ICRA Lanka Limited has revised the Issuer rating assigned to Construction Guarantee Fund (“CGF”/ “the Fund”) to [SL] A(pronounced S L A) with stable outlook from [SL] A- (pronounced S L A minus) with stable outlook.

Rationale

The rating revision primarily factors in the Government of Sri Lanka (GOSL)’s recognition of the Fund as a long standing key player in the construction industry in Sri Lanka. This was further witnessed by the Fund’s recent partnership with the Road Development Authority (RDA), providing its the services/guarantees on behalf all the construction contractors under the “Saubagya Dakma Programme”, which targets  the construction of 100,000 Km-rural roadnetworks  around the country. This programme has not only helped the Fund to increase its  operational scope during CY2020 but also to envisage its due recognition as a Fund Manager in the local construction industry with two decades of experience. Moreover, ICRA Lanka takes comfort of the ownership and the sovereign support to the Fund. ICRA Lanka also notes the Fund’s unique operational model as a non-profit service organization in Sri Lanka, its stringent underwriting standards, and its self-sustaining operational structure that requires minimal support from the GOSL. This coupled with the entity’s governance system that is admistered through a Board of Trustees, representing key public and private sector officials, has enabled the Fund to operate as an autonomous body without interference from the GOSL. ICRA Lanka notes the Fund’s comfortable liquidity profile and the healthy capitalization 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 the capital) currently stands at ~7.50(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).

The rating strengths are partly offset by the continued downturn in the domestic construction sector over the past three years amidst the exceptional events that have taken place during this period. 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 especially over the past two years. However, the Fund’s overall financial performance has significantly improved during 8MCY2020, largely due to increased market share amidst the recent partnership with RDA as mentioned above. During CY2020, although, the Fund has experienced some claims due to industry downturn, the overall invocations remain at a lower level compared with the Fund’s total capital position. The reported contract-disputes during the past few years are largely due to employer’s fault to settle the due payments on behalf of the contractors on a timely manner and therefore, this has also contributed to the lower invocation levels by the employers.

Outlook; Stable

The Stable outlook reflects ICRA’s expectations that the Fund will continue to benefit from its sector specialty as well as the new partnership with the RDA.

Credit Strengths

Sovereign Support and operational independence; The Construction Guarantee Fund 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 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-Special Purpose Vehicle (SPV), without direct influence from the government and also to operate without highly leveraging the Fund’s capital base over the past two decades, although the total gross liability of the Fund has increased significantly during 8MCY2020.

Extensive Experience of the Management and Conservative Risk Management Policy; 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. Over the past years, the management has been able to maintain good relationships with all stakeholders in the industry including the Ministries, Employers and Contractors and this has ensured the Fund to operate even when construction industry was experiencing a slowdown. 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. Although, the Fund has increased its scope/services in CY2020 under the 100,000 Km rural road development programme, the trade payments for the construction contractors under this programme are  channelled through the Construction Gurantee Fund. This has also helped the Fund to manage its project portfolio based on the progress of the construction projects. 

Lower Competition in the industry; Construction Guarantee Fund provides various guarantees/bonds without retaining any collateral, 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 & 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. Moreover, under the 100,000 Km-rural road development programme, the Fund provides its services for all the construction contractors of this programme regardless of their contractor grades.

Relatively lower claims position; during the past two decades, the Fund has only experienced bond encashment, amounting to~ LKR 92 Mn. These were largely underwritten during 2008-2015 wherein, the price variations rights of the small & 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 due payments to the contractors and therefore, this has also contributed to the lower invocation levels by the Employers. ICRA Lanka also takes comfort of recent developments in the construction industry, especially in the contract dispute resolutions (such as adjudication & 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 minimize its number of claims during CY2019/20, but also to develop a good relationship between the Employer and the Contractor through the negotiation path, whenever a dispute arises. However, given the increased scope of the Fund under the 100,000 Km rural road development programme, 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 CY2019/20, the premium collection during 8MCY2020, has increased signficatly due to increased levies amidst the new services offered by the Fund under the 100,000 Km-rural road development programme. During 8MCY2020, the Fund has recorded a premium income of LKR 312.8 Mn, as compared to LKR 109.6 Mn in the previous year. However, during this period, the Fund has also recorded some claims/invocations, amounting to LKR 1.9 Mn. The Fund’s has a comfortable liquidity position with healthy capitalization 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 ~7.50 (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).

Credit challenges

Macro-economic 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 the 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 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 (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 sepciality 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 due to various reasons. ICRA Lanka note during CY2020, the Fund’s effective liability exposure has increased significantly amidst its increased scope under the 100,000 Km rural roal development programme. Therefore, the ability of the management to further improve its due-diligence process and thereby limit its higher risk-contract liabilities remains to be reviewed in the future.

Analytical approach: For arriving at the ratings, ICRA Lanka has applied its rating methodologies as indicated below. Links to applicable criteria:  https://www.icralanka.com/corporate-rating-methodology