Posts|November 11, 2021
2022 Surety Outlook: Update Your Playbook & Account for New Challenges
Written by Jase Hamilton & Oliver Craig
Construction, like most industries, has experienced no shortage of challenges in recent years. Contractors have seen rising material costs, significant labor shortages, project delays or cancellations, and administrative/political challenges – largely fueled by a global pandemic that continues to send shockwaves through our economy. Nevertheless, the construction industry prevailed in 2020, and with it, the surety industry appears to have adapted as most companies reported profits in 2020 and 2021. This does not mean we are out of the woods just yet…. many of the challenges we faced in the past will have lasting effects, and some new challenges are yet to be fully realized.
Unprecedented government spending in response to the COVID-19 pandemic created a windfall of working capital for many contractors. However, contractors have now exhausted the majority (if not all) of the funds received under the Paycheck Protection Program (PPP). Coupled with declining backlogs, companies need to be aware of their fixed costs and overhead now more than ever as potential lulls in top-line revenues are likely to occur in 2022. It is unlikely there will be another government backstop in the future given the sheer amount of dollars already injected into the U.S. economy over the last two years.
Operating challenges for contractors are likely to persist due to ongoing material supply shortages and delays, as most work being awarded now may not start for 3-6 months as a result of material procurement issues. Surveys indicate certain materials may have up to 3 to 12-month lead times, meaning the work a contractor is winning today may not actually contribute to cash flow and operational profitability until late 2022. This in turn creates concerns about material price escalations. Contractors need to be vigilant in negotiating escalation clauses in all contracts. Another recent survey of industry professionals also suggested over 75% of respondents believe material-related challenges are likely to persist throughout 2022. Therefore, all bidding processes and historical material prices should be reviewed and adjusted accordingly.
If it’s not material, it’s labor. Labor continues to easily be the most discussed challenge in the construction industry today. How can I retain key employees for work I am winning today that won’t start for six months? Who are the future managers, leaders, and owners of my company? These are common questions most business owners face when planning for the future of their company. A detailed review of other fixed costs is the first step in offsetting this challenge, but let’s be honest – if you have a solution for human capital, we all want to hear it. It remains paramount that the industry as a whole focus on promoting and educating young talent as to the meaningful career opportunities in the construction industry. With older generations retiring at an accelerating rate, labor shortages will continue to persist until more people enter the construction workforce.
Another consideration for contractors should be evaluating technological solutions. Whether it’s remote work capabilities, Building Information Modeling (BIM), Enterprise Resource Planning (ERP) software, Artificial Intelligence (AI), Data Analytics (DA), Predictive-Based Solutions (PBS) or other automated programs – technology in construction is here to stay. The quicker a contractor adopts and begins implementing new technologies, the more successful they will be. A new technology compliance layer for federal contractors also lies ahead with the rollout of Cybersecurity Maturity Model Certification (CMMC). The CMMC requirements require notable investment in contractors’ cybersecurity practices to remain compliant, and it is expected this federal standard will likely be adopted by other public agencies. All contractors will benefit from continuously educating, integrating CMMC-like requirements and incorporating other developing technologies into their operations to make them more competitive in the future.
Sureties Persevere – But at a Slowing Pace
The Surety industry has seen unprecedented, profitable growth over the past ten years. Although there was a slight uptick in claims in recent cycles, last year was still no exception. In 2020, the U.S. surety industry as a whole reported Direct Written Premium of $6.9B, giving many surety companies sufficient capital to navigate through any challenges. Capacity remains high, but new and emerging trends will almost definitely lead to additional scrutiny from surety partners as we work our way through the remainder of 2021 and into 2022.
Source data - SFAA - last 10 years Direct Premium Written and Loss Ratios for U.S. Surety Companies
Surety companies typically underwrite to a loss ratio in the low 20% range. As shown in the chart above, there has been a positive variance since 2011 (i.e. less than 23% loss ratio). Although 2020 loss ratios were largely considered positive results (essentially breakeven), we expect most sureties will tighten their underwriting guidelines due to the current market trends and lingering levels of uncertainty. Most contractors can expect sureties to put more emphasis on a company’s financial management and the controls they have in place to mitigate the growing challenges facing the industry.
Financial Management – There’s Truth in the Numbers
Today’s construction and economic landscapes continue to evolve, presenting an ever-present threat of uncertainty that has impacted the credit markets. For contractors, this means the ability to obtain credit from both their surety and banking partners is becoming more challenging, as underwriting guidelines continue to tighten. In order to respond to the restricting marketplace, “best-in-class” contractors are staying disciplined, evaluating their business plans and dedicating additional time to focus on financial management.
Key components to a company’s financial management are the ability to preserve project profitability, manage cash flow and debt/leverage, and grow retained earnings. Each one of these financial metrics are vital to ensuring long-term success in any market condition.
Preserve Project Profitability – Preserving project profitability is not exclusive to just the construction phase. It begins with the pre-bid process, and continues throughout construction and close-out. Contractors should take consideration of the following to preserve project profitably:
- Thoughtful project selection (i.e. geography, materials, TOC, etc.)
