Surety Bonding Capacity in a Changing Market

Growth, complexity and capital structure shifts are reshaping the surety landscape for today’s contractors. From record-setting backlogs to the rise of employee stock ownership plan (ESOP) transactions, the past year has introduced new underwriting considerations that demand greater transparency, disciplined financial management and more proactive communication. In this Q&A, Bryce Grissom, senior vice president for surety at Travelers, shares his perspective on what’s changed most in surety underwriting, where contractors often misjudge their bonding limitations and how firms can better align backlog expansion with financial strength.

What has changed most in surety underwriting over the past 12-18 months, and what do contractors still misunderstand about those changes?

A challenge that contractors, surety agents and underwriters are navigating in today’s construction industry is the growth in both single job size and total backlog. Over the past 12-18 months, many contractors are working through their largest jobs ever that come with increasing complexity and longer duration. If a job encounters issues with profit fade or generating cash flow, there is the potential to put strain on the balance sheet. This makes visibility into the work program and open communication among all parties in the surety relationship critical.

Another significant shift in surety underwriting has been the surge in highly leveraged ESOP transactions, which present new risk assessment challenges. Whereas private equity (PE) firms were most active four or five years ago, ESOP transactions are now becoming more popular, often at multiples larger than what a PE firm would pay.

Some of the recent valuations of construction firms seem to be overly optimistic, assuming that the construction industry and the earnings being generated today will continue to grow indefinitely. These valuations do not always consider a potential slowdown in economic growth, much less a potential recession. The debt service requirements to fund these transactions can result in liquidity challenges that could put the new employee owners in a difficult financial position.

Although we at Travelers are strong believers in employee ownership structures, the additional leverage some newly formed ESOPs are assuming may not be as easily serviced as many experts would have you believe and could negatively impact a firm’s access to both banking and surety credit.

Beyond financial statements, what operational, managerial or project-control factors most influence a contractor’s bondability and capacity for growth?

Competent, reliable underwriting depends on a contractor submitting a well-thought-out and strategic business plan. Financial results are going to fluctuate, but surety underwriters are most comfortable when they can clearly understand where a contractor is headed and, therefore, be in a position to better evaluate the risks surrounding that plan. Ultimately, though, nothing replaces a contractor’s ability to generate cash earnings from operations.

Where do contractors most often misjudge why their bonding capacity is limited, and how can that gap in understanding be addressed?

Over the last 40 years, we have seen erosion in some of the more traditional working capital and net worth ratios. Deterioration in liquidity and capital ratios will have a direct impact on bonding capacity.

What distinguishes contractors who successfully recover from a bond claim from those who struggle to regain surety support?

The most important factor is early engagement with frequent and open communication. Bringing the surety underwriting and claim teams together with the contractor enhances trust and leverages the strengths and experience on both sides of this equation, enabling the surety company to better help and support the contractor.

How should contractors strategically balance backlog growth with financial strength, operational capacity and risk management?

There isn’t a single answer to this question. The first thing a surety will try to assess is how much risk a contractor is taking in its backlog. These risks can include simple things such as geographic expansion, growth in job size or taking on new types of work with new owners, all of which typically increase the risk profile.

Of late, contractor procurement type can also impact how aggressive a surety may choose to be. Firms that are successful in utilizing more collaborative procurement models — such as progressive design-build — will likely be viewed more favorably than those that are more active in hard-bid and straight design-build procurement models. There are opportunities for mobilization payments and cash flow terms that further lessen the risk burden and can help expand operational capacity.     

How far in advance should contractors engage their surety team when planning expansion, new markets or alternative delivery methods?

Earlier is always better. Large national or global sureties can contribute a wealth of knowledge that contractors might not possess or even be aware of. This kind of data and deep expertise can ensure that as a contractor grows in its current business or expands into new markets, they do so with the most current information and the valuable products and services they need to be successful.

What do contractors most underestimate about the value a surety provides beyond issuing a bond, and what long-term advice would you give them today?

A truly supportive partnership allows the surety to help the contractor more thoughtfully manage their risk. Besides simply providing bonding, the right surety will offer experience and knowledge on the pitfalls to avoid, as well as access to opportunities to successfully execute a business plan. A surety that can provide claim and legal expertise, in-depth consultation on strategic business planning and matters of succession are key differentiators that go beyond issuing a bond.

Some sureties have very experienced underwriting talent who have seen the ups and downs of prior market cycles and who understand current contractual term trends on active major procurements. If a contractor wants to take advantage of this positive viewpoint and industry knowledge, all they have to do is ask.

Lastly, a contractor should have confidence that its surety broker and underwriter are supportive of its business plan. Underwriting major procurements shouldn’t be a race to the fastest “yes.” If a contractor submits a bid for work that is outside of the plan, the surety should ask questions. In fact, if they do ask questions about the bid’s prudence, then it’s safe to assume that the surety is in alignment with the long-term vision of the contractor and looking out for the contractor’s best interests.