A Written Policy for Lending to Contractors

LENDING TO...

A Written Policy for Lending to Contractors

by Dev Strischek

The bank with a sound, written policy should be able to build a prudent, profitable contractor portfolio. This article offers a generic policy that readers can tailor to their individual bank's credit culture and season to their own risk appetite. The form and content of this policy represent a composite of many banks' contractor policies shared with the author by bankers who have attended RMA's "Analyzing Construction Contractors" workshop over the past 15 years. The author invites readers to, "Sharpen your pencils, hold on to your erasers, and as you edit the contractor credit policy presented here, follow the 1773 advice of a college tutor quoted by English writer Samuel Johnson: Read over your compositions, and where ever you meet a passage which you think is particularly fine, strike it out."

? 1999 by RMA. Strischek is managing director of credit and risk management, Florida Corporate & Investment Banking, SunTrust Banks, Inc., Orlando. He is a former president of RMA and currently serves on both the Editorial Advisory Board of The Journal of Lending & Credit Risk Management and the Award for Journalistic Excellence Committee. A frequent contributor to the Journal, Strischek has contributed numerous past articles helping bankers to lend to contractors successfully. 32 The Journal of Lending & Credit Risk Management June 1999

A Written Policy for Lending to Contractors

During their careers, bankers lend to borrowers, good and bad, eventually to learn through experience which is which. William Saroyan observed that good people are good because they've come to wisdom through failure. By that measure there are many good people in construction as well as in banking. Commercial bankers find lending to contractors challenging because of their vulnerability to the economic business cycle, low entry barriers, price competition, and industry volatility. ? Construction activity oscillates far more than the

undulating business cycle that drives it. ? Entry into many construction lines of business has

no formidable barriers other than regulatory licensing and the capital investment required for the heavier construction trades. Easy entry draws many into the construction business who have neither the financial strength nor the management acumen to survive. ? The ability of the many competing contractors to differentiate themselves is limited; the problem is exacerbated by bidding for work on price. ? Low gross profit margins leave little funds to cover variable interest and tax expenses. Given these problems, it is more the wonder that bankers would risk lending to contractors at all. Still, banks prosper as communities grow, and the growth requires physical infrastructure to sustain economic expansion. Someone has to build the homes and offices, lay the roads and water lines, and wire the electric and cable utilities. Contractors contribute much to the local economy, and banks that lend prudently to creditworthy contractors help themselves and their community. With an effective policy, banks can lend successfully to contractors. To that end, an example is offered in this article that banks can tailor to their own needs. For example, every bank has its own distinctive credit culture and its own unique way of expressing its credit policies. Some banks prefer guidelines to policies and show their tolerance by a preference for "should" over "shall." Other banks view their policies as educational and include insights, tips, or explanations for the policy in question. The bank that prefers brief guidelines will write a shorter policy than the bank that wants specific, complete policies. Regardless, it usually is easier to edit

down a more comprehensive policy than to enlarge a brief one. The generic policy presented on the following pages is long enough for most lenders to edit it more liberally or more conservatively as appropriate.

Portfolio Risk Management High risk. The contracting business is riskier than

other lines of business. Problems lurk in: ? Its high sensitivity to business cycles. ? Intense competition due to relative ease of entry

into many of the construction trades. ? Low profit margins caused by the competitive bid

process. ? The high probability of work stoppage caused by

inclement weather or other work flow interruptions. ? The limited supply of management experience in

field construction, marketing, finance, logistics, and other facets necessary to success in construction. Contractors fail more frequently than those in other lines of business, and the failure rates rise faster during recession. The statistical record of contractor failure validates its classification as a high risk industry.

Authorities. Because of its high risk, only lenders judged to possess the appropriate experience and skills are authorized to extend credit to contractors. Construction lending authority will be granted to such qualified lenders by the appropriate executive management. Construction lending authority is required to extend any credit to companies defined as contractors in the following paragraphs. Further, contractor requests with policy exceptions will require the concurrence of credit policy officers authorized to concur on contractor requests.

Policy exceptions. Certain red flags in lending to contractors have been identified as policy exceptions. A credit request with one or more policy exceptions requires the concurrence of the appropriate credit risk officer, that is, the credit risk officer with sufficient approval authority to concur with the request. Exhibit 1 lists all the exceptions in this policy, requires identification of each as "yes" or "no," and requires the signature of both the lender and the credit risk officer. Exhibit 1 is to be attached to all contractor credit requests.

Risk rating. Because of the inherent risk in lend-

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A Written Policy for Lending to Contractors

Credit Policy for Contractors

ing to contractors, existing commitments or a credit request to a contractor rated watch list or worse is an exception to policy and requires the concurrence of the appropriate credit risk officer.

Contractors. Construction work can be categorized into three groups identified by SIC codes. Credit extension to any borrower within these SIC codes requires construction lending authority:

Type of contractor Building construction

Highway and heavy construction

Specialty construction

Description of work examples Houses, office buildings, shopping centers Highways, streets bridges, dams, public works, sewage plants Plumbing, heating, electrical, drywall, painting, and roofing

SIC codes 1500-1599 1600-1699

1700-1799

Exhibit 2 lists SIC codes for contractors in greater detail. If a type of construction activity is not specifically listed, use its SIC code to determine if it is a contractor. Questions or issues associated with definition will be decided by the chief credit officer or designee.

