The financial landscape and the rising risks of subcontractor defaults

In recent years, the construction industry has faced unprecedented financial challenges. Increasing material costs, fluctuating labour markets and inflationary pressures have squeezed the budgets of main contractors and subcontractors alike. Subcontractors, who often operate on thinner margins and more variable cash flows, are particularly vulnerable to these financial pressures – and this in turn has led to a notable rise in subcontractor defaults and bankruptcies globally, writes John Ridgeway.

Such defaults pose significant risks to projects and companies, often leading to major delays, project cost overruns and even legal complications. In response, companies across the world are increasingly turning to measures like rigorous pre-qualification processes and surety bonds, which aim to vet subcontractors for financial stability and assure project completion.

In the U.S., construction costs rose sharply from 2021 to 2023 due to inflation and supply chain disruptions. According to a 2023 report by the Associated General Contractors of America (AGC), material prices jumped nearly 20% in some cases, straining subcontractors’ budgets and causing cash flow issues. Many subcontractors have faced difficulties absorbing these costs, especially on fixed-price contracts where they cannot easily pass on increases to clients.

The increase in subcontractor defaults has led many to rely more heavily on pre-qualification measures. This includes financial vetting and the use of surety bonds, (we use an AI generated image as an illustration) which act as a safety net to mitigate potential project disruptions. For example, surety bonds allow project owners or general contractors to recoup losses or secure replacement subcontractors without bearing the full financial burden.

In the UK, subcontractor insolvencies rose by nearly 17% between 2022 and 2023, according to the UK Insolvency Service. With mounting material costs and decreased project margins, smaller firms have struggled to keep up with cash flow requirements. The collapse of British Steel in 2019 exemplified how larger supply chain disruptions can impact subcontractors further down the supply chain, resulting in a wave of defaults that affected numerous projects across the country.

In response, UK construction firms have adopted pre-qualification measures like the Common Assessment Standard (CAS), which reviews subcontractor financial health, project history and legal compliance before engagement. The increasing use of CAS helps identify subcontractors with unstable financial conditions, reducing the risk of project disruption due to insolvency.

In Australia, the construction market has been particularly vulnerable to subcontractor defaults due to tight profit margins. Recent data from the Australian Constructors Association shows that 2023 saw a rise in default rates among smaller subcontractors, often due to cash flow issues exacerbated by delayed payments and rising operating costs. As a result, more firms have been integrating surety bonds into their contractual requirements.

Surety bonds in Australia function similarly to those in the U.S., providing contractors with protection if a subcontractor defaults. These bonds give the primary contractor or project owner a financial guarantee that a replacement subcontractor will be provided or that financial compensation will be available, mitigating the fallout from default.

In the Middle East, where large-scale infrastructure and development projects are common, subcontractor cash flow issues frequently arise due to delayed payments from main contractors. This problem has been especially acute in places like the UAE and Saudi Arabia, where subcontractors often finance their work through short-term loans. The lack of timely payment from main contractors has led to a rise in defaults, disrupting high-profile projects.

To address this, firms in the region are increasingly implementing pre-qualification protocols, focusing on subcontractors’ financial stability and payment history. In some cases, main contractors have adopted measures like staggered payment schedules tied to project milestones, ensuring subcontractors receive regular payments and reducing the likelihood of cash flow-related defaults.

Mitigation strategies

As already discussed - to mitigate the risks of subcontractor defaults, construction companies worldwide are introducing pre-qualification procedures and surety bonds – but how do they work?

Pre-qualification procedures help construction firms assess the financial health, work history, and performance metrics of potential subcontractors before awarding contracts. These procedures often include financial audits, credit checks and reviews of previous project performance, ensuring that only subcontractors with stable financials and proven reliability are engaged. This not only reduces the likelihood of default but also provides the main contractor with greater confidence in subcontractor capabilities.

In the U.S., the Surety and Fidelity Association of America (SFAA) has found that projects using pre-qualification steps see a significant reduction in subcontractor defaults. Firms that require a full financial assessment before contracting, experience fewer project disruptions, supporting the benefits of a proactive risk management approach.

Surety bonds act as a financial safety net. When a subcontractor defaults, the bond covers the cost of replacing them or compensates the project owner, thereby reducing potential losses. There are several types of bonds, including bid bonds, performance bonds and payment bonds, each designed to protect against different risks. Performance bonds, for example, ensure that if a subcontractor fails to complete the work, the bond will cover the costs to find and fund a replacement.

In Canada, surety bonds are a staple in large infrastructure projects. The Canadian Construction Association reports that requiring performance and payment bonds on government projects has saved millions by preventing defaults from derailing critical infrastructure work. These bonds have been especially valuable in protecting against financial risk in high-stakes, public-sector projects.

Challenges and criticisms

While pre-qualification and surety bonds offer important safeguards, they are not without challenges. Surety bonds can be expensive for subcontractors, especially smaller firms with limited cash flow. The premiums for these bonds are typically passed on to the project costs, adding an extra financial burden. Additionally, the process of obtaining a bond can be time-consuming, delaying project initiation.

Pre-qualification procedures, while effective in risk mitigation, may also inadvertently exclude smaller or newer subcontractors who lack a lengthy financial track record. These firms may be financially stable but unable to demonstrate long-term stability, making it difficult for them to secure large projects. This can limit opportunities for newer firms and reduce the pool of available subcontractors, potentially driving up costs due to reduced competition.

In response, as subcontractor defaults continue to be a global issue, the construction industry is exploring new approaches to risk management. For example, advances in technology are enabling real-time financial monitoring and predictive analytics. By tracking subcontractors’ financial health continuously rather than relying solely on initial pre-qualification, main contractors can identify signs of financial instability early. Digital platforms like Procore and Oracle’s construction suite now offer modules for financial tracking, providing contractors with a more granular insight into subcontractor health.

Some construction firms are also adopting more flexible payment arrangements to ease subcontractor cash flow pressures. Milestone-based payments, for example, provide subcontractors with regular, predictable income, reducing the risk of cash flow interruptions. Collaborative contracts, which align payments with progress, can help subcontractors maintain liquidity, reducing the likelihood of default.

In addition to traditional surety bonds, some companies are also turning to subcontractor default insurance (SDI), which provides broader coverage and more flexibility. Unlike surety bonds, SDI can cover defaults on multiple subcontractors within a single project, offering a more comprehensive risk mitigation solution. SDI is becoming more popular, particularly in North America, as it provides additional coverage options compared to traditional bonding.

As a result, by adopting these risk management strategies, the industry is becoming better equipped to navigate financial uncertainties and protect project timelines and budgets. More importantly, the increasing adoption of these measures worldwide reflects an industry-wide commitment to stability and resilience, even in the face of financial volatility.