Over the next decade many business owners face the reality of transitioning out of the company they’ve dedicated their life to. For some, their succession plan will it continue to serve as their livelihood in some capacity, albeit without being at the helm. Owners and their executive management teams will be hitting retirement age and transition of ownership comes into question. How will they decide the fate of what’s taken so long to build, who will carry on the business and ideal structure that transition should take while being able to extract equity to support the next phase of their lives. For others, market conditions may be changing the shape of their businesses making it difficult to compete. In either case, anticipated merger and acquisition activity is expected to climb.
Surety to support private equity investment strategies, along with mergers and acquisition surety has become more commonplace as a result of industry consolidation. Companies of all types are moving into the hands of private capital as a liquidity event for existing ownership and as a growth strategy for the latter. Consolidating industries such as construction, logistics, transport, manufacturing, financial services and others often require some form of performance obligation. This brings, or rather should bring, surety bonding capacity into question during acquisition due diligence, as consideration for more sophisticated bonding programs may be required to support the business plan set in place by new ownership. PE/M&A strategies are growth oriented rather than status quo in an effort to generate returns for shareholders versus simply operating as a means to a paycheck. As strategy shifts so does the firm’s financial structuring and so should its bonding program.
It’s critical to ask the right questions while conducting due diligence. Not doing so, could result in a myriad of issues preventing or delaying strategy execution after the acquisition has closed. Or worse, could result in a deal you wish you’d walked away from.
First, a Surety Primer.
What is Surety? If we had a dime for each time we’re asked that question, we’d have enough banked to be one of your LPs.
Simply put – surety is typically an unsecured 3rd party credit extension also better known as a performance guarantee. Unsecured in the sense that it operates on the principle of indemnity, therefore is primarily signature based rather than backed by hard assets. A credit extension meaning the surety bond is a financial instrument that guarantees the performance obligation of one party under its contract with another, thereby protecting the latter against financial risk should the former default. Underwriting of the transaction is largely based on the credit quality of the applicant vis a vis the risk profile of the underlying performance obligation. While written by insurance companies, also called the Surety, the bond mechanics more closely resemble banking and rely upon similar principles.
Performance obligations in the surety world run the gamut, but an easy to digest example is that of a municipal construction project and a construction firm.
Municipal Construction Example
The New Jersey DOT hires BuiltRight Civil Construction to build a new overpass over I-95 near Newark airport. As a part of their contract, NJDOT requires their contractors to produce a performance guarantee in the form of a surety bond. The bond will guarantee to the NJDOT that BuiltRight will complete the project as per the agreed upon spec in their contract – time, cost, etc. Why?
If BuiltRight defaults whether they run out of working capital or simply build it wrong, the municipality is stuck with the financial burden that comes with finding a replacement contractor to complete or fix the problem. Which means it’s actually the taxpayer paying for the mistake. The surety bond protects the municipality and taxpayer by transferring risk of default to the surety.
A surety bond acts as a risk transfer mechanism for the benefit of the NJDOT, in this example. It’s a 3rd party backstop to enforce the terms of the agreement. If the bonded party, the applicant, fails to perform their obligation to the purchaser, the surety then steps in to complete the performance obligation and make payment to legitimate claimants for goods and services associated with the project.
The Importance of Surety for Acquisitions
Depending on the sector of investment, it can be either a critical component to continued operations or an investment return enhancer. Sectors such as civil construction, solar and water treatment often have inherent surety bond mandates within their contracts since much of their work involves public entities. (Recall, they were designed to protect the public.) In the US, if there is a public funding component to any project, there is likely a bond mandate that comes with it. In the US, it’s 100% of the bonded component’s contract price. Note as while mandatory on public projects, surety bonds are often required under private projects as well, driven by the financing requirements. This is becoming more the norm.
Surety USA vs the Rest of the World
Outside of the US, or international surety, percentage bonds are the norm ranging from as little as 10% to 50%. As contractor defaults across several countries with percentage bonds have caused severe financial distress, the call for increased surety mandates continue to hit policy makers’ desks demanding a revamp of the surety process beyond its antiquated framework into one more protective of the public. The US model is a prime example of a protective model.
