As the construction market continues its rebound from the crippling losses it took during the Great Recession, contractors must be increasingly diligent and disciplined in choosing which subcontractors they partner with. The old adage of, “we have done business with them for years,” no longer cuts it in today’s rapidly growing and changing marketplace. Gabriel Valls, of risk management firm Zurich North America, dives into this issue and strategies to mitigate subcontractor-related risks in the latest volume of FMI Quarterly.

Recent figures from the U.S. Census Bureau and the Bureau of Labor Statistics indicate major growth in the construction industry, with 2017 construction spending projected to top the nearly $1.2 trillion dollars spent in 2016, while the industry added an average of 20,000 per month from January to May of 2017 (a monthly increase of 54% from the same period in 2016). While this is positive news, contractors need to be mindful that in a rebounding construction market, the risk of subcontractor default is greater, even than at the height of the recession in 2008. This is due to the challenge in balancing the significant cash required to fund a growing backlog, while still mending wounds inflicted to a company’s workforce and finances by the recession.

As the construction market continues to rebound, it also evolves. Much of the workforce left during the recession, never to return to the industry while the remaining workforce continues to age. While the industry remains handicapped by unfilled jobs, the amount of work available is outpacing the capacity of contractors. This issue is compounded by the fact that many owners are pursuing more large and unique jobs in order to capitalize on the booming market. The combination of these factors creates substantial financial burden and pressure to perform, which is contractually passed along to subcontractors. If subcontractors can’t perform, it’s the reputation and the business of the general contractor that is substantially at risk. That is why today, more than ever, it is important to make sure that a chosen subcontractor can shoulder that burden.

The best way to mitigate this risk is to develop a robust prequalification system that is engrained in the culture of the organization. This system must be consistently applied, which takes significant discipline. If senior management doesn’t fully buy-in, they may choose to cave to competitive and economic pressures, and bypass it completely. Similarly, if the lower rungs of the organization don’t buy-in, important steps may be glossed over. If the system isn’t dynamic enough to respond to changes in market conditions, the system must also evolve over time as the value is eroded

A strong prequalification system should dive beyond basic metrics, and according to Valls, focus on the following three areas:

  • Character – A contractor should consider the reputation of the prospective contractor as well as its history of default or litigation.
  • Capacity – A contractor should consider the prospective subcontractor’s history with contracts similar to the one being bid upon, as well as the prospective subcontractor’s currently available manpower and facilities.
  • Capital – A contractor should consider a number of things regarding the finances of the prospective subcontractor, including:
    • Quality and accuracy of the financial statements
    • Strength of the balance sheet
    • Sufficiency of equity and liquidity
    • Credit history
    • Adequacy of line of credit
    • Profitability over the past three years
    • Existence of a surety relationship

Furthermore, Valls suggests a number of activities to enhance the prequalification system, and to extract its maximum value, including:

  • Prequalification for each contract awarded, rather than a periodic prequalification for each subcontractor
  • Creating and maintaining a database of subcontractors and prequalification results
  • Conducting post-project evaluations to ensure that the system worked as it should have, and to identify areas for improvement going forward
  • Creating a risk mitigation plan to illustrate how prequalification plays a part, and to identify gaps that need to be covered

Now is a great time to consider instituting a rigorous subcontractor prequalification system or improving upon one that is already in place. It’s an industry best practice which has proven to mitigate risk and drive future success.

Additional Resources

If you would like to read Vall’s article in the FMI Quarterly, you can download a copy of the publication here.

If you have questions on creating a robust subcontractor prequalification system or anything else, please call Barnes Dennig at 513-241-8313 or click here to have a member of the team call you. We hope to speak with you soon!