A charter management organization (CMO) with 13 schools borrowed $26 million to complete new campuses for three of its schools. The CMO signed a design-build construction contract for more than $18 million. However, the project came in $1 million over budget. The CMO paid for the cost overruns out of its operating budget, failing its financial covenants as a result.

What went wrong that could have been avoided? For a start, investors should require the CMO to sign a guaranteed maximum price construction contract (“GMP contract”) based upon the architect’s final plans and specifications. As a result, subcontractors understand the scope of the work they are bidding on, and the general contractor can therefore give a guaranteed maximum price that is accurate. Using the alternative, a design-build contract which is based on incomplete plans from the architect, leaves much room for variability.  This kind of variance is what led to the cost overruns for the 13-school CMO.

Another issue that heightens construction risk is construction delay. It is prudent to include a liquidated damages provision in the GMP contract. This provision holds the general contractors accountable if they miss the expected completion date. For each day of unexcused delay, the general contractor will pay a penalty equal to one day of debt service on the bonds. This keeps workers from shifting to other jobs before the work is completed, which protects the projected school opening date.

To encourage value engineering, a shared savings clause should be incorporated into the GMP contract. This will inspire general contractors to look for project savings throughout the construction project. A typical shared savings clause states that if the completed project costs less that the GMP contract amount, then the savings are shared with the general contractor – 70% for the CMO and 30% for the general contractor. This encourages the general contractor to look for efficiencies that help the charter school, the contractor, and ultimately, the bondholder(s).

Appropriate budgeting should not be overlooked during this process. In most GMP contracts, the general contractor will add approximately 5% to the total construction cost to cover unforeseen expenditures and change orders. Construction contingencies are not always used but can save a project from cost overruns should unexpected costs arise, or something necessary outside of the project scope be requested. Staying within the construction budget is of the utmost importance so the charter school is not at risk of spending cash they may not have.

Charter school board members typically come from diverse professional backgrounds, but they don’t always include individuals with construction experience. One way to make sure the charter school understands all aspects of the construction project is to hire a construction monitor. This individual will have a background in architecture or construction and will be able to clearly explain to the management team what the construction project entails. A construction monitor will also keep a close eye on the project timeline, enhancing the probability of a timely completion.  Updating bondholder(s) on a monthly basis from groundbreaking to completion is also important. School Improvement Partnership tracks this process for its investor clients, detailing any unexcused delays and change orders that can increase the cost of construction beyond the amount borrowed for the project.

The GMP contract, liquidated damages provision, shared savings clause, appropriate contingency, and monthly monitoring all help ensure that bond investors aren’t faced with a bond default before the charter school even opens. Although nothing eliminates construction risk for bondholders, this best-practice approach mitigates the ninth most common cause of charter school bond defaults. Next week: #8.