Assuredness in Today’s Global Surety Market

The construction industry began 2020 with the same fervor seen in 2019, with few signs of contraction prior to the COVID-19 outbreak. But as the pandemic gripped the world, the construction industry lost significant gross domestic product (GDP) and millions of jobs, wiping out the growth and momentum built up over several years.

While most of the country is opening, the Delta variant of COVID-19 presents a wildcard in the equation that industry professionals must monitor closely.

For the time being, the United States construction industry is enjoying a return to normal, led by the residential sector and a significant increase in public, infrastructure and commercial projects. Any new infrastructure spending will provide additional stimulus to the major segments of the construction market. But with optimism comes concerns over starts, labor availability, margin constraints and supply chain issues.

This brings us to sureties. Like the construction industry, the surety market was healthy prior to the pandemic. In 2020, there was some tightening of surety credit for certain sectors, but generally speaking, the premier contractors had no issues securing bonds and that trend is expected to continue and the surety and finance industry is forecasted to be robust for the remainder of 2021 and into 2022. While the surety market should remain solid for financially sound construction companies, the reluctance by surety firms to provide credit packages to hard-hit COVID-19 impacted construction firms in the United States, will likely continue.

Megaprojects Fueling Cautious Growth

The construction market continues to benefit from large construction “megaprojects,” like new campus facilities for high-tech giants such as Google and Apple. Amazon’s continued building of massive warehousing and distribution centers will also be a factor. In addition, large multibillion-dollar projects, such as the California High Speed Rail System, the Las Vegas Convention Center People Mover and Hudson Yards, have provided major fuel for the industry. Both surety and financial firms will take center stage to support these efforts, and the need for increased credit will become more prevalent. As the world economy reopens for business, the megaproject trend is likely to continue.

While public-private partnerships (P3s) seemed to be the likely financing trend for mega projects, leaders in the industry, such as Skanska, Granite Construction and Fluor, have publicly announced that they will not be participating in P3-funded megaprojects and instead continue to work on select projects on a case-by-case basis. Many contractors have come to realize that the risks megaprojects bring, such as material costs escalation, scarce labor availability, technology and regulatory issues can be nearly impossible to manage. Tomorrow’s megaproject will be completed by well-managed firms with an understanding of the risks that come with a significant multiyear contract.

Surety Concerns

Entering 2020, record construction expansion produced somewhat reduced underwriting standards and new companies entering the bonding area, such as Berkshire Hathaway, resulted in a significant surplus of credit.

Fueled by a robust market in the last few years, construction firms and their surety providers have been forced to rethink their approach to the market and pivot resources to projects and firms that provide an acceptable financial return while offering more controllable risk. As the quantity of opportunities continues to increase, so will the overall quality of projects available for bidding, allowing construction firms to be more selective.

COVID-19

With the virus now perceived as a bit more under control in the U.S., COVID-19 has become less of an operational issue, but has created havoc in an already compressed labor market and tightened supply chains. Workers who may have left the industry during the pandemic have not returned, and employers are struggling with ways to attract and retain employees. The incredible supply chain disruption that has resulted from the pandemic is cause for grave concerns about contract pricing, change order procurement, in-field production sequencing and general margin constraints.

Labor Shortage

One of the greatest issues for the construction industry is the tight supply of skilled workers. With baby boomers set to retire within the next 5 years, and intense federal pressure to limit and reduce the immigrant labor force from Mexico and Central America, the construction industry is faced with the task of finding enough skilled workers to meet demand. Additionally, the industry is still struggling to attract young people to the trades.

The labor challenges have been a major focus during underwriting of surety credit. If labor isn’t available to support a project, there could be pressure on production schedules and, ultimately a loss of job profit, which the surety firms continue to monitor closely. The construction industry must find ways to welcome the next generation of workers.

Material Pricing Pressures

The cost of building materials is one of the single biggest issues that our economy faces as products are becoming both more expensive and difficult to source.

While the pandemic was a major factor, prices were already on the rise due to new projects and the price of specific trade projects. Steel, PVC, lumber, concrete, asphalt, HVAC equipment and other major material segments of the construction industry are in turmoil, and it’s unlikely that things will change until late 2021 or early 2022. As a result, surety firms are challenging their customers to make sure they are as protected as possible from the unknowns in the marketplace and have systems in place to address supply chain issues, contract pricing provisions and initial bid estimate exposure.

Margin Reduction & Effects of Competition

The trend of margin reduction has come about from companies trying to source work and build backlogs. With a finite number of projects, the bidders have been steadily increasing, causing margins to come down. Surety firms are warning their customers to stay away from working in geographical areas or specialty sectors that are too far removed from their core business, and to not battle it out with the companies that are buying up backlog projects. The margin reduction will eventually be under control, but for now it’s an issue and surety firms are taking notice.

Ownership Transition

Finally, a central issue that will continue in 2021 and 2022 for the global surety market is the area of ownership transition. Changes in ownership and related equity redemptions have resulted in significant adjustments to the debt and capital structure of construction firms.

It is imperative that ownership transition deals are evaluated carefully to ensure a full understanding of potential changes to a surety program.

The Bottom Line

Surety firms will continue to provide bonding programs based on the three Cs of credit evaluation: character, credit and collateral; all of which are subject to the aforementioned issues. To that end, surety firms will continue to provide increased bonding programs to construction companies that exhibit best-in-class financial performance metrics. While backlogs continue to be significant for many contractors, the ultimate completion of this work in 2021 and 2022 will be based upon the market’s ability to recover from the impact of COVID-19, manage any new variants like Delta, cultivate a stable workforce, gain stability in the supply chain segment and control project margins. Let’s hope that the pandemic continues to fade and we can move forward toward a brighter future.