Idea Transcript
LENDING TO...
A Written Policy for Lending to Contractors by Dev Strischek
T
he 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.
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The Journal of Lending & Credit Risk Management June 1999
A Written Policy for Lending to Contractors
uring 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
D
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 lend33
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
Description of work examples
SIC codes
Building construction
Houses, office buildings, shopping centers
1500-1599
Highway and heavy construction
Highways, streets bridges, dams, public works, sewage plants
1600-1699
Specialty construction
Plumbing, heating, electrical, drywall, painting, and roofing
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.
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The Journal of Lending & Credit Risk Management June 1999
Credit Analysis The contractor is a manufacturer of a unique, oneof-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
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 35
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
Indicator
1. poor estimating and job cost reporting 2. poor project management
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
3. no comprehensive business plan
4. poor communication with customers, vendors, and employees 5. poor financial management
6. factors beyond contractor’s control
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 36
The Journal of Lending & Credit Risk Management June 1999
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
A Written Policy for Lending to Contractors
Figure 1 Analytical Factor 1. Ability to repay from: a. operating cash flow b. collateral (sufficiently margined) c. guarantees (adjusted net worth)
Strength
Weakness
-yes -yes -yes
-no -no -no
2. Financial condition and performance a. profitability: (1) sales (2) gross profit margin (3) operating leverage (4) profitability trends b. Liquidity (1) receivables (2) payables (3) net working capital (NWC) (4) cash position c. Leverage (1) immediate debt pressure (2) D/W ratio d. Solvency (1) interest & cash flow coverage (2) capital expenditures (3) debt repayment schedule
3. Financial statement quality a. b. c. d.
preparer quality scope accounting method
4. Company overview a. years in business b. legal status c. line of business d. customers
-SGR>actual sales growth rate -able to maintain jobGPMs - low, say < 5.0 -up
-SCR< actua salesl growth rate -declining GPMs on major jobs -high, say >5.0 -down
-fast-turning or improvingtrend -fast-turning or improving trend -low sales/NWC ratio, positive NWC -positive
-slow-turning or declining trend -slow-turning or declining trend -high sales/NWC ratio, negative NWC
-current debt/total assets lower than average -lower than industry average
-current debt/total assets higher than industry average -higher than industry average
-better than industry average -budgeted -available
-worse than industry average no - formal budget -unavailable
-CPA prepared -audited, no qualifications -consolidating or combining -percentage of completion
-company prepared -unaudited: compilation or review -parent only -completed contract, cash basis, tax basis, or hybrid
-5 or more years -corp. or S corp. -general contractor -public works
-less than 5 years -proprietor or partnership -subcontractor -client with little track record or questionable reputation -unfavorable responses, -unrated or poor credit rating -unlicensed -unable to get bonding or required insurance coverage -many competitors -very sensitive to seasonal or cyclical factors -fixed assets in disrepair, excess equipment, or “irrelevant” assets
e. trade & bank creditors, personal credit reports f. regulatory compliance g. insurance and bonding
-favorable responses; satisfactory credit ratings -licensed -bondable, insurable
h. competition i. economic conditions
-few competitors -insensitive to seasonal or cyclical factors -well-maintained plant & equipment, scheduled maintenance
