The public and private capital that funds construction either isn’t there or is sitting on the proverbial sidelines, with nonresidential construction put-in-place declining 21.8 percent from October 2008 to May 2012, according to the U.S. Census Bureau. Future indicators of construction activity like the Architectural Billing Index are trending downward in 2012 after a brief rise in the latter part of 2011. While there are indications that certain sectors are expanding (e.g., power, manufacturing and health care), the overall outlook for construction is negative in the near term.
As a result, most contractors dramatically scaled back their operations in the hopes of finding the right balance between overhead and the amount of profit that can be earned in today’s market. Landing a job with a healthy profit margin gets harder by the day.
The list of what can go wrong on a project is long, but one of the most common problems is subcontractor failure. Margins are so thin that one key subcontractor failure can be the difference between a successful and unsuccessful job. Very little can be done about the inherent weakness of today’s construction market, but prequalifying all project partners is one way to take control.
Contractor prequalification is the foundation on which surety bond underwriting is built. Every day, sureties make risk decisions about whom to bond, how much bonding to provide, and under what terms and conditions to issue the bond. Prime contractors face the same choices every day when assembling project teams.
Financial consequences prime contractors face because of subcontractor failure often can be transferred to third parties via bonding or subcontractor default insurance. Subcontractor bonding is the most common form of third-party risk transfer and often is used alone or in combination with subcontractor default insurance. However, transferring the risk to third parties is not always possible, making subcontractor prequalification even more important.
Bonding companies make prequalification decisions by evaluating contractors’ financial condition, credit history and experience. General contractors should use the same methodology when evaluating prospective subcontractors. They should secure financial statements from the last two to three years, order credit reports and request information on the subcontractors’ bank line of credit. Also, create a questionnaire for subcontractors that covers their safety record, a listing of the largest jobs they have completed, brief biographies on key employees, references and insurance coverage with the name of their insurance agent.
Once all that information is evaluated, make a job-specific decision on each subcontractor and determine how much overall risk to “self-insure” versus transfer to third parties.
Even the best in-house prequalification efforts can fail. Bonding companies do this all day, every day, and still make mistakes. The important thing is to implement a process and put the final decision on subcontractor risk in the hands of senior management. Communication within an organization is critical to managing subcontractor risk, and it is becoming even more important now that many contractors have expanded geographically in the pursuit of projects. As a result, it’s important to track aggregate exposure of a subcontractor across an entire operation.
Prequalification of business partners should not be limited to subcontractors. Project owners, joint venture partners, small business teaming partners, bonding companies and banks also should be evaluated for their financial stability. Determining the financial health of bonding companies and banks is relatively easy because they are rated by independent rating agencies. Project owners are just as financially stressed as everyone else these days, so determining their credit worthiness and the source of their project funding is critical to ensuring contract funds will be collected when due.
For joint venture partners and small business teaming partners, apply the same tools used for subcontractor prequalification.
Proper prequalification efforts require a sizable commitment of resources, but the return on investment is worth the effort. Build a process, work the process and make an informed decision based on the results of the process. Then, require a surety bond as a final protective measure.