Survey: Competition, Capacity Characterize Surety Bond Market

Although today’s construction industry is coming out of a trench and contractors are intensifying competition by bidding low to get enough work to utilize available capacity, an increase in private sector opportunities has surety bond producers predicting a brighter future, according to a “Surety Credit Survey” conducted by Grant Thornton LLP.

Sixty-six percent of survey respondents predicted the environment will improve in 2005. Regarding their own market, respondents were fairly comfortable demand will stay the same or increase during the next three years. More than one-third (35 percent) saw the demand for bonds increasing, and 42 percent said it will stay the same.

Members of the National Association of Surety Bond Producers were asked to characterize revenue sources by client types. Three-quarters (74 percent) reported a major portion is derived from general building clients, half (47 percent) came from specialty trade clients, while just more than one-third reported it deriving from either heavy/highway contractors (37 percent) or utilities (35 percent).

Three-quarters (76 percent) of their client base had revenues of less than $25 million, while 30 percent said it was $25 million to $100 million. Only 15 percent reported a major portion of their client base have revenues of more than $100 million.

One-third (32 percent) provide bonding services in the Midwest or the Southeast (31 percent), a quarter in the Northeast (26 percent) or the Southwest (25 percent) and one in five bond producers surveyed operate in the Western, Rocky Mountain or Northwest regions.

Competitive and economic environment
Regardless of capacity or available jobs, the marketplace is highly competitive, with companies often tempted to underbid and over-promise to win contracts. Nearly half (47 percent) of survey respondents described the current environment as “about the same” as a year ago, while 21 percent said it’s better. Almost one-third (31 percent), however, characterized it as “worse” than the recent past.

With local and state governments decreasing the number of new jobs they take, an upswing in private sector opportunities should continue to fuel not only growth, but also competitiveness in the marketplace.

The quest to use capacity may also be stimulating competition for financially stressed contractors. On average, respondents reported that 15 percent of contractors are experiencing “unusual financial hardship,” most often (64 percent) citing “low profit margins” as a major cause of the difficulties. Low profit margins were also the leading cause of financial difficulties cited in the mid 1996 (45 percent), but for different reasons. Work was abundant then, so contractors tried to get higher margins, but encountered difficulty in both managing the volume of work and finding qualified laborers and supervisors.

Bond producers were almost evenly split regarding how much aggregate surety capacity will be available in the next three years. This was not the case in 1996, when more said surety capacity would increase (1996 – 42 percent vs. 2005 – 32 percent), providing further evidence of the market changes since 1996’s “boom time” for surety bonds. This shift in available capacity may be a result of surety companies consolidating or leaving the marketplace with reinsurers.

Construction surety credit availability
Consistent with the changed marketplace, 49 percent of surety bond producers said it was difficult for their construction clients to obtain surety credit, compared with 14 percent in 1996. Twelve percent said it was easy to obtain surety credit these days, while 58 percent felt that way in 1996. However, looking at respondents’ expectations for the future paints an optimistic picture. More than one-quarter (27 percent) anticipated it will be easier to obtain credit for their clients next year. Fifty-eight percent of the bond producers anticipated the ease or difficulty of obtaining surety credit will not change next year, while only 12 percent anticipate it will be more difficult.

The ability to obtain surety credit for construction will depend on the type of project in which the client is engaged. Three-quarters (78 percent) of the bond producers said it was challenging to obtain bonding for hazardous waste projects. About one-third of the respondents said petrochemical (34 percent), telecommunication (31 percent) and power plant (28 percent) projects are also difficult to bond. About half said it’s easier to obtain surety credit for projects in the areas of water/sewer (43 percent), heavy/highway/transportation (45 percent), commercial/industrial (46 percent), and government (50 percent). Not surprisingly, 43 percent said it was difficult to obtain surety credit for sole proprietorships, while more than half (53 percent) said it was easy to obtain surety credit for C Corporations.