j. production & facilities
5. Proposed credit accommodation a. b. c. d.
term purpose collateral guarantees
-short-term -carry current assets -secured -guaranteed
-declining or negative, overdrafts
-long-term -refinancing, restructuring -unsecured -no guarantees
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A Written Policy for Lending to Contractors
from jobs-in-progress and retention (RET) from net progress billings (NPB) as illustrated in the following illustration: Contract ($M) Boca Raton Hotel
NPB
RET
Total
Bonded (Yes/No)
60
300
360
Y
Crock Pot Deli at Gatorland 40
200
240
N
Finished
100
500
600
1,200
120
1320
Y
Tallahassee Chassis Repair 1,800
80
1,880
Y
Orlando Orthodontics Jobs-in-progress
2,000
200
2,200
Total
2,100
700
2,800
The purpose of this analysis is to identify how much of the receivables portfolio is bona fide receivables and how much is still in the form of progress billings. A failed contractor’s progress billings are much harder to collect than the amounts due on finished jobs. Further, if any of the jobs are bonded, these should be identified. The surety’s payment and performance bond allows the surety to step into the shoes of the bonded contractor by means of a legal process called subrogation. The surety acquires the contractor’s job rights in the bonded project, and these job rights are usually superior to a lender’s rights of assignment in the specific contract. Next, the surety company’s Best’s Insurance rating should be noted. Finally, the surety company’s analyst should be contacted as part of credit inquiry process, at inception as well as at annual review, to confirm the contractor’s bonding capacity and reputation with the surety. A surety rated C or lower, a surety analysis with a negative evaluation of the contractor, or a decrease in the contractor’s bonding capacity should be sufficient grounds to decline, reduce, or exit the relationship. Guarantees. An extension of credit to a contractor is to be fully and unconditionally guaranteed by its principals. Limited guarantees, comfort letters, or nonrecourse extensions are exceptions to policy and require the approval of the appropriate credit risk officer. The objective of the guarantor analysis should be to determine the amount (if any) of outside or adjusted net worth (ANW) and the personal cash flow (PCF) of the guarantors. The following format illustrates the approach: Guarantor Conrad Tractor
Book NW Less: Adjust Outside ANW Outside PCF 1,000
Constance Traction 1,400 Total
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2,400
800
200
25
900
500
210
1,700
700
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The Journal of Lending & Credit Risk Management June 1999
The ANW evaluation should be based on current financial statements and the PCF evaluation on current tax returns. Stale financial statements or tax returns are an exception to policy that requires the concurrence of the appropriate credit risk officer. Underwriting Guidelines Exceptions to these guidelines must be approved by the appropriate credit risk officer: Borrower. Contractor should be headquartered in the bank’s target market and/or engaged in projects within the bank’s target market. Amount. Total credit exposure should be accommodated by the existing contractor industry capacity as set by the bank’s current concentration guidelines. Facilities. Lines of credit, term facilities, and letters of credit may be extended to contractors: Lines of credit are appropriate for seasonal borrowing needs, and advances under the line are to be limited to an appropriate percentage of receivables. The advances are to be on a demand note basis. The intent is to link the borrowing to a valid need for working capital. See the collateral section for specific advance rates and borrowing base format: Term facilities are appropriate for purchase or lease of specific fixed asset acquisitions and are to be collateralized by the assets acquired conforming to the bank’s LTV policies for such assets. The bank’s leasing department must underwrite all leases. Letters of credit should be collateralized by cash or marketable securities with LTV’s conforming to bank policy. A credit facility not designated here is an exception to policy and requires the concurrence of the appropriate credit risk officer. Maturity/term. Lines of credit are to expire annually and require at least a 30-day rest period. Term facilities are to conform to policy based on the fixed asset being financed. Letters of credit are not to exceed one year in duration unless secured by cash or marketable securities. Collateral. All lines of credit extensions are to be secured by an assignment of contract receivables, a blanket lien on assets, or a security interest in the fixed assets being financed. Unsecured credit is an exception to policy and must have the concurrence of the appro-
A Written Policy for Lending to Contractors
priate credit risk officer. The amounts advanced are to conform to bank policies on loan-to-value (LTV). The current maximum advance rate on eligible progress billings is 75% and on amounts due for completed projects is 90%. Advances are to be tied to the receivables and evidenced by a current borrowing base certificate according to the following example. Facilities that forego a borrowing base requirement are exceptions to policy and require the concurrence of a credit risk officer: Finished Jobs Contract Receivables as of 12/31/01
4,750,000
Less: — current portion of -0deferred taxes payable — unsubordinated amounts -0due related parties — liens, judgments, fines payable -0— progress billings on jobs (5,000) 60 days or more behind schedule. — progress billings on jobs over (10,000) cost budgets by 10% or more — progress billings on jobs behind (5,000) POC* projections by 10% or more — payables and any other current 5,000 liabilities over 30 days past due Subtotal
Jobs in Progress
Total
11,000,000 $15,750,000
-0-
-0-
-0-
-0-
-0(20,000)
-0(25,000)
(100,000)
(110,000)
(25,000)
(30,000)
140,000
(145,000)
25,000
285,000
310,000
4,725,000
10,715,000
15,440,000
Jobs in Progress 10,215,000 x 75% =
7,661,250
7,661,250
Total
7,661,250 $11,913,750
Eligible Receivables
Completed Jobs 4,725,000 x 90% = 4,252,500 4,252,500
4,252,500
* POC=percentage of completion, e.g. a job scheduled to be 65% complete by 12/31/01, is only 54% complete.
