Monday, November 2, 2009

How in the World Did That Guy Get a Bond?

By Daniel Huckabay, President – Commercial Surety Bond Agency
It seems like I get asked this question a lot these days - especially when it comes to those one or two contractors on every bid that are below everyone else's cost to do the work. Fortunately for me, I haven't had the question asked about any of my clients. But it does leave you wondering what surety companies are basing their underwriting off of for some of these contractors and what the ramifications will be?
The surety industry has been interesting to watch over the last few years. This decade started with several tough years economically. As a result, sureties took substantial losses and there was a significant reduction in the number of surety companies in California through mergers, some exiting the California market and others going out of business altogether. These tough early years brought the usual disciplined underwriting after surety companies get whacked with losses, and that combined with the very strong economy from 2004 to 2007, resulted in some of the most profitable years in history for sureties as well as for contractors.
As the economy began to take a nosedive at the end of 2007, a strange and counterintuitive thing happened, more surety companies entered the California market. Since the downturn began, there have been at least eight sureties expand their presence or open up completely new offices in California. So just as contractors are facing less work and more competition, so are the surety companies. Most of these new surety companies target smaller contractors bidding jobs less than $5 million, and as a consequence, the surety underwriting for small contractors has become more competitive and in some cases, less stringent.
This change in the surety marketplace has no doubt made it easier for contractors in the private sector that had never previously been bonded to establish a bond program. Surety companies have historically been cautious in granting credit to a contractor making this move unless the owner or a key employee has prior experience in the public works arena or the contractor was going to take a slow and limited approach with say one job at a time.
Today, however, many of the smaller surety companies are not performing a thorough enough evaluation of these contractors. More often than not, they don’t even meet with the contractors, and therefore never hear the contractors plan first hand or whether they have the experience and capability to execute it. Most importantly, the sureties are missing out on the most important piece, which is evaluating a contractor’s character. This has long been the cornerstone of the underwriting process, and an individual’s personal and business philosophies can only truly be understood in face-to-face meetings.
So then what are these surety companies basing their underwriting on? Many of the contractors that previously did private work made a substantial amount of money during the upswing, and I can only guess that surety companies are banking on these strong balance sheets to offset the lack of experience. However, as we all know, it only takes one or two bad jobs in the construction business to wipe out capital that it took years to accumulate. They are also using tools such as fund control and collateral, which will certainly offset some of their added risk and exposure, but how much so remains to be seen.
In a down cycle such as we are in, it typically takes 12 to 18 months for contractors to pick up bad work, stumble and eventually default. If this holds true this time around, we should see many contractors go out of business next year. We've already seen several companies go out of business this year, and I would expect that number to increase significantly by the second and third quarters in 2010.
As contractors default, surety companies will face rising losses beginning next year and continuing well into 2011 and perhaps 2012. This will no doubt cause many of the sureties, especially the smaller ones, to tighten their underwriting standards. This means many of those contractors that do manage to hang in there will face a different problem - having their bonding capacity reduced or cut completely as surety companies shy away from contractors that have losses or show signs of an inability to stay in business.
But with great challenges comes opportunities for those contractors that plan ahead now. Through all of this, the number of contractors that are bondable will shrink and many of those that can get bonds, will be able to get less two years from now. This affords those that can take certain steps to maintain or increase their bond capacity over the next 12 to 24 months a significant competitive advantage. After all, what better way to reduce your competition than to bid work that others can't, because they aren't able to get a bond.
Here are 7 things you can do to improve and expand your bond program.
  1. Retain as much money in your company as possible. Because most contractors aren't making much money these days, this really means limiting the distributions you take from your company or lowering your salary/rent paid to yourself wherever possible. Think of investing in your company financial strength as a tool that helps you get bonds to get work, just like investment in equipment allows you to complete work.
  2. Defer equipment purchases if you can. This will only lower your cash or increase your debt depending on whether you finance it, and surety companies, now more than ever, want contractors with a strong working capital position consisting of plenty of cash and little or no debt. (working capital = current assets minus current liabilities)
  1. Improve your internal accounting systems. Surety companies are big on contractors having accounting systems that enable them to know where they are at all times financially. The better, and more timely, you are able to communicate this information to your surety company, the more confident and comfortable they'll feel with you. Remember, surety companies operate under the rule of thumb that bad news travels slow. Avoid the suspicion and concern by producing internal financial statements within 30 days of the period ending, quarterly or six-month CPA prepared financial statements within 60 days and year-end financial statements within 90 days. Any delay could cause a bond to get declined until surety gets a financial statement.
  1. Upgrade your year-end financial statement to a review if you currently only get a compiled from your CPA. As sureties experience increased losses due to contractors failing, their requirements across the board are bound to get more stringent. This is particularly true with the smaller surety companies that now except compiled financial statements since they will likely have the highest frequency of losses. We've already seen several change their minimum requirement to a CPA review, and this will definitely become more commonplace.
  1. Meet with your bond company at least once a year. Let them know in detail how you are doing and what your projections are. Have a well thought out plan that you can clearly outline to them. Surety companies like to work with contractors that know where they stand now, where they're headed in the future and know how they are going to get there.
  1. Make sure you have the right set of advisors guiding you. Now more than ever getting advice from construction specialists is imperative. This includes not only your surety agent, but your CPA, banker and insurance broker.
  1. Ask your surety their advice on what you can do to improve your bond program. It comes at a great price, it’s free! You can't get a better deal than that. Plus it will indicate to them that you value their input and treat them as a partner in your business - especially if you follow through on their advice.