It’s Here or Looming: How a Recession Could Affect Your Bonding Program | woodruff sawyer

Surprisingly and fortunately, both industries have shown resilience in the face of the unknowns caused by the pandemic. Now is the time to plan for what’s to come, even if we don’t know precisely when it will happen.

With a few notable exceptions in the ranks of individual surety companies, the 2021 results point to overall profitability for the industry. The surety bond market has been consistently profitable since the end of the Great Recession, leading to several new entrants, excess capital, and a looser market with relatively easier terms and conditions.

So far, even COVID-19 has not been able to derail the industry’s good fortune. By almost every measure, 2020 and 2021 have been two of the most successful the industry has seen. In 2022, we continue to see the same themes of abundant competition, capital and capacity in the market. However, all of this can easily change due to current events and broader macroeconomic factors.

As we approach the halfway point of 2022, it’s hard to deny the feeling that we’re in uncharted territory. After all, at one point the S&P 500 was down 20% on the year, mortgage rates came back above 5.0% for the first time since 2011, and inflation in April hit 8, 5%, a 40-year high. As usual, there is a wide variety of opinions on what all the data means and how it should be interpreted as a macroeconomic crystal ball.

Fortunately, you don’t need to accurately predict when a recession will occur in order to position your business for predictable and sustainable surety credit. No matter where we are in the business cycle, there are proven steps you can take to ensure your business will always have the bonding capacity you need to execute your business plan.

Anticipating a tightening of the surety bond market

As noted, the surety industry has remained profitable over the past 15 years, allowing capacity to flow with relatively loose market conditions. At some point, and likely in the aftermath of a recession, the current phase of the surety market cycle will end and underwriting will become more disciplined. Capacity will be harder to find, terms and conditions will be less favorable and prices may even increase.

The continued success of the surety industry also means that there are well-established industry veterans who have never had to navigate a tougher surety market. So how can you recognize a changing market? And what can you do to best insulate your business from this external fatality?

Now consider the bond underwriting factors

The good news is that financially strong, well-managed entrepreneurs can still use their “bondability” to differentiate themselves from less qualified competitors. This becomes even more critical and beneficial in the context of a slow growing or shrinking economy where surety credit may be less available.

As such, now is the time to develop a better understanding of surety underwriting qualifications and how to incorporate them into your business planning process.

Credit analysis

As underwriting discipline intensifies, there will be more emphasis on underwriting fundamentals, which will take the form of:

  • Understand how companies manage liquidity, cash flow and leverage
  • Understand that working capital is an important quantitative measure of liquidity; sureties will focus on quality current assets, including accounts receivable and under-invoicing
  • Work-in-progress (WIP) schedules are being scrutinized more closely, with more attention paid to indicators such as profit loss and under/overcharging
  • Sureties assessing break-even points from work-in-progress and overhead analysis and looking to see if contractors have planned overhead reductions to help absorb potential revenue and profit reductions
  • Search for adequate compensation packages to include affiliates, LLCs and individual owners.

Management planning and forecasting

Underwriters will expect to see management plans and forecast models that reflect uncertainties and options for various future market conditions. Expect your guarantor to ask for revenue, profit, and arrears forecasts.

Succession and continuity planning will continue to be an important underwriting consideration, particularly for those entering into long-term contracts.

Management of subcontractor and supplier risks

Guarantors will want a deeper understanding of your subcontractors’ and vendors’ qualification processes, both before work is awarded and on an ongoing basis. They will want companies to consider many factors, which resemble their own underwriting considerations:

  • Strong relationships built from a track record of past performance
  • In-depth knowledge of the client’s organizational capabilities and other commitments, particularly as they relate to specific project personnel
  • Credit analysis based on credible financial information (e.g. financial statements prepared by CPA, solid references, access to liquidity)
  • Bonding of selected subcontractors, especially those on the critical path.

Manage your surety relationship

As economic and market conditions continue to change, you need to take an active approach to your bonding relationship. We recommend that you extend your planning process to this essential credit provider in the following ways:

Establish a relationship with the surety. Contact your broker and allow the surety to make an informed decision. In the absence of information, sureties will err on the side of caution.

Character matters. Be transparent and open with your advisors. Now is when your creditors will test and assess your leadership and integrity.

Ask a professional bond producer to be your partner. Not all sureties will react in the same way to a slowing or hardening of the market. Make sure your business plan is consistent with your surety’s underwriting philosophy and approach to market conditions.

Develop a business plan for the current economic environment. A plan that outlines your strategic goals supported by financial resources and all key operational areas of the business will help guide the bonding discussion. Your surety program shouldn’t dictate your business plan—it should Support your business plan.

Assess your banking relationship. Available liquidity is always needed. If an economic downturn is affecting your cash flow, make sure you have a relationship with a construction banker, not just a bank.

Communicate financial progress throughout the year in a timely manner. Your ability to produce credible interim financial information is paramount. Disseminating accurate WIP information is essential, but you also need to figure out how best to use it as an internal management tool.

Monitor the quantity and quality of your cash and practice prudent debt management. Construction companies go bankrupt when they run out of cash. Manage cash flow, reduce secondary assets and review debt and debt service ratios. Increased revenue will not solve a liquidity problem, and sureties will be reluctant to increase support if it is not supported by their basic financial metrics.

Look forward and up

The robust market of recent years has offered construction companies the opportunity to be more selective in their projects while benefiting from unprecedented access to surety credit. Companies have been able to focus on the types of jobs they do best, while building strong internal balance sheets, relationships and processes during this time of economic expansion.

The discipline, financial resources and tools developed during the good times will serve the successful building organization well in the next recession. The ability of a contractor and their broker to effectively communicate this information to a surety is critical to laying the foundation for a sustainable surety program.

None of us can know exactly what the future holds. However, brokers, sureties, and other professional advisors can help entrepreneurs prepare for several scenarios, helping them emerge stronger from whatever happens.

Comments are closed.