Term debt secured by equipment is to be cross-collateralized and cross-defaulted with all other bank debt. The term should not exceed the useful life of the equipment. Outside valuation of the equipment is recommended, and one industry source is The GreenGuide. Of the three categories of valuation commonly quotednew price, resale price, and wholesale price, the lowest of the three should be selected for underwriting purposes. Wholesale price is typically the lowest of the three quotes. Guarantors. The credit extension is to be fully and unconditionally guaranteed by the borrower’s principals. Anything less than a full and unconditional guaranty is an exception to policy and requires the concurrence of the appropriate credit risk officer.
Financial statement quality. The credit analysis and repayment ability must be based on current financial statements and company tax returns. CPA-prepared financials are preferable to company-prepared statements, and audited fiscal year-to-year statements are preferable to unaudited (compilation and review) numbers or company prepared figures. Statements based on percentage-of-completion are preferable to completed contract financials. Covenants and conditions. All of the following are to be incorporated into credit extensions to contractors. Deletion, dilution, or diminution of any of these is an exception to policy and requires the concurrence of the appropriate credit risk officer: 1. No additional lenders without prior bank consent. 2. Subordination of any related party debt, both in principal and interest payments until the bank’s commitment is extinguished. 3. No decrease or loss of bonding capacity. 4. All bank facilities are to be cross-defaulted and cross-collateralized. 5. Bank to be loss payee on key person life or disability insurance equal to the amount of the total credit exposure, or assignment of cash value life insurance (CVLI) equal to the amount of the total credit exposure, or a total combination of key person life/disability insurance and CVLI equal to the amount of total credit exposure. 6. No change in ownership or control without prior bank approval. 7. No acquisition or disposition of assets whose book value or purchase price, whichever is less, is in excess of 25% of total credit exposure without prior bank approval. 8. Interest on indebtedness to be paid monthly. 9. No change in auditing firm or bonding company without prior bank approval. 10. Copies of all documentation submitted to surety company. 11. Financial statements must include balance sheet, income statement, cash flow statement, receivables aging, payables aging, and contract status report. Financial statements and related reports are to adhere to this schedule based on the total credit exposure (TCE) of the borrower:
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A Written Policy for Lending to Contractors
Frequency of reporting (A) Report Document TCE< $1MM TCE > $1MM Responsible Party Balance Sheet Quarterly Monthly Borrower Income Statement Quarterly Monthly Borrower Cash Flow Statement Quarterly Monthly Borrower Receivables Aging Quarterly Monthly Borrower Payables Aging Quarterly Monthly Borrower Borrowing Base Certificate As needed Monthly Borrower Contract Status Report (B) Quarterly Monthly Borrower Cash Flow Projections Annual Annual Borrower and Bank Lien Searches Annual Annual Bank Covenant Compliance Quarterly Quarterly Bank Surety Company Documentation Quarterly Quarterly Borrower (A) Monthly reports to be received no later than 30 days after month-end, quarterly reports no later than 45 days after quarter-end, and annual reports no later than 90 days after year-end. (B) Contract status report must disclose start and finish dates, type and location of project total contract price, total estimated cost, estimated gross profit, percentage of completion, revenue earned to date, total costs incurred to date, total costs recognized to date, gross profit recognized to date, billings to date, estimated costs to complete, and under (over) billing to date.
