Construction Guarantee Fund: Rating reaffirmed; Outlook revised to Negative
|Instrument*||Rated Amount (LKR Mn)||Rating Action|
|Issuer Rating||N/A||[SL]A reaffirmed; Outlook revised to Negative from Stable|
ICRA Lanka Limited has reaffirmed the Issuer Rating assigned to Construction Guarantee Fund (“CGF”/ “the Fund”) at [SL]A (pronounced S L A) while revising the outlook to Negative from Stable.
The outlook revision to Negative factors in the challenging macro-economic outlook and its adverse impact on the construction sector, in particular. Given the current extremely challenging operating environment, the construction sector is adversely affected by delayed payments by the Government of Sri Lanka (GoSL), material shortages, and high input prices. ICRA Lanka notes that one of the fund’s major projects underwritten in CY2020 for the construction of a 100,000 km road network wherein only 2,600 km is completed., and, CGF has provided approximately 90% of the contractor guarantees for the project. While ICRA Lanka takes note of the ongoing discussions to reduce the scope of the project on mutual terms, the final outcome of the same will be a key monitorable, from a rating point of view.
The rating outlook revision also factors in the potential weakening of the earnings profile of the fund due to the sharp moderation of new business during CY2022. ICRA Lanka notes a sharp decline in new construction contracts in Q1CY2022 and thus dwindled the cumulated bond liabilities to LKR 6.4 Bn in CY2021 from LKR 7.0 Bn in CY2020. ICRA Lanka anticipates new development activities in the country to be at historically low levels and in the meantime, all the development projects carried out by GoSL have been suspended since May 2022. Thus, the topline to the CGF will be directly impacted due to the stagnation of its core operational activities. Furthermore, the potentiality of claims to arise through these disputes between contractors and employers of the projects poses a moderate risk to the existing liabilities.
The rating, however, continues to favourably factor in the GOSL’s continued support for the Fund as a long-standing key party to the construction industry in Sri Lanka. This was further witnessed by the Fund’s recent partnership with the Road Development Authority (RDA), providing its services/guarantees on behalf of all the construction contractors under the “Saubagya Dakma Programme”, which targets the construction of 100,000 Km-rural road networks around the country. The rating also considers the entity’s governance structure backed by an independent Board of Trustees. The rating also takes comfort from the Fund’s long track record of low claim expenses, comfortable liquidity profile, and conservative investment profile.
The outlook revision to Negative factors in the challenging outlook of the construction sector, potential reduction in fee-based income, and the moderate risk of potential claims through temporarily halted contracts. The outlook may be revised to “Stable” if the macro-economic environment improved favourably for the sector. The rating could be downgraded in case of further deterioration of conditions and/or sizable claims materialized through existing liabilities, thereby impacting the earnings profile.
Sovereign support and operational independence; The CGF was originally set up by a budget proposal by the parliament in 1999 and the Government had disbursed a capital grant of LKR 55 Mn in four instalments. The Secretary to the Treasury was tasked as the settlor of the Fund and delegated the total management of the Fund through a Board of Trustees, who are also appointed from reputed government bodies and private sector entities. Moreover, the Board of Trustees acknowledged in the Trust Deed, has provided the overall maximum liability that the Fund could undertake (against its capital base) and further delegated responsibilities to the senior management. This structure has helped the Fund to operate as a self-sustained Special Purpose Vehicle (SPV), without direct influence from the government.
Extensive experience in the construction sector; The Fund is guided by a well-experienced management team, who have several decades of experience in the construction industry. The entity also has a strong Board of Trustees, consisting of reputed Public and Private sector representatives of the industry. The Fund has now been operational for more than 20 years with extensive experience in dealing with all the stakeholders in the industry – the Ministry, Employers and Contractors. The Board of trustees consists of six highly experienced public and private sector officials and the key personnel attached to Admin, MIS, Finance, Risk Management, and Legal functions are qualified professionals in related disciplines.
Minimal claims due to proper risk-based underwriting; Since inception, the Fund has faced claims of ~LKR 99 million (0.5% of total bonds issued to date) due to guarantee encashment by the employers are low relative to the accumulated surpluses. This is because the fund is employing a risk-based underwriting approach with a proper contractor and project evaluation; and the fund contests all the bond/ guarantee claims by the employers, unlike the banks. Moreover, ICRA Lanka notes that CGF being a GoSL entity, is in a better position to negotiate any contract disputes on behalf of its clients, with the Government Employers such as RDA, UDA and Municipal Councils. This has also helped the Fund to resolve the contract disputes more amicably and thereby reduced the level of claims/invocations over the past. However, given the ongoing discussions to reduce the scope and to curtail the 100,000 Km rural road development programme under mutual terms, ICRA Lanka will continue to monitor the outcome of the same and the new claims position going forward.
Track-record of profitable operations, however, the fee income is expected to moderate with the recent contraction in the construction sector; Over the past two decades, the CGF has maintained a healthy financial profile with ROE of 21.8% and ROA of 11.2% in CY2021, despite the several down-cycles in the construction sector. The Fund has been collecting levies towards the guarantees issued to contractors and also received a healthy investment income from its LKR 2.14 Bn financial investment base. CGF reported total fee income of LKR 279 Mn and an investment income of LKR 150 Mn in CY2021 compared to LKR 292 Mn and LKR 140 Mn respectively in CY2020. The fund was able to report a PAT of LKR 319 Mn in CY2021 from LKR 365 Mn in CY2020. ICRA Lanka also notes that the low claims track record of the fund has also contributed to the overall healthy profitability.