Why is this important when making an acquisition? Similar to cash in a business, think of surety credit as fuel in your car. Without it you’re not getting very far. In contracting businesses where surety is required, the ability to secure surety credit determines whether you’re able to operate, let alone grow, as a business. More often than not, it’s required to bid a project in the first place.
The absence of continued surety support after making an acquisition is more than a red flag. It’s a disaster. If the acquisition target is concentrated in an industry where surety bond mandates exist, it’s crucial to ensure the bond program will remain in effect post acquisition and support the growth to which the PE firm has modelled during its holding period. Participation from an experienced private equity surety bond agent is critical during due diligence, through financial closing and the asset retention period.
Making us a part of your acquisition team can help ensure you pay the right price if addressed at the right time. Or prevent you from committing to a bad deal. We’ve been tapped post acquisition to secure billion dollar surety programs for portfolio companies that simply couldn’t support it. This required unplanned capital injections at the private equity firm level, changing the economics of a deal and the overall portfolio.
At a minimum, acquisition teams upon performing due diligence should make it a habit to review previous contracts in search of evidence suggesting performance guarantee mandates. If required, be sure to speak to the target’s CFO regarding prior and ongoing surety capacity. For best practice, bring RSG to the table. An experienced surety broker to help advise along the way.
Advisors to Investors & Their Advisors
It’s not uncommon for our Private Equity, Family Office and M&A clients to be introduced to us via our professional advisor associates – bankers, accountants, lawyers and insurance brokers to name a few. With over 40 years in the business within the New York metro epicenter of Finance, we’ve organically developed our practice into an outsourced surety arm for professional service providers including investment banks, domestic and international insurance brokerages and multinational corporates.
But not just that, our staff includes individuals who formerly worked in the Private Equity, Hedge Fund and Family Office world. So we talk your talk and understand your business.
Contractor M&A Consolidation Landscape
A multitude of factors have fertilized the M&A landscape in recent years ranging from a low interest rate environment to decreased global barriers to entry. M&A is a means to boost revenues and profitability, diversify revenue within an experienced sector, reduce geographical risk, buy growth or invest in technological infrastructure.
Particularly within the 2010’s, global contractors sought to boost revenue and market positioning by expanding beyond their backyards into new geographical territories, including the US. This pursuit of buying markets provides access to larger projects, teams and regional infrastructure. This presents a quick means to scale growth versus the organic alternative, which may be more capital intensive and comes with a steeper learning curve attempting to crack a local market as an outsider.
Whether buyer motivation stemmed from acquiring new territory, capabilities or integrations the past several years have seen a flurry of ownership changes in the construction industry. Amongst several, sellers are facing three big changes that are shaping acquisition activity at all levels.
Skilled Labor Workforce Shift
Ask any contractor and they will tell you skilled construction labor is difficult to find. Trade union membership has diminished to approximately 10% of current employed Americans, a continuing decline from 20% two decades ago. While Union benefits and wages remain compelling perks, they are facing challenges in attracting new millennial membership and across younger generations that follow. This younger demographic having grown up in a rapid technological revolution over the same time frame shows an increasing tendency toward tech oriented career paths versus manual labor. Or manual labor that’s tech enabled. Naturally, the skilled trade labor pool is shrinking as a result.
Construction Technological Disruption
While construction has benefitted from a laggard effect of a tech boom, it is certainly not immune to disruption. A multi trillion dollar industry plagued with inefficiencies have startups and the venture capitalists that back them examining all aspects of the construction lifecycle. Some contractors view this as too much change too quickly, however history (Uber anyone?) tells us an industry shouldn’t resist change but instead adapt to it. Those who do not implement a tech stack into their construction operations and workflows are due to face greater challenges in the future. While construction technology in its most state of the art forms are still rather nascent, the next 5-10 years present an industry ripe for disruption. Rigid outfits may present themselves as acquisition targets to those that have demonstrated success in adopting technology within construction or to built environment investors seeking out vertically integrated construction investments.
