and the consequent economic benefits that result from this certainty around the construction delivery process. Surety bonds have played a major role in US and Canada’s growth since they emerged as a modern North American industry in the late 19th and early 20th centuries. In the US even today, as alternative procurement methods such as P3 have grown in popularity, with more than 30 states having enacted some form of P3 legislation, surety bonds have continued to support billions of dollars of investments in P3 projects. Since surety is the most cost-effective form of capital, many companies are maximising their surety capacity to replace bank guarantees and LOCs and release valuable capital.

It is notable that in the US and a lot of developed countries of the world, surety bonds are mandated by law on public works projects as alternative forms of financial security such as bank guarantees or letters of credit do not provide 100 per cent performance protection and nor do they assure a competent contractor.

The benefits are immense
• The entire guarantee requirements of the country are currently catered to by the Banks who are “generalist” offering guarantees as part of their bouquet of products and services. Being primarily financial underwriters, they do not have a clear understanding of any sector. Sureties on the other hand are “specialist” with depth of expertise and bring immense value to the implementation of the contracted terms.
• The Indian banking industry which is already on the mat battling multiple challenges of burgeoning NPAs which threatens to spiral out of control, ever increasing instances of fraud and a sharp dip in profits andhas become extremely wary of lending to the infrastructure sector. It is also stretched to meet capacity needs in the face of increased construction activity resulting from the government’s thrust in creation of world class infrastructure.In this scenario, even if new contracts are awarded, the industry will continue to strain under dwindling liquidity.
• Sureties help bring capabilities by way of a rigorous pre-qualification process on the contractor’s ability to fulfil the obligations of the contract and may also be able to offer technical, financial, or management assistance to a contractor
• The contractor submitting the bank guarantee is extremely vulnerable as the banks usually do not ascertain whether the contractor in question has committed any breach of the contracted terms at the time of the call on the guarantee. Hence, he has no recourse in the event of a project owner improperly/fraudulently calling on his guarantee other than to proceed legally which can be not onlytime consuming but cumbersome as well.
• Sureties depend on their underwriting expertise to assess the risks associated with the project. Hence, they usually do not require cash collaterals or margins to issue a performance bond or a security deposit guarantee. Unlike a bank guarantee, Sureties do not consume on the working capital limits thus releasing scarce resources, enhancing valuable liquidity. Considering the plans that government has for investments in infrastructure, the introduction of guarantee companies has the potential of releasing over Rs. 55 trillion back in to the economy in the form of precious working capital.

The bonding capacity of any contractor is an attestation of his execution capabilities and increases the contractor’s or subcontractor’s project opportunities. In a number of geographies, Sureties have helped the smaller businesses bid for large projects which they otherwise wouldn’t have qualified for. The US Small business administration is one such example where the state also participates in the risk so as to enable the small but capable businesses to have access to bonding facilities to bid for and execute larger projects.Surety bonds and guarantees have over the years also helped protect the interests of the tax payer, the project owners, the lenders, and the prime contractors from the potentially devastating expense of contractor or sub-contractor failure.

While the US and Europe are now developed markets for sureties, it is now beginning to enjoy wide spread acceptance and is a growing product in many major geographies which include Japan, Australia, Brazil, Chile, Mexico, Argentina andAfrica. India can’t be far behind.

Authored by:
Vikash Khandelwal,
CEO, Srei-CBL Guarantees Joint Venture

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