The process of supporting developers and construction companies, especially those who have difficulty accessing mezzanine or equity, recapitalize their balance sheet to help them with Surety Bonding and sourcing new pipeline, is the whole thing.
Construction is inherently a riskly proposition. People get in and out every day. Perhaps not quite to the level of nightclubs and restaurants, but construction companies fail at an alarming rate. On one hand this may not seem like the best way to introduce the concept of investing in construction companies. But on the better hand, it’s perfect. It’s perfect because like many things, those who survive and find their way through the maize and moving parts have found their own secret sauces. Hence, the longer one is in the business, the better risk they become given their proven medal. There’s a prima facia case to be made for these companies that convey the savvy, competency, and overall diligence in doing what they do successfully – juggling at a profit. Even the companies that have been around for a long time and run into problems, do so because they change their approach (get too aggressive, risky, change cultures, get outside their niche). The very building blocks that got them there are abandoned as they begin to believe their own hype versus the grind that created their successes. To answer more questions would be encroaching upon the trade secret areas mentioned earlier.
Again, why hasn’t this been done before? It has. It’s been pieced together but not intentionally. Construction companies get loans everyday. Construction companies get lines of credit everyday. Construction companies are insured everyday. And, the larger companies take outside investments in operations everyday. Construction companies are vetted by surety companies everyday. And finally, construction companies are underwritten for current and backed for future projects (bond lines) everyday based on their past performance.
We bring all these facets together in one place to make it not only cheaper for the companies but more efficient with less moving parts and an actual goal in mind (growth and stability) versus surviving at a predetermined level based on current assests that drive precisely what they can bid on (new jobs).
Insurance, or in this case, surety bonding, is the mechanism by which construction companies ensure a project owner that the project will be finished without regard to any issues that arise. This means that once a contract price has been agreed upon, it will be completed regardless of any issues that may arise financially along the way. The surety company looks at a number of factors to determine first of all whether or not they will bond a company and then what the rate wil lbe. But unlike insuring a car, a home, or other things, not just anyone will be approved, for an inflated rate. There is a window that a construction company has to fit within in order to be underwritten at all, and there are a number of factors that go into that window. In fact, they are conservative enough, that even companies that have never failed and there is no reason to believe they will, are limited in bond line capacity.
Construction companies have a number of things to contend with per cash-flow, like many businesses. Specifically:
- General Liability Insurance
- Workers Compensation Insurance
- Vehicle Maintenance
- General & Adminstration
- Constrution Operations
- Pre-Constructioin (includes marketing)
- Cash On Hand/Hard Assets (required for surety underwriting)
Number 10 above is where our opportunity lies. If it comes in the form of assets, then generally these assets have notes attached and there is some limit on how much they can be pledged as collateral for anything else given the first in line note holder(s). But, everyday, there are creative ways to make it work while the small companies are laden with anxiety job-to-job; not because they don’t have confidence in performance, but because it’s always all on the line mentally, emotionally, and financially.
If number 10 is in the form of cash, then this cash is tied up and cannot be used for items 1-9. Clearly this limits not only the current “size” of the company but the ability to grow by pursuing more work. In other words, the company has to stick to it’s current size. We all know the age old issue with small business; being undercapitalized. In this business, the bonding aspect ensures that this either remains the case or that one must pick a size and industry margins – and stay there infinitely – a company cannot outrun its bondline.
Construction companies must have either cash or assets that satisfy the underwriting for surety bonds for said surety companies. This cash or asset pledge is generally 10% of whatever the face amount of the bond is in addition to a given rate. For example, in order to perform $100 million dollars of government construction any given company must bond the work at the same amount. So in order to bond $100 million of construction work with the government a given construction company must have cash or assets equivalent to $10 million. As one might well assume, it’s a rare case that, in particular, smaller to mid-sized companies have either.
Many construction projects occur each day around the country that do not require surety bonds. But the marketplace in 2017 that did require surety bonds was just under $6 billion nationwide (premium written). It certainly varies from state to state. For example, about $61 million in premium was written in Oklahoma in 2017 while $841 million was written in California in the same period. As a point of reference, premiums are generally 1% – 3.5% of the bond/project amount, which means that $61 million in premiums (at 2%) is about $3,000,000,000 in construction projects written in Oklahoma in 2017. So if we made loans on 10% of those projects ($300 million) at 10%, then our gross return would be $30,000,000.
