Contractors May Benefit by Taking Equity in the Project They are Constructing
Contractors may benefit in making a small equity investment in the projects they construct. The financial benefit can arise from the investment itself and from improved understanding and communication with the owner during construction itself.
In the past, it was not unusual for construction companies to make small equity investments in the projects they worked on. For example, a construction company building a power plant would take a 5% equity interest in the project. By taking a financial stake in the project, contractors planned to protect their business interest in the project. That was the theory, anyway. Many of these investments did not provide the good returns; often-times the return was negative. While the construction company’s management was great at operating the construction business, it was not so great when it came to the financing business. So the idea went out of fashion.
But maybe it is time to revisit the idea.
In general, EPCs that successfully realized investment returns typically invest through an independent financing arm. Samsung C & T and AECOM have successfully invested through an affiliated financing arm. This structure appears to be working well, likely due to the independence and specialization of the financing division. The construction division’s desire to get hired for the project does not overpower the financing arm’s clinical financial analysis of whether or not the project will be profitable, and therefore, worth the investment.
There are also other benefits to an equity investment. In a project, the EPC often is in the dark as to how the project owner views the on-going work, or how the owner views the change or enlargement of the work scope, and the corresponding increase in the construction cost. On the other hand, the EPC views the change to the project as an opportunity to increase profit. There are times when the project owner and the EPC see eye-to-eye on the necessary change order and reach an agreement on the scope and price. But more often than not, this is not the case, especially when the project is delayed. In such circumstances, the owner may resort to calling the performance bond and demand that the EPC continue with the work and resolve the dispute after the project is completed.
In a project where the EPC’s investment arm has made an investment, the outcome may differ, especially if the investment allows the EPC to have a board seat or access to project management. The EPC will certainly have better insight into the owner’s thought process in a way that a contractor would not because of the ability to observe the decision making process of the owner, or at least be made privy to information that is driving the owner’s decisions. Under such circumstances, the EPC will better understand the concerns of the owner before it morphs into a lawsuit.
But disputes nevertheless happen and an owner will call the performance bond. The performance bond typically ranges from 5% to 10% (or more) of the value of the construction work, often wiping out the profit margin of the EPC if such bonds are called. When that happens, it often takes years to resolve the dispute and to recover the bond amount forfeited, if any.
Rather than posting a large bond, it may be better for an EPC to make an equity investment in the project and reduce the amount of the bond. At the beginning of the project, the owner may appreciate the investment; and that at the end of the project construction, the EPC may find it reassuring. Indeed, the EPC’s equity investment would give confidence to the owners and lenders to the project, and even function as a development funding for developers. During and at the end of the construction work, if any disagreement is not resolved, the EPC may find the equity investment to be more valuable than the prospect of losing the bond.
There may be a conflict of interest and disadvantages to an EPC becoming an investor. But the benefits to the EPC that makes an equity investment in a project is obvious. It may be time to revisit the financing model again.