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Managing Risk in a Volatile Market

Some may argue that describing effective risk management as “the difference between life and death” sounds extreme, but that is a perspective reserved for companies still around to argue.

Through the Great Recession, many firms that were unwilling to acknowledge or poorly recognized risks they encountered are no longer a going concern, while contractors that understood and acknowledged the risks involved in construction were much more prepared to manage and mitigate those risks. While risk will be ever-present in construction, the volatility and uncertainty of late has made make managing risk that much more challenging, and has many companies tempering their optimism.

The last five years have proven to be some of the most turbulent times in the construction industry’s history. While there is seemingly some light at the end of the tunnel, several circumstances indicate that a full recovery is still some time away, and the road to get there likely will be a bumpy one.

  • The surety industry is deeply involved in understanding and underwriting the financial risk of the industry on a daily basis and serves as a telling proxy for risk levels. Despite some recent improvement, there still seems to be concern throughout the surety market that there may be more fallout from the recession.
  • In addition, several markets and sectors have already experienced boom-and-bust cycles. While some continue to grow and expand at a manageable pace, several others have accelerated far faster, putting more financial pressure on contractors and many others. Rapid growth of this nature is always a cause for bubble-related concerns.
  • Like any market coming out of a downturn, the construction industry is still battling the effects of the Great Recession. By looking upstream, it is evident that this is still very much a buyer’s market. Contractors’ willingness to take work at minimal margins during the downturn has educated owners, so while backlogs have begun to stabilize and increase, margins continue to lag. Looking around, the competition is considering the same list of opportunities and everyone is playing a risky game of brinkmanship to build backlog. These dynamics are leading to thinly capitalized balance sheets among generals and subcontractors alike.

Survival is the ultimate testament to a firm’s resilience. Working with contractors across the country, FMI has learned that survival is not an accident, but rather an intentional reaction and evolution to changing conditions. With volatility and uncertainly still present in the market, there are several things these best-in-class contractors do to better protect themselves during turbulent times.

  • Strong Project Risk Assessment Process. A critical part of managing risk is being disciplined about what work the company takes on and understanding the risk it is assuming. Contractors must be aware of the deals they are striking, which is critical to ensure they are not being overly leveraged to accept terms and conditions that they wouldn’t normally take. Having a structured and repeatable project risk assessment process can greatly clarify the risks of a potential job, and can inform not only estimating, but also operations as projects progress. Being disciplined and consistent is critical to the effectiveness of the process, but once incorporated as a regular part of business, it becomes a seamless layer of protection.
  • Strong Subcontractor Prequalification Process. It would be naive to pretend that subcontractors are insulated from volatility in the market. And while many contractors “know their subcontractors very well,” most perform a subjective evaluation of their subcontractors at best. All too many operate on the assumption that a strong subcontractor never becomes a weak subcontractor, but unfortunately, that is not the case. Objectively evaluating subcontractors based on a variety of elements (including but not limited to financials) give firms a much clearer picture of the partnerships they are forming.
  • Monitoring Internal Financial Indicators. In a growing market, it is very easy to outpace the supply line or stretch working capital to unmanageable levels. Seemingly irresistible project opportunities present themselves, and after a few years of grinding and struggling to “feed the beast,” contractors can’t help themselves. Diligently monitoring working capital levels and driving positive cash flow behaviors will help contractors see potential problems before they manifest into serious issues.

Good, bad or indifferent, the recession has painted a new landscape with tighter margins and less room for error. As the landscape continues to change and volatility remains, contractors should adapt how they are managing risk. Doing so will better protect the balance sheet and legacy of the company, improve operations, increase margins and mitigate the effects of an occurrence.

In reality, risk management is not a new concept for anyone in the industry; employees across organizations manage multiple sets of risks on a daily basis. However, risk management among leading organizations is intentional and formalized at an enterprise level, rather than executed on a reactive or individual basis.

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