Target market. Management ability is critical to contractor success; an accurate assessment of management is fundamental to evaluating creditworthiness. Therefore, the contractor should be headquartered in our market area and/or be doing business in that area. Ideally, the contractor both resides and does business in our market area, giving us the chance to observe the management and the company's performance. Lending to a contractor headquartered outside the market and with no current projects in the bank's market is an exception to policy, and a credit request must have the concurrence of the appropriate credit risk officer.

Portfolio concentration. From time to time, management will establish percentage guidelines for total credit exposure to contractors in the form of a maximum percentage (%) of the bank's commercial credit portfolio and as a percentage (%) of the bank's legal lending unit, whichever is lower. A credit extension that causes the bank to exceed this maximum concentration limit is an exception to policy and must be approved by the appropriate credit risk officer. Current limits are 10% of total commercial credit commitments or 10% of the bank's legal lending limit.

Credit Analysis The contractor is a manufacturer of a unique, one-

of-a-kind product that takes a long time to build, so much of a contractor's working capital is tied up in its large, slow-turning, construction-in-progress inventory. Operating cash flow is heavily dependent upon the contractor's ability to assemble the proof of the percentage of work accomplished in form and content satisfactory to the owner. These monthly progress billings are the source of cash the contractor uses to pay for labor, materials, taxes, principal and interest.

Another challenge for the contractor is that many jobs are on a bid basis. In effect, the contractor bids a price before the costs of producing the product are known. Therefore, the accuracy of job cost estimating and the success in bidding work together to eliminate poor estimators and bad negotiators over time. The longterm winner in construction is someone who can consistently bring in projects on time, on budget, and, consequently, at a relatively low gross profit margin.

The credit analysis of a contractor should be aimed at the same goal as the analysis of any other borrower, to gauge the ability of the contractor to repay his existing and proposed obligations, presumably from cash flow, collateral, and guarantees. However, the industry's volatility over the business cycle, the innate illiquidity caused by the work-in-progress inventory, and the low gross profit margins of the bidding process warrant some additional guidance in the analytical process.

Type of contractor. Is the borrower a general contractor (GC) or a subcontractor (SUB)? Generally, GCs have stronger financial statements than do SUBs, and they are one step closer to the source of payment for work performed. Further, because all SUBs are paid retention at the same time, usually 45 to 90 days after the project is legally noted as completed, those SUBs at the end of the job do not have to wait as long. The typical 10% holdback for retention can amount to half of the average 20% gross margin in a job.

Line of business. What kind of contractor is the borrower? Remember, general contractors usually are financially stronger than subcontractors. Is the contractor legally licensed? Lending to an unlicensed contractor may subordinate the bank's position to other creditors. Is the license holder an active employee? Inactive licensees

34 The Journal of Lending & Credit Risk Management June 1999

A Written Policy for Lending to Contractors

do not meet the intent of the law. Does the work require considerable investment in equipment? Heavy construction typically is more capital-intensive than the specialty trades. Is the work more hazardous, such as demolition, than other lines? Insurance coverage will be more difficult to obtain and more expensive to maintain. Does the contractor stick with its core business or switch from one line to another? Switching from one product line to another requires considerable investment in estimating, engineering, and monitoring.

Management. Who are the principals? How long have they been with the company, and in the industry? Look for resumes of their experiences, skills, training, and education. High turnover is an occupational hazard in construction, so expect to see numerous job changes. Job changes should come at natural breaks, such as the completion of projects, the wind-down of a business cycle, and so forth.

Bid process. Does the owner review all the bidsor at least the larger bids-before they are turned in? Look for his or her signature or initials on the estimates in the job files.

Construction supervision. Does the owner visit his or her job sites? If so, how often? Successful contractors try to visit all their job sites weekly and spend 25% of their time in the field. Does the company assign a manager to each job or assign multiple jobs to its project managers? Closer supervision tends to keep projects on time and on budget.

Site visits. Visit some of the significant jobs. Compare what you see with the most recent percentage of completion. Does the job look 45% complete? If not, ask how the figure was derived. How well does the owner interact with the job crews? How knowledgeable is the owner about the projects? Savvy owners usually can tell you costs to date, revenues to date, completion date, and so forth.

Customers. What percentage of the contractors is public works and what percentage is private work? Most public jobs are bid, so the gross profit margins tend to be lower and the administrative requirements higher. However, public jobs tend to be large, so the gross profit dollars are attractive. The lower gross margins also reflect the lower risk perceived in government work. Of course, the Miller Act requires most government projects to be built by bonded contractors and

subcontractors.

Billing policies. How frequently is each job billed? Which jobs are under-billed or over-billed? Contractors like to "front-end load" their billings, that is, bill more, relative to costs early in the contract; however, this over-billing process can leave the contractor short of billable revenue to pay the remaining costs to complete the contract.

