by Scott Adams, President - Avalon Risk Associates

Any private equity firm not already familiar with surety bonds prior to the collapse of Enron are now getting an unexpected and eye-opening introduction to the product. Surety bonds have long existed as a relatively small and obscure product within the overall property and casualty insurance world. So small in fact, that they are often overlooked in many leveraged buy-outs until late in the deal (or even after the deal!) and then can pose a significant challenge to the bankers and investors in obtaining this important type of operational credit.

By way of a brief overview, surety bonds have been around for over 80 years and originated by federal and local statutes as a financial safety net provided to taxpayers on public works construction projects. Known as performance and payment bonds, surety bonds are required to be posted by any contractor (known as a PRINCIPAL) with the owner of a project (known as an OBLIGEE and in public works is a government entity) and guarantees to the owner that the project will be built according to the contract documents and that all payments to vendors on the job will be paid. Over the years, private owners have also come to require this protection for their construction projects and a whole variety of other surety products evolved as a result of its easy applicability as a guarantee of any type of contract between two parties many of which do not involve construction at all.

Bonds are underwritten by surety insurance companies (most of which are divisions of large multi-nationals, but smaller privately held surety companies do exist) and the guarantee provided the OBLIGEE is from the surety company as a third party indemnitor on behalf of the contractor, or PRINCIPAL. The surety then charges a premium to the contractor for providing this “co-signature” guarantee and monitors the project progression.

Sureties extensively underwrite the risks they take on these bonds because they are jointly and severally bound to the owner for completion of the project. Historically, sureties have not charged a significant premium (generally between 1-2% of the contract price) for the risk. As a result, sureties cannot sustain high losses and still remain profitable. Keep in mind that this is a credit product and not an insurance risk, so losses are not contemplated in the underwriting or pricing models of sureties. Think of surety more as a loan of the surety’s credit worthiness and be aware that complete indemnification from loss by the Principal is a requirement of the credit.

About 60% of surety bonds are written as guarantees for construction contracts and 40% are written for a variety of other types of obligations ranging from court bonds (i.e. appeal bonds, injunction bonds etc.) to bonds for certain types of licenses and tax obligations.

The underwriting of these credits is heavily centered on the financial statements of the Principals. The underwriting process is very conservative in nature, which is where private equity transactions usually disconnect. Specifically, a high level of importance is put on the tangible equity of a Principal, (the larger the better remembering that goodwill will be discounted out of the analysis) as well as the overall level of debt (the lower the better, as this represents solvency risk over time) of a Principal. One of the reasons the underwriting is so conservative is that, unlike traditional insurance policies, bonds are not cancelable obligations. Once a bond is put into the hands of its beneficiary, or Obligee, it cannot be cancelled by the insurer without triggering a call under the bond. This means that should a surety execute a bond with a 1-2 year time frame, they are assuming that time frame risk with minimal mitigation options open to them if the Principal’s financial condition should begin to deteriorate in that time frame.

For high quality credit risks, surety bonds are written for Principals on an unsecured basis, meaning corporate signature guarantee only. For lower quality risks or for more hazardous contractual obligations, some level of hard security is taken by the surety. Risks with high levels of debt should be prepared to post a significant amount of collateral to secure bonds and the current market climate will only exacerbate that issue as larger surety companies pull back entirely from riskier deals despite the offer of collateral.

From 1992-2000, the surety industry enjoyed an unprecedented historical run of profitable years. In that time frame, underwriting standards loosened, premium rates dropped and overall credit terms became soft, relatively speaking. Then, in 2001, the declining economy, increased rate of business failures and, most importantly, the size of the business failures, have all combined for the “perfect storm” in the surety business. In an industry that only wrote $3.6 billion in overall premium, it had almost $2 billion of outstanding, unsecured surety exposure on Enron alone, spread out over about seven of the ten largest surety writers. This kind of exposure has resulted in two very strong responses from the industry. First, high-level insurance company executives have revisited this line of business in their portfolio and do not like what they see. It presents too much exposure at too low a price and many are either pulling way back or are pulling out altogether. Second, those that are staying in are generally the smaller surety companies that are faring better these past 12 months because they maintained smaller and more collateralized positions on their risks.

In summary, private equity firms looking to do successful deals wherein the principal company relies in whole or in part on obtaining surety bonds, should be aware of the following issues and be pro-active in addressing them.

• Hard collateral; increased rates and lower capacities are characteristics of today’s surety market.
• Terms of sale for incoming and out going shipments
• Surety markets that will take on a leveraged risk will be watching closely for any performance deviation from stated projections and will react accordingly by demanding the posting of collateral mid-stream; raising rates on subsequent bonds or lowering capacities. You will be judged very closely by how you do in comparison to projections you gave the surety. Make sure these projections are as accurate and conservative as possible.
• Private equity firms/shareholders may be asked to execute subordination agreements to the surety for any debt owed to the shareholders by the principal or possibly capital retention agreements which protect the equity base of the principal from discretionary decreases while a surety’s bonds are in force.
• Some private equity firms may be required to provide limited indemnity to the surety on behalf of the principal for their surety line.
• Banking support will be closely scrutinized by the surety as many of today’s corporate failures are the result of an increasing liquidity crises originating with the lending sector of the economy and are often unexpected.
• Try to retain operating profits in the company and build a good track record with the surety for consistent performance over time.
• Communicate clearly and often with the surety (through a professional broker if you have one) so that no surprises occur in the ongoing underwriting process. Alert the surety of known upcoming events or issues that may lower the credit worthiness of the principal so that pro-active measure can be jointly pursued. Sureties hate surprises!
• Understand the relative importance of surety bonds to the Principal well in advance of any acquisition or recapitalization transaction so that you are able to address it in your business plan accordingly.
• Be prepared for careful underwriting of the specific underlying contract or obligation that is to be bonded. Sureties may want to have some input into this contract to try and reduce its exposure and protect your interests as well. Bonds that are guaranteeing pure financial obligations versus those guaranteeing performance obligations will be harder to come by, if at all.

www.AvalonSurety.com