Succession
In decades past, succession for construction firms typically took traditional, familiar paths. It was passed on to a child that grew up learning the business or passed to the hands of a key employee via a sale and earnout. While this transferability still remains, the prior two challenges combined contribute to complicate matters. In the former, children are less interested in the business and prefer a different career path. In the latter, it’s similar in that a key employee isn’t necessarily interested in nor the best path to cashing out equity quickly in a rapidly changing environment filled with uncertainty. This leaves the various acquirers, often in the form of private equity, as the favorable path to liquidity. With private markets increasingly receiving the lions share of investment dollars for the past two decades, the market is oversupplied with dry powder looking for target acquisitions. One thing acquirers know for certain is that construction will never cease to exist in some form, therefore the right portfolio mix will lead to returns for years to come. This they’re willing to pay for.
Whether the above challenges or a multitude of other motivations to sell or acquire, global construction merger and acquisition remains active at all levels. The US continues to be a hotbed for acquisitions for both our domestic private equity clients and our larger foreign multinational clients angling for an entry point into the US market. In either case, we’ve closely worked with both to structure programs to support long term growth and stay closely involved in program management to meet the needs of the dynamic backlog that supports it.
How PE Financing affects Surety Programs
After a private equity acquisition, the acquired company’s balance sheet tends to take on a new complexion, as does the ownership structure. The amount of debt on a balance sheet has significant influence on surety capacity, specifically as it relates to debt to equity ratio and cash flow generation. Therefore the specified private equity strategy being employed is scrutinized within the surety underwriting model.
Distressed debt scenarios or LBOs will have a challenging time securing surety credit simply because the strategy overleverages the balance sheet to capacities where a surety is boxed out. The specifics are subjective, highly dependent on loan agreements and structuring in place, however the challenge is that these strategies place a high amount of debt service on to the asset. In turn placing a lot of pressure on cash flows. For the firm, if the portfolio company defaults, the exit strategy is to sell off assets, leaving little for the surety to grasp on to. Remember, surety is typically an unsecured credit arrangement!
Why PE Strategy is important to Underwriters / Post Acquisition Structuring & Capitalization
Of course all funds are not created equal nor do they all utilize a highly levered strategy. And not all leverage is considered suffocating debt. What’s certain is that post acquisition structuring and capitalization will take on a new form. The question becomes to what extent does the balance sheet and legal complexion change as a result from the new equity, debt and ownership.
Leverage, Liquidity & Net Worth
High leverage and compressed cash flows to cover debt service can prohibit surety credit availability. The transaction may place burdensome debt on the company thereby negatively impacting a once healthy equity position. Similar to banks, sureties identity tolerable risks when the presence of tangible net worth and liquidity are present. Subsequent to the transaction, a surety will want to see the portfolio company’s balance sheet focusing on historical operating results compared to new debt obligation demands, sources and terms of any new debt imposed by the acquisition, etc. Ultimately, is there evidence of a reasonable debt to equity ratio alongside stabilized and projected cash flows to cover interest expense and debt paydown.
Goodwill
In non-distressed purchases, price multiples exceed book value creating substantial goodwill on the balance sheet. Sureties do not consider this a part of their tangible net worth calculation therefore tend to exclude or discount it from underwriting. As the saying goes – you can’t pay bills with goodwill.
Management Team
What level of involvement will the existing team have in the restructured operation? The existing team is intimately involved with the business. Having key members remain involved in a vested capacity for a predefined period ensures they’ll remain in place to add value. What mechanisms are in place to ensure commitment? If members are being replaced, how will this take place and who will be driving the hiring process within the PE firm.
Business Strategy
A crucial element of both the PE firm, Family Office and the portfolio company. At the acquisition level, a surety favors a growth plan within the scope and capability of the acquisition target as evidenced by historical performance. Bidding work in areas outside of their region or jobs well beyond the size or scope of their sweet spot are potential red flags whether part of prospective plan or while maintaining an already in place surety program.
At the PE firm or Family Office level, expertise within the PortCo domain is favorably considered. A Family Office with history operating in the sector or PE management team with domain expertise signal competence over broad or general investment mandates. A strategic arrangement between investors and PortCo provides synergistic operating and management experience, breadth in network and longer term commitment.
