With ample private money available and eager investors, private equity (PE) acquisition activity continues to transpire in the U.S. marketplace.
This is evident in construction and manufacturing, among many other industries. Naturally, many construction firms require a surety bond program in place to provide necessary performance guarantees as a part of their ongoing operations. For PE firms and construction companies contemplating an acquisition, do not allow the surety piece of the puzzle to be an afterthought.
To provide some background, the surety industry was a bit slow overall to adapt its traditional underwriting methods and provide competitive surety support of PE-acquired firms. Because a PE acquisition typically changes the complexion of the purchased company’s balance sheet significantly, the surety (as a creditor) has a much different financial picture to consider for the extension of surety credit. This is in addition to the fact that the ultimate parental ownership of the company becomes a PE firm, which typically does not provide its indemnity to the surety company in support of the construction corporation’s surety bonds.
Surety companies have come around as PE activity has become more prevalent. However, the key is to structure the acquisition in such a way that a firm dependent on surety bonds will be positioned to have a surety program available post-acquisition that supports its business plan.
There are a number of key financial components to contemplate during the due diligence and valuation process of a private equity acquisition.
Goodwill and Equity
Because the purchase price is a multiple that exceeds the current book value, the resulting transaction typically creates a significant amount of goodwill and possibly other intangible assets on the balance sheet. Surety companies rely heavily on the “tangible net worth” of a company when determining how much surety credit to provide. Goodwill and intangible assets are eliminated in their analysis to arrive at the tangible net worth calculation.
An old surety industry rule of thumb is the total surety program offered is roughly 20 times a construction company’s tangible equity. While there are many underwriting variables that affect this benchmark, it brings to light a working guideline. Finding the right balance of how much goodwill and resulting tangible net worth in the newly owned company is critical to determine how much bonding, and the associated pricing, the newly owned firm can obtain. Shortfalls in tangible net worth may prompt a requirement by the surety company to take collateral to support the desired program.
Leverage and Working Capital
The buyout process can take various forms financially, and often the post-acquisition balance sheet adds a significant amount of interest-bearing debt in addition to depletion of cash reserves. Surety companies considering a particular case place a lot of emphasis on the debt leverage of the balance sheet. Finding the right balance, or healthy amount, of debt on the post-acquisition balance sheet as it relates to the tangible net worth and volume of the company is a very important consideration.
Along those same lines, a surety underwrites the company’s ability to service the debt repayment schedule, looks at projected annual interest expense and how this will affect cash flow and the bottom line profit. The liquidity, or working capital, in the resulting balance sheet is another key component surety underwriters weigh into their analysis, as well as how much access to cash through a bank line of credit. The key financial metrics surety companies utilize in their analysis of the financial picture are intertwined.
Other factors also play a role in how “surety friendly” a new PE deal is.
- Understanding the PE firm’s investment philosophy and strategy. How long does it hold its investments and how involved in the company’s operations will it be?
- Retention of any key management for business continuity purposes. What mechanisms are put in place to ensure this?
- Mapping out the business plan of the new company. Will the company be taking on new types of work, entering new geographical territories or maintaining a similar approach as prior to the acquisition?
The key is to have a surety broker involved in the process early on in a consultative role. Utilize the broker during the due diligence phase and steps along the way to ensure an adequate surety program can be put in place after the transaction occurs.
Pro-forma financial statements and financial projections have a lot of importance in this process. The broker can provide guidance on the expected terms for the surety program, such as premium rates and any collateral requirements. The stakeholders need to be aware of these terms, not only to factor into their valuation, but also to better project financial results because they will be directly impacted by the terms.
Putting off these surety discussions until the end of the process has resulted in some of these deals falling apart after so much time and resources were expended in the process. And if not structured properly, an unexpected collateral requirement by the surety to support the bonds will add additional cost and tie up bank line borrowing availability. A well-versed surety broker engaged early in the process can be a trusted advisor.