ICRA Lanka reaffirms issuer rating of [SL]A- for Construction Guarantee Fund

ICRA Lanka Ltd., subsidiary of ICRA Ltd., group company of Moody’s Investors Service, has reaffirmed the Issuer rating of [SL]A- (pronounced SLA minus1) with stable outlook for Construction Guarantee Fund (‘CGF’/‘the Fund’).

ICRA Lanka reaffirms the rating of Construction Guarantee Fund, primarily by factoring in the Government of Sri Lanka (GOSL) ownership and the sovereign support to the Fund; coupled with the well-established acceptance and position of the Fund in the Sri Lankan construction sector with two decades of experience. 

ICRA Lanka notes the Fund’s unique operational model as a non-profit service organisation in Sri Lanka, its relatively stringent underwriting standards, and its self-sustaining operational structure that requires minimal support from the GOSL. This coupled with the entity’s senior management and governance system through a Board of Trustees, representing key public and private sector officials, has enabled the Fund to operate as an autonomous body without direct interference from the GOSL.

The reaffirmed rating strengths are partly offset by the continued downturn in the domestic construction sector, which is closely correlated with the macroeconomic conditions of the country. Historically, the Fund’s bond exposure has been highly skewed towards the State-funded construction contracts.

Given the government’s fiscal constraints, ICRA Lanka views this exposure on a negative note as delayed payments from the Government sector have affected the construction industry in Sri Lanka over the past few years. 

Moreover, the small to medium-scale construction contractors have been adversely affected by the continued downturn in the construction industry during this period under review. However, the Fund’s overall financial performance has not been significantly affected during CY2018/19, largely due to increased market share and the additional services that were offered by the Fund. 

During CY2018/19, although, the Fund has experienced some claims due to industry downturn, the overall invocations remain at a lower level compared with the Fund’s capital position. The reported contract-disputes during the past few years are largely due to employer’s fault to settle the payment on behalf of the contractors on a timely manner and therefore, this has also contributed to the lower invocation levels by the employers.

During CY2017, the fund’s effective liability in relation to a single contractor had increased noticeably. Moreover, the inability of this contractor to complete his ongoing projects due to liquidity constraints, had accentuated the fund’s overall risk profile during this period under review. However, currently the Fund’s effective liability towards this contractor has substantially reduced, following the Fund’s taking over of the ongoing construction contracts and achievement of substantial completion.

Notwithstanding, the downturn of the construction industry, the Fund’s premium income during CY2018/19 has increased amidst the additional services that were offered by the Fund. However, during this period, the administration and other expenses have increased on account of increased risk management activities undertaken by the Fund. 

ICRA Lanka notes the Fund’s comfortable liquidity profile and the healthy capitalisation metrics, commensurate with its business profile. The investments of the fund mainly consist of government securities and risk free assets. The leverage of the capital (the cumulative guarantees issued to capital) currently stands at 1.60(x), indicating sound capital buffer for its business albeit the maximum level set at 10(x) by the Board of Trustees (in the absence of regulatory capital requirements).

Outlook: Stable

The Stable outlook reflects ICRA’s expectations that the Fund will continue to benefit from its sector specialty as well as the expected recovery of the construction industry.

Credit strengths

Sovereign support and operational independence; The Construction Guarantee Fund was originally set up through an act of the parliament and the Government had disbursed a capital grant of Rs. 55 million in four instalments. The Secretary to the Treasury was tasked as the settlor of the Fund and manages the Fund through a Board of Trustees, who are also appointed from reputed government bodies and from private sector entities. 

Moreover, the Board of Trustees acknowledged in the Trust Deed, have 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 business, without direct influence from the Government and also to operate without highly leveraging the Fund’s capital base over the past two decades. 

Moreover, the Fund is still actively managed by the founding members of the organisation and therefore, the commitment of these members has also helped the Fund to operate as an autonomous body without direct interference from the GOSL.

Extensive Experience of the Management and Conservative Risk Management Policy; the Fund is being 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. 

Over the past years, the management has been able to maintain good relationships with all stakeholders in the industry including the Ministry, Employers and Contractors and this has ensured the Fund to operate even when construction industry was experiencing a slowdown in the economy. 

Moreover, Construction Guarantee Fund being a Government 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 reduce the level of claims/invocations over the past.

Lower Competition in the industry; Construction Guarantee Fund provides various guarantees/bonds without retaining any security, insurance money or property for the guarantees offered. 

However, Commercial Banks/Insurance companies also offer such facilities by retaining valuable properties as security in addition to higher service charges to mitigate their risks. 