Exit Strategy
When does it need to occur and what is the route? Time remaining in a fund’s lifecycle signals to the surety the fund’s ongoing commitment to the investment. If early on in the investment horizon of the fund, emphasis will be placed on PortCo’s financial condition – refer back to the topic of leverage and liquidity. If towards the end of the lifecycle where the fund is in their harvesting period, the emphasis shifts to the impact a new financial structuring and ownership may have on the surety program ongoing. Are they a strategic buyer that will bring value? What effect will they have on existing performance bonds and guaranteed obligations set in place?
Indemnity/Guarantee Requirements
Referring back above, the PortCo may not be in a position where adequate net worth is available to support growth or provide a surety comfort in the event plan is not hit. The inherent nature of private equity in isolating risk creates a push pull dynamic when it comes to securing surety credit, where the surety’s approach to de-risking is via fully securing themselves through related assets. Given the indemnity of a PE firm or its LPs is rarely offered, this can be a challenge. But never impossible. For Family Offices, this can be less challenging as a single investor or limited co-investment relationship exists, where there is less isolation between LPs, the Firm, its Principals and their investments.
In the private equity, merger & acquisition world, surety bond programs tend to be an afterthought, which can become a costly mistake. In our surety private equity practice, we’ve experienced acquiring firms execute sophisticated acquisitions that did not properly account for the surety piece. It is of critical importance to involve specialized surety brokerage early within the process, viewing the transaction with both an investor and surety underwriter lens.
Investment Return Enhancement with Surety
While much of our focus here has been allocated to active transactions as they relate to establishing surety bond programs for contractors, surety use extends beyond that too many commercial applications. At the portfolio company level, different types of surety bonds apply to specific sectors respective of their day to day operations or license to in the first place. At the private equity fund and family office level, surety bonds can be utilized as a financial structuring tool to enhance returns.
Surety bonds enable investment managers to create additional portfolio value by liquidating otherwise locked up capital within their investments to instead be applied in a manner that generates returns. Without absorbing additional risk.
At the fund level, those with investments within contracting, transportation, manufacturing and others often require bank backed performance guarantees which tend to be secured by letters of credit or cash. In many cases surety can be used to replace bank instruments and other forms of collateral obligations with insurance backed surety bonds. Their use effectively returns cash back to the private equity fund which can then be reallocated toward operations or as investment capital.
To illustrate, one can think of $20,000,000 housed in an escrow account when an investment generates an 8% return as essentially a $1,600,000 lost opportunity. Or an $1,600,000 gain using surety bonds to put that capital back to work.
In addition to the economics, the benefits to using surety as a substitute for bank backed instruments include:
As you can see surety bonds can be quite valuable to investment managers on several fronts, whether required by the acquired company in its operations or optional as an enhancement to investment returns.
With seasoned experience within both the surety and investment management worlds, our goal is in establishing a ‘Fund Program’ for our private equity, family office and M & A clients. Doing so enables us to understand the investment objective and play the role of transaction advisor ensuring capital efficiency for the firm along with prevention of credit capacity issues that will restrict an acquired asset from performing.
As surety brokers, our effectiveness and agility increase through an “owner’s mindset” approach gaining familiarization of the firm’s business model, investment landscape and how that shapes their growth plan. Underwriters tend to overask on information requests. Fact is, there is information required in order to conduct comprehensive underwriting and then there is nice to have information. Our job as brokers is to ensure they receive what they need, rather than disclose more than what’s required as not to overwhelm our PE clients or impose on confidential or proprietary information. As your advocate, it’s our job to understand your company intimately, then determine which information will be needed in order to tell your story effectively with the goal of achieving the best placement possible.
Early input such as viewing contract analysis through a surety lens enables us to identify issues which may compromise deal certainty or value while simultaneously enhancing the firm’s negotiating strength. Surety as an afterthought can lead to a mispriced valuation, or worse. We win when you do, hence our underlying principle of working together for your success.
