The construction marketplace continues to show signs of improvement as contractors work through backlogs that include sub-par margin work secured a few years ago.
This improvement in the industry, along with the surety industry experiencing better-than-average loss ratios, means potential expansion in the procurement of favorable surety programs for many construction firms.
The post-recession construction economy has given healthy contractors the opportunity to grow. They are seeing increased volume opportunities that include improved profit margins and surety programs from top-tier surety firms that provide very generous bonding programs.
Unhealthy contractors, on the other hand, continue to struggle, lose bonding programs and in severe cases, cease operations.
Top-tier surety firms are looking to support healthy contractors that are focused on construction projects that profile in line with the following criteria:
- core capabilities comfort zone;
- known geographic work locations;
- average contract project size range;
- financially sound owners and general contractors; and
- size consistent with financial position of company.
The construction industry in 2016
Best-in-class contractors have learned from the recession, internalized those key lessons and incorporated them into their management processes. They have focused on lean operations and have been mindful of financial risk management. More specifically, the most successful construction firms continue to stay focused on the following key operational elements.
- Project selection. Healthy contractors are highly selective about the projects they take on, focusing on work that is within their core capabilities and makes both financial and operational sense.
- Project management and oversight. Healthy contractors are focused on assigning experienced project teams to high-risk jobs.
- Project change order resolution controls.
- Corporate overhead cost control. Healthy contractors regularly monitor operating costs to ensure the company does not overspend in its day-to-day operations.
- Financial checks and balances. Ensure sound, thoughtful financial decisions.
The key to a successful bonding relationship is open, active and honest communication. As construction firms start to plan for the 2016 year-end, it is imperative that the surety firm be kept up to date on a variety of matters, including:
- projected 2016 financial results;
- bank line of credit agreement, along with anticipated borrowing capacity;
- status of significant under-billings and potential construction claims;
- status of significant construction litigation;
- cash flow requirements for 2016 tax liabilities; and
- backlog update and job fade issues.
At a minimum, this communication should occur on an interim basis and then once more when the CPA firm completes the final, year-end financial report.
The surety industry in 2016
Overall, the surety industry outlook is stable for 2016. Surety firms continue to provide generous bonding programs to construction firms that exhibit some of the following key attributes:
- significant cash balances;
- minimal line of credit borrowings;
- significant net working capital;
- significant equity; and
- low history of contract fade.
On the other hand, surety firms will continue to reduce support for construction firms that exhibit some of the following attributes:
- minimal cash balances;
- minimal line of credit availability;
- minimal “tangible” working capital;
- minimal “tangible” equity; and
- significant project profit fade.
Similar to 2015, the surety industry in 2016 is anticipating some continued losses from both middle market and large market specialty trade contractors, as well as general building and engineering contractors. These losses will be the result of construction firms that, during the past few years, secured low-margin or no-margin projects with tough contract terms that have turned out to be operational and financial nightmares.
Sureties will continue to be hungry for the best-in-class contractors and will compete aggressively on bonding program capacity, indemnification agreement terms, and conditions and bond rates. However, on the opposite spectrum, sureties will continue to be very cautious and provide minimal surety credit, if any, to struggling contractors.
Surety credit underwriters will continue to focus on project owners, project financing arrangements, contract provisions with high-risk financial exposure for the contractor and warranty provisions. The underwriters will place intense focus on quality and classification of contract accounts receivable, recovery potential for recorded and unrecorded change orders and claims, realization of significant under-billings and availability to proper bank lines of credit.
The three “Cs” of contractor credit evaluation will remain a focus for underwriters:
- Capital: the construction firm’s overall financial position.
- Capacity: the construction firm’s computed bonding capacity based a variety of factors, including, but not limited to a multiple of net working capital and equity.
- Character: bad character can be the downfall to a contractor’s bonding program even with a strong balance sheet.
Bonding companies will continue to support and provide favorable bonding programs to contractors that focus on projects within their core competencies and are highly discriminating when it comes to project selection. Bonding companies will continue to avoid providing credit to risky projects with unknown project elements, contract terms, partnerships and problematic owners. Simply put, bonding companies are looking for the contractors that stick to what they know best, do it well and make money.