Risk and capital: A paradigm shift for capital underwriting?
August 1, 2014 by DAVID BOWCOTT
“We’ve always done it this way.” That statement represents the death of many a good idea. When the person questioning the way things are done hears those words, they often shrug their shoulders and simply go back to doing things the way they have ALWAYS been done.
I’ve heard that statement many times from a particular segment of the economy—and that segment represents the money, both equity and debt.
Money, or capital, fuels the development of everything around us that serves the needs of humanity (railways, skyscrapers, condominiums, chromium ferris mines, schools, oil refineries, pipelines, cellular phones, automobiles, etc…). The agreements that govern their deployment into projects that develop the assets that surround us tend to follow a similar framework. All capital is risk adverse, senior debt being the most risk adverse and equity being the least.
To illustrate my point, let’s look at the most risk adverse component of any financing: the senior most debt on a deal. The common credit underwriting protocols look to find ways to secure themselves through corporate guarantees, letters of credit, cash reserves and other so-called reliable security. Basically, the credit-underwriting framework for the debt primarily ensures the money behind the debt is secured if things go to hell in a hand basket. As long as there is a more than sufficient amount of capital backing the project to which the debt is acting as fuel, the debt feels comfortable being deployed.
I’m not saying this isn’t a sound approach to credit underwriting; I am questioning if it is the only approach.
Now, let’s consider how credit underwrites a construction project and, in particular, how they underwrite the asset completion risks. They often require the drivers of the asset development to drop as much of the asset’s completion risk to a contractor (this is the case with both design-bid-build and design build). They do perform a cursory underwriting of the contractor’s ability to complete the job, however, a majority of their underwriting is focused on the financial strength of the contractor and the performance security being put up to secure the event of a default in the contractor’s performance.
The thinking is: “We believe the contractor can perform this contract. However, if they cannot, we need not worry as we have sufficient security from the contractor to cover the risk of our capital not being repaid.” It has almost become an “easy way” to underwrite credit. I question how much effort is being put forward by the capital community to truly understand the construction industry, the risks associated with the construction of specific assets, and most importantly the solutions available to ensure those risks do not manifest.
It’s relatively easy to find a big balance sheet, get a big corporate guarantee, letter of credit, and avoid all the hard work of determining if the contractor is fully capable to complete the job successfully. When this question was raised in the past, the capital community said: “We’ve always done it this way, so don’t expect it will change anytime soon!” Well, some are beginning to question what the ideal paradigm is for the rules that govern whether capital is deployed or whether it remains on the sidelines. They believe the traditional approach might not have done enough to delve into the contractor’s ability to deliver the job successfully. In today’s world some believe a focus on probability of failure is much more sustainable for their capital than one that ensures recovery of funds when things go wrong. Everyone associated with a project would rather the project be successful than have the comfort of knowing they won’t lose money if it fails.
Some in the capital community are beginning to turn to data on past failure (or data on near past failure) and solutions to prevent and mitigate risks associated with failure. The data and solutions when applied optimally are providing greater certainty of success, and at the same time are beginning to reduce the often-excessive security requirements on folks delivering the asset (design firms and contractors).
To that end, the role of the construction and insurance industries is growing within the capital community as they use the data and solutions available from these to improve probability of success. Pay attention to this trend as it could lead to a more efficient framework for delivery assets with greater certainty of success.
Just because it has always been done the same way, doesn’t mean it is the right way!