Is there a need to revamp surety capacity measures?
December 1, 2013 by DAVID BOWCOTT
Vital to most contractors’ existence is access to security that guarantees their contractual obligations to their clients. These guarantees take the form of parental guarantees, holdbacks, letters of credit, surety bonds, EDC performance security guarantees, subcontractor default insurance, cash reserves, etc. When posting these various forms of guarantee the contractor is trying to balance the owners acceptance of the chosen form of guarantee with the constraints that guarantee places on the contractors finances.
One of the most critical forms of guarantee is the surety bond. These bonds can be used at the tender stage to secure the contractor’s bid to the owner, and they can also be used once the contract has been awarded to the contractor to secure performance. In some cases, they provide a guarantee that the contractor will pay their subcontractors
Surety is secured primarily through an indemnity agreement executed by the contractor. Sometimes this indemnity comes from the contractor’s parent company and in the case of smaller contractors, may include indemnity for the shareholders of the company. It is from this security package that the surety will determine the terms and conditions they extend to the contractor. Key items within those terms and conditions are the rates, the single job size limits, and the aggregated facility limit. Most contractors, if they are smart, should focus on the aggregate facility limit. This is the amount of surety capacity the surety company is willing to extend the contractor at any given time.
How does the surety arrive at the aggregate facility limit? Well, the primary driver of aggregate facility size is the financial statements of the parties indemnifying the surety company, with a focus on the parent and operating company’s financial statements. The surety will look at the consolidated financials of the indemnifying companies and adjust any assets and liabilities based on their analysis of notes to the financial statements, as well as ancillary documentation such as aged accounts receivable/payable, work on hand, bank terms and conditions, etc. Ultimately they arrive at a working capital number (current assets minus current liabilities) and tangible net worth (asset less liabilities).
Let’s assume these numbers are of a similar size. From this number the surety will apply a multiple to arrive at the aggregate facility limit. These multiples vary based on several factors: type of contractor; size of contractor; makeup of the working capital; makeup of the tangible net worth; and third-party influences on your company. For instance, a mid-sized GC with $10 million in solid working capital, $20 million in tangible net worth and limited outside influence might command an aggregate facility limit of $600 million. A subcontractor with the same measures might command an aggregate facility limit of $300 million (it is lower primarily due to the holdback risk faced by the subcontractor).
One factor that doesn’t get as much consideration in sizing the aggregate facility limit is consideration of the nature of the contracts. Contracts are the vehicle by which the balance sheet of the contractor takes on risk. These days they allocate risk in a multitude of ways. As such, these contract risk allocations are also arrived at in a variety of ways. For instance, a Construction Management Agent contract has minimal risk to the contractor. However, a design-bid-build lump sum contract can have significant risk for them. As it respects how these contract allocations are arrived at, one contractor might work closely with owners to allocate the risk in a negotiated, low-pressure environment that encourages dialogue between owner, contractor, design and subcontractor before finalizing terms.
A different owner might have a design firm drive several contractors to bid a project at a prescribed time to ensure all pricing is secured by subcontractors and the scope is in line with design. The nature of the contract and the process used to arrive at the contract, need to be considered more thoroughly when sizing aggregate surety facilities. So standard multiples, such as the 30 times outlined for the GC above, need to consider these factors to create a facility that is more in line with today’s diverse contracting environment.
Some surety companies are updating the metrics they use to size surety facilities. I strongly encourage you to make sure your surety is considering these factors, and that your company is getting the capacity it deserves. Capacity is King for contractors, and if you have the right dialogue with your surety, capacity should not be an impediment
to achieving your business goals.
David Bowcott is senior vice-president, national director of large/strategic accounts at AON Reed Stenhouse Inc. Send comments to email@example.com