- Developing a go/no-go policy to evaluate and price potential risks
- Establishing aggressive payment and retention schedules
- Implementing proactive billing and collection policies
- Early communication and documentation of material price escalations and associated delays
- Aggressively negotiating change orders and Requests for Equitable Adjustments (REA)
Manage Cash Flow & Debt/Leverage – Access to capital is increasingly important during trying times. A contractor’s ability to take advantage of a new opportunity or to cash-flow an issue can be the difference between success and failure. Outstanding credit facilities such as an operating Line of Credit (LOC) and other fixed debt obligations create stress on cash flow and increase overall leverage. In an effort to manage cash flow and minimize the negative impact of outstanding credit obligations, management should focus on:
- Preparing complete, accurate, and timely job costing and financial reporting
- Reviewing and updating cash flow projections monthly
- Developing project-specific cash flow projections for larger projects
- Aggressively negotiating the Schedule of Values (SOV) to achieve an overbilled position
- Evaluating the company’s existing debt to assess if rate/term refinances are appropriate to reduce overall debt service (i.e. monthly payments)
- Projecting the impact of large fixed asset purchases and leases on the company’s operating cash flow and overall leverage. Discussions with your financial/credit partners should be ongoing to assess the potential, long-term impact to your surety and banking relationships.
Grow Retained Earnings – The discipline to retain earnings in a company not only proves operational success from year-to-year, it also demonstrates a commitment and investment in your company and employees for future success. Contractors should consider the following when retaining earnings:
- Establish a baseline for retained earnings to meet your credit needs
- Develop proforma projections that mirror both your short and long-term business plan
- Meet with your CPA, Banker and Surety annually to discuss year-end financial planning
Financial management isn’t just an accounting function. It’s part of a company’s culture and should be adopted companywide. From the estimating team to the project managers, administrative staff to sales, the controller to the CEO, everyone at the company should be fiscally responsible. Your financial plan should be a collaboration with, and agreed to by both internal and external business partners.
Other Surety Considerations
There are a number of other matters that are and will become the focus of sureties in the coming years. Business continuity and succession plans, new accounting standards such as ASC 842 (Lease Accounting) and overall economic trends (i.e. inflation, interest rates, supply chain issues) will all be topics contractors should proactively address with their credit partners.
Continuity & Succession Planning – recent studies suggest 4 out of 5 closely-held contracting companies are still controlled by their founder. Of these companies, 40% expect the leadership to change in the next five years, while that figure increases to 60% for companies expecting a change in the next ten years. When preparing a succession plan, depending on the path the company selects, these plans typically take between seven and ten years to effectively implement. This means over half of the small-to-middle-market contractors in the U.S. need to start succession planning now. There are a multitude of options available when it comes to continuity and succession planning:
- Buy-Sell Agreements
- Third Party Purchase
- Employee Stock Ownership Plans (ESOPs)
- Voluntary Wind-Down
Each one of these strategies has unique benefits and challenges. If your company is like many others and expects an ownership/leadership transition in the next ten years, conversations with your management team and outside advisors will help you begin to formulate a transition plan. Some of the key components to a successful transition plan include:
- Differentiate between Financial and Key Management succession
- Commit appropriate time and resources – expect 7-10 years for complete transition
- Get advice from Professionals and Peers – surety broker, CPA, banker, attorney and consultants
- Keep Creditors in mind – transitions often create higher leverage and reduced operating cash flow
- Set a fair and reasonable valuation of company – aligns current and future ownership
- Have a clear vision for future of business – seller notes encourage current ownership’s commitment to the future
ASC 842 (Lease Accounting) – this new pronouncement from the Financial Accounting Standards Board (FASB) requires companies to account for various leases on the company balance sheet. The effective date for private companies to implement this new accounting standard is any fiscal year beginning after December 15, 2021. Therefore, most companies will start reporting these new assets and liabilities on financial statements in 2022. While a company’s overall business and financial position hasn’t changed, it remains to be seen how credit partners, including your surety and bank, will modify their underwriting standards. Some key considerations for this change include:
- Creating proforma balance sheets to evaluate the impact on leverage and net worth
- Consideration for implementing this strategy on interim, in-house financial statements
- Proactive discussions with credit partners to understand expectations
It’s important to remember that in theory, the company’s creditworthiness hasn’t changed. Communication on what your credit partners will expect should start now, and the best way to do that is have a clear picture of where you stand today, and how that will change over the next 12-18 months. Surprises never work to a contractor’s benefit when seeking credit, and the earlier you evaluate this new standard, the lesser the risk of reduced capacity when it comes to your bonding program and banking relationship.
The remainder of 2021 and 2022 are sure to present plenty of challenges and opportunities for contractors, especially considering the federal government’s evolving policies, including new tax proposals and goals for infrastructure investment. Contractors who are working proactively to plan for the future and properly oversee the financial management of their firm will be in the best position for continued success. It’s important to remember why we all love the industry we work in, and do our best to pass that along to future generations. Construction is essential to the communities we live in, and working together on education and investment in the future will help bridge the gap to the next generation of leaders.
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