What the Heck is Due Diligence? 2

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Friday, July 24th, 2015
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Due Diligence
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From banks and institutions through to mum and dad investors, it is essential to undertake adequate due diligence on your potential developer/builder prior to contract.

All too often, price takes precedence. However, this can lead to a nasty (often costly) shock when things go wrong. As a technical advisor to international banks and investment firms, my job is to be a ‘technical translator,’ assessing project risk on their behalf.

Here’s how I do it for a Design & Construction project:

The assessment of project risk doesn’t happen in a colour coded spreadsheet or a workshop; it’s a detailed assessment of all aspects of what it takes to get a project from inception to completion. Key areas of focus can be defined as follows:

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1. Partnership

Although the financial sector is often seen as mercenary, banks place a lot of emphasis on the softer side of corporate relationships.  Typically the term ‘partnership’ will apply to whether there has been a historical relationship between the key parties (e.g. builder and developer) – do they have similar corporate values, financial strength and experience? The theory of balance is key in the area. An inexperienced developer needs an experienced builder, but an accomplished developer may be able to up skill a less experienced builder without substantially increasing risk.

Where a history of working together can be evidenced, typically a lot of early issues can be avoided such as protracted commercial negotiations, misalignment of expectations and lack of trust. Collective success on prior work will count significantly more than separable experience, and so this should be conveyed. If you are the developer, this partnership concept could equally apply to the builder and their sub-contractors or design consultants.

2. Project Team and Capability

It is just as important to use discretion when selecting your consultants and advisors as it is in appointing your builder. Having the right people with the right experience can leverage past experience and avoid costly mistakes. Even when consultants have vast experience in areas relevant to your project, this is often not enough. On that basis, seek out answers to the following key due diligence questions:

  • What experience does the firm have in delivering equivalent services?
  • Of the staff nominated, what personal experience do they have in this area?
  • What capacity does the organisation have to service your project?
  • Have they experience working under your procurement route (e.g. novated design team)?
  • Do they have experience working with the other project parties (e.g. builder, other consultants, municipality)?
  • What lessons have they learned from that experience and how will it be brought to bear on your project?

Capability should be judged by evidence, whether this be written or verbal via reference checks. Don’t fear formality in this context; any service provider, consultant or adviser should be willing to put forward referees for past work. If not, consider it a warning sign.

Common pitfalls which occur at a design team level is a lack of integration, failure to take collective responsibility for the project outcome and breakdown in communication. In many ways, past experience between the parties working together will mitigate the potential learning curve and bedding down process experienced at the start of projects.

3. Construction Methodology

Taking a moment to step into the builder’s shoes is important to identify whether their planned approach is actually going to work. Aspects such as overly ambitious access assumptions or an inconsistent approach to tenant management can create pinch points and project stress. In order to avoid potential for delays and increased costs, it is important to ensure the construction methodology is consistent with the client’s expectations and constraints.

The key point of reviewing this aspect is to test the validity of assumptions and the level of risk associated with each. Often through engaging in this dialogue, a range of assumptions can actually be tested and verified before commencement to mitigate construction phase risk and potentially to identify opportunities to the benefit of all parties.

4. Cost

Cost is a tricky area to step into for many as the desire for ‘best price’ is often seen as conflicting with ‘least risk.’ However, there is a structured way in which a builder’s price can be tested to achieve comfort prior to contract execution.

Typically, this involves undertaking an independent cost estimate (often termed a ‘pre-tender estimate’) to define, based on the scope, the market price to carry out the works – normally priced by a quantity surveyor.

This sets expectations upon which tender returns can be assessed. Typically tender returns should fall within plus or minus five per cent of the pre-tender estimate (PTE). If costs are substantially lower and the PTE has been verified as accurate, it is a warning sign that the market price has been artificially reduced to win the work. If this is the case, it is prudent to retain the difference between the tender price and the PTE, as in most cases, the project costs will escalate (at least) to the PTE level.

From a due diligence point of view, a price which is in excess of the PTE will mean (based on the independent PTE) that the likelihood of builder default on the project is somewhat reduced.

5. Program

A complex and often subjective topic, program reviews can often be daunting and limited to a cursory look at total duration.  This can, however, neglect more important aspects such as what are the critical activities (meaning there is no flexibility as to when these can occur) on the project?  And, how easily will these be affected by external factors?

Typical issues with builder programs can also be that they are reverse engineered to a prescribed client time frame. This can mean that builders simply ‘draw a pretty picture’ to suit the client’s need without applying the systematic and detailed approach to defining the logic, sequence and time frames associated with each task on the project. Seeing granularity in the program can be taken as a further validation of the construction methodology as this should be solidified by both the program and the cost.

If in doubt, consult a professional program reviewer. Technology today can allow program consultants to quickly provide a key health check of your builder’s program based on industry standards for logic, sequence and detail.

6. What if?

A key part of any due diligence is also to continually ask ‘what if?’ This includes assumptions made in any area of the project, in order to develop from the earliest stage, an appreciation of the project variables, risk and contingency plan.

Ultimately, the what-ifs should be covered off in the contract between the parties to include consideration of (not least) the following areas:

  • Rights and process around contract termination
  • Definition of performance
  • Actions upon insolvency
  • Warranties upon work provided
  • Basis and limitations of reimbursement
  • Insurances
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  1. L . Burke Files

    Might I suggest looking at the International Due Diligence Organization for more information on processes and method for due diligence. Also – this is very well set out process for site due diligence with the inclusion of the team members.

  2. Mark Whitby

    Good article Adam,

    It seems that your approach if taken by builders would translate into lower risks and possibly lower insurance premiums… I hope so.

    But in my experience with building warranty insurance, my letter to one company (and enquiries to a bank) regarding reducing the risk of slab (or footing) failure in return for lower premiums fell on deaf ears… I suppose because when there are so few competing insurers you just put up the premiums to cover the cost of the successful claimants.