This article is extracted from the report 'Construction Megatrends'

Covid-19 has led to a paradox for global markets. While significant liquidity is available at historically low interest rates, poor economic conditions and an uncertain outlook do not see an equitable distribution of funds to various, and perhaps essential industries.  

This has resulted in untapped pools of liquidity that, in theory, construction companies, or their paymasters, could draw upon to help support contracting operations through the slowdown. But in reality, contractors and their suppliers will find it difficult to access these funds due to their vulnerability to payment delays or, in the case of smaller entities, lack of financial reserves.

Mena lenders trudge into a tougher year

In these circumstances, size matters. As does diversity of activities. Lenders and investors will be more comfortable providing finance to companies of scale that have multiple service lines, ideally non-cyclical (although the pandemic has made this concept relative), as opposed to firms dependent or proficient in only a single line or a very specific business line. 

Financial reserves are another critical factor. Sponsors of regional contractors that have diversified without appropriate capital structure and cash buffers have no capacity to accept payment delays, making them very susceptible to liquidity crunches and thereby become easier takeover targets

One route to achieving scale is through the acquisition of companies or business lines, perhaps through project specific takeovers. But to do this, companies require acquisition currency, either in the form of debt or equity. As most contractors are not big enough to be listed and marketable as equity investments, there needs to be a reliance on debt.

Strategic debt

Most people will be aware of a phenomenon that seems to ensure that banks will almost trip over one another to lend money when you don't need it. But when you do need it, the banks disappear. Construction companies, more than anyone else, need to know and take advantage of this.  

In order to minimise risk and safeguard margins, most contractors tend to follow the project-debt-only model, while avoiding raising debt at the parent company. In our view, this is very short-term and perhaps naive logic. Lenders are generally happy to provide funded and unfunded lines to projects, but contractors might be missing a strategic trick. 

Raising money in the form of a revolving credit facility (RCF), where commitment fees are paid until the right acquisition/project/specific use comes along, gives you access to financial dynamite.

Acquisition opportunities are likely to present themselves once the market is aware of a contractors' firepower and capital availability. It might even guide sponsors to run projects with contractors that have such access. 

In order to minimise risk and safeguard margins, most contractors tend to follow the project-debt-only model, while avoiding raising debt at the parent company.

In such uncertain times for the contracting sector, this could be an essential differentiation factor (even from a equity valuation perspective) in the short to medium term.

Real bonds

Although there has been progress made in taking out mini-perm project finance debt through bonds by project sponsors, the debt capital markets (DCM) route has not been considered seriously by contractors. 

While the DCM, in the form of 3-5 year bonds or sukuk is not for every contractor, larger companies that have drawn down on RCF or have loans taken at the parent company must look to diversify away from the bank market to the institutional funding capital markets. 

While not easy, this can relieve cash flow pressure in adverse times, such as the ones we find ourselves in today.  And while investors will price up these instruments, they may be the safest bet in the longer term. Costs of these instruments get cheaper with familiarity.

Paint it green 

As financiers and investors, we assess credit in traditional ways. But as advisors, we always want our clients to differentiate themselves against similar credit comparables. 

Investors increasingly are attracted to have some dispensation towards environmental, social and governance (ESG) criteria, which may pique interest, demand and eventually pricing.

While many people equate ESG to green projects, which not all contractors do, a wider ESG angle that includes governance, sustainability may also be relevant. Treasurers and chief financial officers should consider that, while the ESG criteria may not start at the parent organisation, they could emanate from any green projects that they may bid for, win and be executing. 

It requires a step change in the way that contractors think about their processes in order to make them ESG compliant. But it is not 'rocket science' and help is available.

While the debt capital markets may not be available to all, it must be a core discussion in every board room of a large contractor, and definitely an aspiration for growing entities. Having a well-defined strategy for your capital structure and positioning it, timing it and executing it effectively is vital. 

Investors increasingly are attracted to have some dispensation towards environmental, social and governance (ESG) criteria, which may pique interest, demand and eventually pricing.

This approach may seem idealistic in the cycle, but are definite and strategic cues and should be kept in mind during the next up-cycle, lest the market (and the readers) forget (quickly).

Private sector participation

In terms of infrastructure project procurement, the coming years will see governments in the region encouraging greater use of the private-sector to design, build, finance and deliver public projects and services.

Until now, public private partnerships (PPPs) have failed to gain much traction in the region outside of the power and utilities sector, where modular construction techniques, alongside sovereign offtake guarantees and long-term feedstock supply agreements remove much of the risk. 

A lack of institutional capacity to package projects as PPPs, and the lack of a track recod of bankable PPP projects has dissuaded investors outside the power and water sector. But the biggest factor has been a lack of political will to push ahead with PPPs. There has been no political or economic imperative to hand over state assets to private developers.

This is changing. As weak oil prices impact fiscal revenues across the region, including in the UAE, new forms of project finance are required. And PPPs are emerging as a preferred model.

PPP in the UAE in 2020

In February, Abu Dhabi Investment Office (Adio) revealed plans to procure infrastructure schemes worth $2.72bn under the PPP model as part of the Ghadan 21 accelerator programme. Subsequently, in March, Abu Dhabi awarded a 12-year PPP contract to replace the emirateís streetlights to Abu Dhabi-based Tatweer for Traffic Assets & Systems Operation & Management.

In April, the emirate's Executive Council formed a committee that will oversee the development and operation of infrastructure, including PPP projects.

A lack of institutional capacity to package projects as PPPs, and the lack of a track recod of bankable PPP projects has dissuaded investors outside the power and water sector.

With the political will to use PPP models now in place, along with new institutional and legislative frameworks, Abu Dhabi is now expected to proceed with more PPPs in the future.

Dubai also is turning to PPP. In 2019, the emirate's Department of Finance allocated $272m-worth of PPP projects in order to attract private sector investments, raise government service quality and reduce the burden on the budget.

With government spending constrained by the impact of stimulus spending in response to the Covid-19 health crisis, along with weaker economic conditions, PPPs not only provide an opportunity for governments to use off-balance-sheet finance to fund capital projects, but perhaps even more important in the long term, they provide a platform to introduce private sector innovation into inefficient public sector bureaucracies. 

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About the author

Aditya Kotibhaskar is the senior director of investment banking at Mashreq Bank