Overused, but at the end of the day (lol), the bottom line is that a construction company has to be able to get the work to pay us back. Hence the right thing to do would be to loan the money in tiers – as they get the work, we loan more in order to chase more work. Otherwise they cannot pay back what they don’t have the work to earn margins on. This way we further reduce our risk by not loaning funds on work not yet won or speculative business development goals.
For the accountant that doesn’t see how it changes the scope of things I still say it’s simple. A company’s financials can basically be changed either through equity or debt.
The other option is to loan the company/developer money via some kind of debt instrument (to be determined). As long as they are still first in line, this would create comfort with the surety provider. They don’t mind that the construction company’s net worth remains the same (increased assets (cash) from debt proceeds vs. increased debt liability = wash). This way, we’ve entered the massive construction arena without the natural risk (cherry picking). In the future it’s a natural segue to development and funding multi-family deals and more.
THE INVESTMENT – THE LOAN
It is a form of collateral toward Surety Bonding does not go to operations but frees up the construction company’s cash and/or assets for operations (government jobs provide cash-flow for operations after the first turn). In the above scenario, the same $1.5 million profit can now pay the $300K of 10% and return the $3 million principal that was predged as collateral to gain the ADDITIONAL $30 million in work that the company could not have pursued without the extra cash on hand/equity.loan. Hence the cash-on-cash internal return, if you will, if about 50%. I chuckle as I write this thinking of an infomercial in wanting to say, “But wait, there’s more!” The types of companies in our crosshairs, the preference companies, may times (almost always the 8(a’s)) realize negotiating margines of 10% or better versus the competitive bid margins or 5% or so). Hence we want to keep turning over the cash like a restaurant turns over tables.
Review of process: If a company invests $100K in itself to chase $1 million of additional work given 10% collateral to get said $1 million bonded; the typical 5% margin ($50K) is 50% cash-on-cash return. The number of smaller companies (annual revenue of $20 – $200 million) that have proven they are able to execute this process like clock work over and again but don’t have the capital to grow, are who we want to have as “customers”. Or these same companies that may not want to grow, but like where they are (sweet spot) and would like to free up cash-flow to live versus always funding the business are prime targets as well.
Finally, for now, I’m working on being able to place the loans via a letter of credit wherein the investor/lender places funds in a given account (earning interest) and never actually has to part with it, save some major loss scenario outside normal statistical expectations (an outlier scenario). Even then, there would be some majority (90%+) of principal retained. This letter of credit scenario is not yet a done deal, but I’m working with banks and the SBA on it (perhaps backing some of the losses and/or matching loans). ANOTHER thing that you gave me a different view on after talking on Friday.
PROCESS, PEOPLE, PERFORMANCE
Alternatives to traditional investments, complicated transactions, and simple stock purchases make sense for those with a sense of cautious adventure and desire for higher returns in a low-risk environment. Finding capital; forming partnerships; and sometimes managing the deal is what we do. Sydney Capital accepts partners on a very limited basis via a network of intimate limited partnerships with friends and associates – there are only several degrees of separation.
Many of the preference contractors (hub zone, 8(a), SDV, woman owned) perform negotiated government work which yields significantly higher margins than what is typical in general contracting. Hence, the better way to roll this thing out is with a bunch of smaller loans versus a few larger ones to start, in my opinion. Either way works, but our net is increased this way. We roll out smaller deals, with funds controls, making sure that everyone is paying their bills. Generally the kinds of companies we choose do pay their bills, but this is just another level of protection in my view. Remember, these companies already qualify for underwriting, but our vetting is the next level. It’s not uncommon at all to have small companies that have great staff, great leadership, and stellar history with competent financial people and records; but lack capital. These type companies could ‘go nuts’ with the right backing. What we’re doing at the end of the day is underwriting the people as well as the projects/process. We have this database of folks and connectivity to the marketplace as well as an understanding of the underlying construction, hence the ability to mitigate risk with said knowledge. As based upon the aforementioned overall understanding, we don’t kiss very many frogs at all given the prior qualifying by their own surety companies: we become the basis to allow them to grow and for others the steroids to knock it out of the park. There are currently companies that perform so well that sureties allow them to do say $60 million with $3 million in assets, but cannot go beyond that from a prudence perspective although they believe in and have already stretched the limits.