Furthermore, the large scale construction contractors, generally prefer such facilities from commercial banks as the Fund’s continuous engagement with the ongoing projects are viewed negatively by large scale contractors. Therefore, the Fund generally caters to small and medium-scale construction contractors and encourages them to uplift their level to a higher capacity/contactor grade in an open manner. 

Moreover, most construction contractors, who have uplifted their capacity/contractor grade with Construction Industry Development Authority (CIDA), then, shift to commercial banks from the Fund. Generally, this would take relatively longer time and these type of contractors are generally replaced with emerging new small-medium scale contractors to the Fund.

Currently, commercial banks are very selective in funding of construction projects due to increased risks of the industry. Therefore, the demand for various guarantees offered by the Fund has increased recently notwithstanding the continued slowdown of the industry in Sri Lanka.

Relatively lower claims position; during the past two decades, the Fund has only experienced bond encashment, amounting to Rs. 92 million. These were largely underwritten during 2008-2015 wherein, the price variations rights of the small and medium contract agreements during this period were forbidden. 

Moreover, during the past three to four years, there were few claims from the employers amidst the continued downturn of the construction industry. The delays in project executions were largely due to employer’s fault to settle the payment to the contractors and therefore, this has also contributed to the lower invocation levels by the Employers. 

ICRA Lanka also take comfort of recent developments in the construction industry, especially in the contract dispute resolutions (such as adjudication and arbitration). Currently, several professional/independent bodies maintain a registry of professional arbitrators and therefore, contract disputes are now viewed as a right of the contractor. 

This has not only helped the Guarantee Fund to minimise its number of claims during CY2018/19, but also to develop a good relationship between the Employer and the Contractor through the negotiation path, whenever a dispute arises. Given the continued downturn of the construction industry, ICRA Lanka will continue to monitor the overall performance of the ongoing contracts liabilities and the new claims position going forward.

Profitable operation; Over the past two decades, the Construction Guarantee Fund has maintained a healthy financial profile. Although, the downturn of the construction industry has continued into CY2018/19, the premium collection has increased due to increased additional premium incomes/levies amidst the additional services that were offered by the Fund. 

During CY2018, the Fund has recorded a premium income of Rs. 56.57 million, as compared to Rs. 55.73 million in the previous year. During 8MCY2019, the fund has recorded a premium income of Rs. 36.54 million. However, during this period, the administration and overhead costs have increased on account of increased risk management activities undertaken by the Fund, while also recording some claims/invocations, amounting to Rs. 13 million. 

The Fund’s has a comfortable liquidity position with healthy capitalisation metrics commensurate with its business risk profile. The investments of the Fund mainly consist of government securities and risk free assets such as fixed deposits which earn moderate returns. 

The leverage of the capital (the cumulative guarantees issued to capital) currently stands at 1.60 (x), indicating sound capital buffer for its business albeit the maximum level set at 10(x) by the board of trustees (in the absence of regulatory capital requirements). 

Moreover, despite the overall adverse performance of the construction sector, the Fund has been able to contain its overall claim levels to 5-6% (total cumulative guarantee encashment to the total cumulative guarantee exposure in September).

Credit challenges

Macroeconomic Outlook and Government Policies; the construction industry in Sri Lanka is a relatively high risk industry and the industry outlook is highly correlated with Government policies. Currently, the outlook of industry has further deteriorated due to Government’s fiscal constraints to continue the ongoing and proposed construction activities. 

Moreover, the continued slowdown in the construction industry as well as the regulatory/Government’s 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 are driven by the growth in the local construction industry, the macroeconomic conditions such as increasing interest rates, depreciation of the rupee and other policy directives of the Government in this industry (as mentioned above) would likely have an impact on the overall performance of the Fund.

Limited Due-diligence and Project Execution Risks; the Fund generally undertakes relatively high contract-liabilities without any financial securities and as a consequence, the Fund has faced higher financial risks. Hence, any weaknesses of the Fund’s due-diligence process are likely to result in higher financial risks. However, the Fund has been able to manage this over the past two decades by building expertise in managing the risks. 

ICRA Lanka takes comfort from the Fund’s sector-expertise in the construction industry, and this has helped the Fund to take over the construction projects on behalf of its contractors, (in order to reduce the Fund’s overall financial liabilities), in the event the contractors are unable to discharge its duties according to the conditions of the contracts due to various reasons. 

ICRA Lanka noticed during CY2017/18, the Fund’s effective liability exposure (per client) had increased noticeably and moreover, the Fund had taken over certain construction contracts in order to reduce its financial liabilities during this period. 

Currently, the Fund’s effective liabilities for these projects have declined substantially following the Fund’s taking over of these projects. Therefore, the ability of the management to further improve its due-diligence process and thereby limit its higher risk-contract liabilities (as mentioned above) remains to be reviewed in the future.