However, going forward, ICRA Lanka expects the fee income to be significantly moderated as the recent contraction in the construction sector has reduced the new bonds provided by the fund. The impact on the same will be somewhat mitigated by the potential increase in investment income due to the sharp increase in systemic interest rates. Moreover, the Fund’s profitability may remain under pressure in the near term.
Low competition and increased scope; The Fund primarily faces competition from banks/FIs in extending financial guarantees. However, due to the specific focus on smaller to medium-sized contractors, the Fund has been able to maintain its client base. Also, the unique business model of providing risk-based guarantees without requiring collateral has enabled the fund to differentiate itself from the Banks. Since early CY2020, at the request of RDA, the fund is providing its services/guarantees on behalf of the construction contractors under 100,000 Km rural development projects.
Challenging macro-economic conditions significantly affecting the construction sector; The current extremely challenging operating environment has significantly affected the construction sector. The industry is affected by the sharp increase in delayed payments by the GoSL, severe material shortages and input prices . This has resulted in a majority of the medium to large-scale projects being put on hold. Even though the 1,00,000 km project was initially planned to be completed in 4 years by 2023, only 2,600 km has been completed up to now. This project has been started with local bank funding with the idea of bridging it later from donors and settling the local banks. However, it did not materialize due to no proper project planning and assessment of the project by the GOSL. The feasibility has not been proven to the donors by the government. Therefore, banks also had to stop funding further for the project and currently there are outstanding payments of around LKR 60Bn for the contractors. ICRA Lanka notes that a large majority of these projects are put on hold by the employer or by mutual agreement, there are no sizable claims arising from the same. However, ICRA Lanka expects the fee income of CGF to significantly moderate in the immediate to short term as no new business is generated and the existing bonds are being terminated. CGF has issued only 58 bonds worth LKR 100 Mn for 3MCY2022 vis-à-vis 1,101 bonds in CY2021 amounting to LKR 6.3 Bn, signalling a moderation of new contracts.
Limited due diligence; Due to the inherent nature of the business model, the Fund deals with smaller contractors who do not possess adequate collateral/financial strength. Guarantees are extended only based on project cash flows and general technical ratings of contractors. However, CGF evaluates each contractor according to the form of the business (Proprietorship, partnership or limited liability company ) and different measures are taken such as requesting for affidavit/indemnity based on the risk. Furthermore, close monitoring of the projects throughout, technical assistance, advisory assistance, management of cash flows in some instances and access to the project cash flows have mitigated the risk to the fund to a greater extent.
Vulnerability to the changes in government policies; The construction industry in Sri Lanka is a relatively a high-risk industry and the industry outlook is highly dependent on the Government policies. Currently, the outlook of the industry has further deteriorated due to Government’s fiscal constraints for the continuation of ongoing and proposed construction activities. Moreover, the continued slowdown in the construction industry as well as the regulatory/Government policy changes in relation to the construction industry, has also affected the small to medium-scale construction contractors in Sri Lanka. Since the demand for various construction bonds/guarantees is driven by the growth in the local construction industry, the macro-economic conditions such as changes in interest rates, depreciation of the Sri Lankan rupee and other policy directives of the Government in this industry is likely to have an impact on the overall performance of the Fund.
Relatively high incidence of encashment; Compared to other countries, Sri Lankan Authorities have a culture of en-cashing guarantees immediately at disputes and without basis (during CY2021, the fund has paid ~LKR 0.5 Mn for a disputed contract); nevertheless, the Fund has kept claim levels low through its close monitoring of projects and advisory to the contractors.
Analytical approach: For arriving at the ratings, ICRA Lanka has applied its rating methodologies as indicated below.
Construction Guarantee Fund was established in the year 1998, with the view of providing facilities to the Construction community mostly the Private Sector. Since there was no procedure to directly give state sponsorship to finance the Private Sector, a Special Purpose organization with autonomy named Construction Industry Guarantee Fund Ltd was liquidated and a fully state-owned entity named Construction Guarantee Fund was established. The budget proposals presented to the Parliament in 1999, established the Trust/Fund with a state grant and allocated LKR 100 Mn, whilst Secretary to the Treasury was tasked with implementing this proposal. Treasury Secretary as the settlor decided to establish the Fund and manage it through a Board of Trustees. The government had only granted LKR 55 Mn in four instalments after the establishment of the Fund. Construction Guarantee Fund in addition to providing financial facilities to construction contractors, has launched a wide range of other services such as Bill discounting (factoring), Contract Administration, Managing cash flow & Administration and Dispute Resolution & Dispute Avoidance in the construction industry, targeting small & medium scale construction contractors. Sri Lanka is one of the few countries to have implemented this type of service and the Construction Guarantee Fund provides various guarantees and indirect financial facilities required by the contractors engaged in the domestic construction sector without retaining any security/collateral, insurance money or property for the guarantees offered.
Rating history for the last four years: Construction Guarantee Fund
|Niroshan de Silva|
Head of Ratings
Subsidiary of ICRA Limited
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