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Article:

CONTRACT PERFORMANCE BONDS

12 June 2017

Requirements for contract performance bonds, coupled with the ability of construction companies to obtain bonds is constricting the growth of the industry during the upturn in the economic cycle.  Opinions and perspectives vary depending upon a person’s role in the industry. 

The issue is greatest for those construction companies that are growing quickly, or taking on larger contracts or are recovering from a financial set back as some are struggling to get the necessary facilities from their bankers for greater bonding capacity as they don’t have enough security available.  Not surprisingly bank’s appetite for this risk is tightening.

This is not surprising.  Construction is one of the few industries where there is effectively a 10 year guarantee on past projects.  The natural reaction is to extract the profits once earned and leave as little fat in the balance sheet as possible.  That in turn leaves inadequate security for the bank or insurance company.

The financiers know from history that if one bond is called it is likely all bonds are called and the balance sheet will be decimated.  Accordingly they ask for robust security.

For the larger long established construction companies, with a very strong balance sheet, the bank attitudes suit them as it locks out some of the competition and favours those with strong balance sheets.

Some of these provide cash as security so for every dollar of bonding issued, there is a corresponding amount in a term deposit with the bank, secured by a G.S.A and effectively frozen so that the funds cannot be used for operations.

Part of the difficulty is that due to poor margins and after allowance for overheads and income tax the equivalent of several years profits needs to be left in the bank on term deposit.

Providing cash as security is not the only way to obtain performance bonds.  Banks will generally accept property as security, up to a maximum security value of 65% of the actual property value and assuming there is no other debt secured against that property.  This approach also favours those with a strong financial position separate to the construction company, although it requires shareholders to make their personal home and investments available to the bank as security.  They do risk their life savings.  This still may be beneficial as their personal assets support the company operations but are not necessarily at risk to other creditors.

For those who have all of their spare assets tied up in construction bonds they find they are unable to commence new projects until bonds have been released on past projects.

The proportion of contract performance bonds which have been called up for financial reasons is particularly low.  Disregarding sub-contractors and smaller builders operating in the residential sector, the number of major construction company collapses seems to be about 1 per decade based on ABL, Hartner and Mainzeal.

A few companies have been able to avoid providing 100% cash security and instead have opted for a facility which is partly secured and subject to a number of bank covenants.  Setting those covenants is fraught with difficulty.  Construction company balance sheets are quite different to most other trading organisations and conventional ratios are either inappropriate or result in creating and maintaining a balance sheet which is inappropriate for the needs of the business.  One of the issues is that the size of the numbers in a construction company’s balance sheet fluctuate quite dramatically and while a bank covenant based on equity as a percentage of total assets maybe fine when the facility is put in place, there will be times during a large contract where the total asset may increase quite substantially and result in a breach of covenant despite the balance sheet still being strong.

Banks prefer to obtain personal guarantees from shareholders but this becomes problematic in companies where a number of the senior management team have a shareholding and some of the minor shareholders may be unwilling to provide a personal guarantee when they risk everything yet only have a small shareholding.

Bonding also becomes difficult to finance during a shareholding succession plan where the incoming shareholders are unlikely to have sufficient resources to both pay for the shares and provide all of the security required for a bonding facility which can necessitate the departing shareholders having to leave funds in the company for an extended period.  This difficulty and its solutions have a significant impact upon the price at which shares are transferred in a shareholding succession plan.

Some level of performance bonds is appropriate but for the larger projects the percentage by value can be often reduced.  They are not the only security used on projects and the real purpose of the bond should be explored.  Retentions and contractual terms also mitigate some construction risks.

In many cases the solution for both property owners and bankers is greater focus on the skills, reputation and character of the construction company owners and senior team.  More assessment and due diligence of these factors may allow negotiation of a lower level of performance bonds that meets both the commercial and risk management objectives of all parties.