Construction company size is also a factor in obtaining surety credit. As a result of the consolidation of the surety bond market, two-thirds of bond producers say it will be more difficult to obtain bonding for small contractors in the next three years.

The same holds true for large contractors. Fifty-four percent said consolidation adds difficulty in obtaining bonding. The general marketplace perception is that both smaller and larger construction companies inherently come with risk because smaller companies can lack established business processes and larger ones can generate large claims. The outlook is different for medium-sized contractors. Almost two- thirds (62 percent) said there is no change to the ease of obtaining bonding for medium-sized companies.

Construction surety credit requirements
According to the survey, construction companies seeking surety bonds in 2005 will encounter far more roadblocks than they did in 1996. The strength of the balance sheet and financial statement presentation were frequently identified as important to bonding companies (98 percent and 97 percent, respectively). Bond agents were united in advising their clients to prepare proper financial statements (95 percent), by regularly producing interim financial statements (94 percent), and using certified public accountants familiar with the industry (92 percent).

A history of successful projects (81 percent) and consistent profitability (78 percent) were considered important; and many respondents advised clients to develop business plans (53 percent) and reduce overhead expenses (50 percent).

The reputation of the contractor is widely seen as important to getting credit (66 percent); and agents often tell their clients to communicate potential problems early (82 percent) and improve the frequency and the quality of job status reporting (78 percent).

Experience in a specific geographic area was also identified as important (59 percent); and four in 10 (41 percent) bond producers advise their clients to limit their entry/expansion into new geographic areas to avoid overextension of company resources in unfamiliar territories.

Construction companies that were professionally managed and fiscally responsible were more appealing to surety bond producers. More than eight in 10 (81 percent) bond producers (compared to 71 percent in 1996) reported debt levels as a very important consideration in obtaining surety credit. In fact, four in 10 (38 percent) respondents already saw sureties place debt restrictions on construction clients.

S Corporations and Limited Liability Companies were among the fiscally responsible contractors considered attractive to sureties. S Corporation and LLC tax strategies are desirable for estate planning and other long-term tax strategies, while providing owners the unrestricted (no double taxation on dividends) ability to remove accumulated profits from the company. The popularity of these tax strategies and the ease with which owners are able to remove equity from the company is the likely reason why 33 percent reported that sureties are placing restrictions on dividends and distributions.

Three-fourths of surety bond producers also reported that sureties required personal guarantees in the past year, further reinforced by the 72 percent of respondents who said the majority of bonding arrangements require personal indemnification. Fifty-eight percent anticipated personal indemnification requirements will remain at current levels over the next three years, while 35 percent expected requirements to become more demanding.

Dotting the “i’s’ and crossing the “t’s’
During the surety market of the mid- and late-1990s, contractors were able to obtain surety bonds without much difficulty. In 2005 however, the surety marketplace is on the cusp of recovering from the after-effects of years of record losses, repercussions from Sept. 11, 2001, and the economic downturn of the late 1990s and early 2000s.

As a result, surety bond producers were guardedly optimistic about future bond capacity and demand, but foresaw a future that will continue to be challenging for contractors. More rigorous underwriting processes have led bond producers to not only guide construction companies through the process, but also to advise them on how to become more bondable.

To position themselves as attractive candidates in a still tight bonding market, sureties are urging construction companies to achieve internal efficiencies, report consistent profitability and create an environment of effective project management. Contractors that have the appropriate processes in place to communicate accurate and timely information–good or bad–to sureties have an advantage. Most importantly, construction companies must produce solid, complete and properly presented financial statements to even be considered for surety bonds. Companies with less-than-pristine past records may have more difficulty obtaining surety credit.

Although some clouds of uncertainty continue to hover over the surety market, surety bond producers foresaw a brighter future ahead. As the market improves, construction companies have the opportunity to dot the “i’s’ and cross the “t’s’ on their business processes and financial statements to make themselves more attractive to bond producers today and in the future.

Topics Trends Contractors Construction