Contractor status report. Is there a steady flow of new jobs onto the contractor status report? If the jobs-inprogress schedule shows every project 50% or more complete, the contractor's job pipeline is probably running dry. As the pipeline empties, there will be no new jobs to generate interim losses to tax-shield earnings, and the contractor will no longer be able to defer taxes.

Deferred taxes. As noted above, declining work activity often causes deferred taxes to be reclassified current and therefore payable to the IRS. One of the downside risks to contractors in economic downturns or recession is the inability to pay taxes because of the lack of new work to generate immediate cash flow and to shield earnings with book losses on new jobs.

Insurance. What is the company's rating on workmen's compensation and unemployment? What is its OSHA record? Poor ratings mean higher, more expensive insurance and reflect poor recordkeeping, unsafe field practices, or deliberate fraud.

Surety. Is the company bonded? If so, on what jobs? Is the surety rated A or better by A.M. Best's? What is the contractor's current bonding capacity? Has the surety increased or decreased the capacity? Why? What is the surety analyst's opinion of the contractor? Does the bank get copies of the reports sent by the contractor to the bonding company?

Fixed assets. Examine the equipment for maintenance, upkeep, and orderliness. What are the company's trends in equipment downtime, repair expense, and maintenance expense? How does the contractor keep track of owned and leased equipment at each job site? Regularly scheduled maintenance is cheaper than repairs for breakdowns. Sloppiness, deferred maintenance, and poor recordkeeping divert cash flow away from repayment.

Financial condition. How much of the contractor's net worth and profits are derived from jobs in

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A Written Policy for Lending to Contractors

progress? Are you comfortable with the contractor's track record in estimating accuracy as you review the company's cash flow projections? Declining gross margins on jobs-in-progress usually indicates productivity problems caused by ineffective management in the field.

Industry comparisons. The company's financial ratios should meet or be better than the median figures for the contractor's asset or sales peer group in RMA's Annual Statement Studies.

Strengths and weaknesses. The credit analysis should identify the financial and nonfinancial factors that positively or negatively affect the borrower's ability to pay. The most important factors are ability to repay from operating cash flow, from collateral, or from guarantees. Figure 1 summarizes a number of common analytical pros and cons.

Red flags. Besides the usual analytical factors, it is worthwhile to assess the contractor by using the following list of red flags, events, or trends typically associated with troubled contractors:

Red Flags

1. poor estimating and job cost reporting

2. poor project management

3. no comprehensive business plan

4. poor communication with customers, vendors, and employees

5. poor financial management

6. factors beyond contractor's control

Indicator

cost overruns, late reports, declining backlog high labor turnover, poor OSHA or

workmen's compensation ratings fast growth, entry into new products, new geographic market,

rapid increase in project size slowdowns, strikes, litigation, liens, judgments, frequent changes in

bonding companies cash flow problems, loss of bonding, extraneous equipment and

toys--boats, planes, etc. weather-related delays, stoppages, economic recession

One way to mitigate the causes of red flags is to reward the contractor for positive results and to discourage negative actions. Some points to keep in mind include: 1. Tie funding to current financial information and to

satisfactory job progress by reducing funding on jobs that are over budget or behind schedule. 2. Set covenants that stop funding in the event of: a. liens or judgments b. loss of bonding capacity c. change of ownership or management d. change in accounting firm or bonding company e. new borrowings from other lenders

f. any other adverse event not covered above. The underwriting section illustrates these points more fully.

Repayment ability. As will be explained later, contractor assets and individual guarantees are weaker secondary sources of repayment than in many other lines of business. Consequently, repayment ability should indicate the ability to repay on both a most likely cash flow projection and a downside cash flow projection. The most likely projection should assume that the borrower will continue as a going concern, and the downside projection should assume that the contractor will have no new projects but simply finish out the existing work-in-progress jobs. The cash flow downside projection should be based on this example format, which is detailed more fully in RMA's Analyzing Construction Contractors publication:

Downside Cash Flow Analysis Total jobs in progress contracts Less: billed to date Remaining to bill Plus: receivables Total cash inflow

Total Estimated Costs Less: costs incurred to date Estimated costs to complete Plus: Accounts Payable Accruals Deferred Income Taxes Cash operating expenses for one year Total Cash Outflow Cash available to service debt

Existing loans Existing interest expense Proposed new loan Proposed loan repayment Proposed interest expense Total Debt Service CASD/DS (190/132)=

$M 23,500 (17,619) 5,881 3,789 9,670

21,272 15,772 5,500 2,543

90 619 728 9,480 190

(100) (10) 200 (200) (22) 132 1.4X

If the downside projection forecasts insufficient CASD to cover debt service, then additional mitigation is necessary to support the credit extension. Mitigation should include additional collateral, guarantees, or other credit enhancements.

Collateral. All extensions of credit are to be collateralized. An unsecured extension of credit is an exception to policy and requires the concurrence of the appropriate credit risk officer. The collateral analysis should include a receivable aging coincident with the financial statements on which the cash flow projections are based. The analysis should separate finished jobs

36 The Journal of Lending & Credit Risk Management June 1999

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