Financial engineers – you can be forgiven for holding them in total contempt. The finger of guilt for the recession ravaging construction firms points witheringly in their direction.
But, galling as it might seem, construction now needs financial engineers more than it needs civil, structural, mechanical or electrical engineers.
The tools and tool-making talents of financial engineers could prove vital in thawing billions of pounds worth of frozen projects. It offers the potential to generate a vaste source of new construction work through tapping more efficiently and effectively private finance and what remains of the public funds.
With the future path of construction workloads heading southward the industry faces a stark choice: innovate and adapt or shrink.
Leaving aside house building, construction firms are largely dependent on derived demand. They are, in the main, passive within the marketplace reliant on others to generate demand for their services.
So with private clients wary and the public coffers brimming with IOUs the prospects are not peachy. And if construction firms want to fill the hole left by the retreat of their usual clients they will have to look to themselves.
In a recent article in Building Magazine I suggested that the industry should:
- Stop asking the question “Where is the work?” and instead ask “Where might there be work?”
- Assess just where the industry adds value and look beyond construction to a broader view of the built environment
- Develop smarter financial models
- Be smarter at lobbying Government
- And be prepared to back more ventures with investment of risk-sharing.
If this approach is to work, construction firms must find sufficient talent to build the financial models and engineer the tools necessary to build innovative and more effective financial propositions.
Some of these skills exist within the industry and associated firms, within the major management consultants or the offices of cost consultants. There are valuable skills too within the real estate world.
But the smartest financial toolmakers are most likely to be found in the City or the various smart West London streets where hedge fund managers hang out.
These are people who would see the acronym ABS and not think of Volvo. They understand derivatives, corporate bonds, CDSs, CDOs, SPVs, SIVs, hedging, leverage, even if they abuse the concepts, and they have nose for who has what risk appetite. More importantly they have a nose for a patsy.
They “get” risk and know how to slice, dice, package and sell it. And, with a bit of training and the essential input of other smart industry-based experts, they appear to be the ones most likely to deconstruct project risks and repackage and sell them to maximum effect within the financial markets.
Why is that important? Surely that is what developers do?
Well, for a start in a tough market developers on balance choose to retreat, for all the bullish chat we hear about building into a recession. It’s the smart move. They know that better times will arrive if they sit it out and wait.
The mere fact that so much media attention was paid to the Land Securities’s decision earlier this year to go ahead with a £633 million West End property programme is testament to the rarity of investment. West End is hardly high risk.
Projects worth billions of pounds that are less obvious and more marginal are currently on ice. They will remain so for some time.
The question is whether with a different approach to financing, a different appetite for risk and reward, a different imperative, these projects might be freed.
Many probably not. Some maybe. Some probably. Some almost definitely.
If financial models were re-engineered, risks were reallocated or passed on, or new funding streams found, there would be more work for contractors.
Furthermore, there is inevitably a host of other potential projects currently not being considered that might be given life if smart financial engineering can better capture the value of the project to help support the initial capital cost.
And the moves being made to reform public spending through the concept of Total Place, published in a report last week, suggest that many of the barriers to capturing externalities may be lowered.
But rather than deal with hypothetical cases, let’s examine one idea that is progressing.
“Pay as you save” – is a scheme being explored by the Energy Saving Trust with funding from the Department of Energy and Climate Change. It is an idea the UK Green Building Council has been promoting for some time.
The basic concept is simple. Raising say £5,000 or £10,000 capital to buy energy saving kit would be beyond the reach or interest of many homeowners, so why not finance that out of future savings?
That is a relatively simple concept for a financial engineer.
First assess the risks: Is the capital cost realistic? How best to control it and any associated risks? Are the paybacks realistic? What are the default risks and how might they be reduced? What other risks need to be taken into account such as energy price fluctuations, interest rates, exchange rates, inflation etc?
Then: Structure a package or packages to sell to the markets?
The ultimately test is whether you can sell the package or packages in the market.
If you can, well it’s a done deal. You keep the offering to the consumer simple and you are off. You then tweak it as you go along to improve performance.
If you can’t sell the packages, then you look for some way to offset risk, repackage the deal or find new revenue streams.
This might mean examining what happens if you expand the project to include wider packages of work, such as general refurbishment (as the UKGBC suggests in its report). These may provide economies of scale that makes the package more attractive. There may be other technical tweaks that can be made.
Alternatively you could approach Government or local authorities to provide grant aid – on the back of the social gains inherent in the project – or you might lobby for tax breaks.
If all that doesn’t work, then it’s probably a loser.
Naturally this is an oversimplification. Counterparties to any deals would require past data to assess risk – trials would be needed. The technical people would need to establish the most technically suitable options. Marketers would have to assess customer preferences and the structure of demand in the market, so they could present the most appealing offerings to the market.
But it is not that much of an oversimplification.
I don’t wish to belittle the efforts of UKGBC, the Government or the Energy Saving Trust, but the “pay as you save” scheme is not really a “eureka” moment. The need has been evident to all for decades. Indeed the construction industry itself has screamed for years about the importance of improving the energy efficiency of the existing housing stock.
The barriers were also well understood. The issue was, to put it simply, how to satisfy the need and overcome the barriers by finding a funding mechanism that captured the long-term benefits (mainly fuel cost savings) in a way that could provide for an up-front capital cost that acted as a major factor deterring homeowners from investing.
Construction firms might wish to ask themselves why, to get this scheme off the ground, it took an industry sponsored think tank, a quango and a Government department.
Either, the concept works and represents a market opportunity, or it doesn’t. If it doesn’t then the UKGBC, the Government and the Energy Saving Trust have wasted their time. If it does construction firms have missed a trick.
The real question is whether construction firms are looking to create opportunities or do they expect the Government or another party to provide them with ready-made packages of work?
If the industry remains reliant on derived demand, its firms must be prepared to grow and shrink with the market fluctuation and they must accept the scourge of destructive price cutting that comes when times get tough.
There is, however, an alternative. Intervene in the market and make things happen. And financial engineering and a more innovative approach to financial modelling does offer the opportunity to create new work.
How about, off the top of the head, “neighbourhood bonds” for regeneration projects?
Why not seek to sell bonds or shares in a project to local residents, businesses, landowners, long-term commercial tenants, or indeed prospective tenants and residents within the project.
The bondholders/shareholders would who not only receive a dividend but would also benefit from the capital value uplift from the regeneration. They might collectively be given a seat on the project broad in a move that would improve local engagement.
This might provide cheaper capital finance than is available from the market and so capture some of the value of the “regeneration uplift” that is normally lost in the sands. It might also provide a useful vehicle for targeted tax breaks in priority development zones.
I am not saying it will work, but we do need new ideas if construction activity is not to dwindle.
I am not suggesting that financial engineering is not being considered within the construction and development world. TIFs (tax increment financing) have been much considered in the development world of late over recent years. They are used widely in North America.
And there will be other tools that might be considered, such as house builders and residential developers using residential derivatives to hedge against adverse price fluctuations.
But to unleash these opportunities it will take smart financial engineers able to work alongside smart technical engineers and smart commercial people.
If the construction industry could attract such people and provide for them a career path it might in doing so find a path to a land where it is less reliant on clients and more reliant on its own wit and wherewithal.
Ultimately wouldn't it be better to have these boffins working on developing financial tools to help create real things like buildings than dabbling in the alchemy that creates bizarre complex synthetics in the financial markets and ends up threatening the financial world as we know it.