Financial covenants. The following financial covenants are to be employed with the following values and frequency of monitoring and compliance: Frequency Covenants (A)
Monitoring
Compliance
> 1.00
Quarterly
Annually
Net Working Capital
>0
Quarterly
Annually
Tangible Net Worth
>0
Quarterly
Annually
< 4.0
Quarterly
Annually
Current Ratio
Senior Debt/Tangible Capital Funds (B)
Value
(A) Terms are defined according to GAAP unless otherwise noted (B) Senior Debt/Capital Funds = Senior Debt/(Subordinated Debt + Tangible Net Worth)
Documentation. Standard loan documentation is to be used for all credit extended to contractors. Nonstandard documentation is an exception to policy that requires the concurrence of the appropriate credit risk officer. Outside attorneys. If the loan is closed by an outside attorney, the law firm must have been preapproved for preparing documentation and closing loans to contractors. Use of an unapproved attorney to prepare documentation or to close loans for contractors is an exception to policy that requires the concurrence of the appropriate credit risk officer.
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The Journal of Lending & Credit Risk Management June 1999
Summary Your institution can tailor this generic policy to suit your own needs and resources. The policy is clearly tilted toward limiting the lending authority for contractors to a designated few. In many banks, this talent pool will probably consist of commercial real estate lenders involved in project financing or commercial lenders with a portfolio of business customers needing owneroccupied facilities financing, e.g. warehouse, factory, office building, etc. The policy is written very tightly with exceptions to it typically requiring approval of a credit risk officer. You may want to open the box a little more, but the box in this policy is designed to hold only adequately secured, fully guaranteed, cash flowing construction borrowers. The reporting requirements are rigorous and frequent because experience shows that response time to contractor problems is typically short. “Know your borrower” is a major theme throughout the policy. Contractors who stay close to home and to their business are more likely to succeed than those who go outside their markets. Finally, construction is more of a cash flow call than most credit decisions. Cash-consuming work-inprogress inventories, the bonding company’s lien position ahead of bank lenders, the low realizable liquidating values of receivables, and the modest net worth of contractor guarantors leave operating cash flow as the only viable source of repayment. Downside risk analysis is critical to the decision, and the frequent flow of interim financials is necessary to monitor contractor creditworthiness. Written is better than verbal, and “must” is stronger than “should.” Still, as Adlai Stevenson once observed, “Man does not live by words alone, despite the fact that sometimes he has to eat them.” The policy is yours for the editing, not the eating. Dig in, but just in case, bon appetit! ❐ Dev Strischek is managing director of credit and risk management, Florida Corporate & Investment Banking, SunTrust Banks, Inc.
A Written Policy for Lending to Contractors
Exhibit 1 Policy Exceptions for Contractors Policy Exception
Yes
No
Justification
1.Contractor headquartered outside bank’s target market and has no current projects in market. 2.Contractor’s TCE causes bank to exceed its maximum concentration limit for the construction industry as a % of total commercial credit commitments or as % of bank’s legal lending limit, whichever is lower. 3.Existing commitment or new request risk rated “watch list” or worse. 4. Unsecured credit to a contractor or LTV exceeds bank policy. 5. Limited guaranty, comfort letter, or nonrecourse. 6. Stale or incomplete financial statements on borrower or guarantors. 7. Facility not designated as appropriate for contractors. 8. Line of credit longer than one year or has no rest period. 9. Term loan exceeds term for asset being financed. 10. Letter of credit not secured by cash or marketable securities. 11. No requirement for a borrowing base certificate. 12.Diminution or deletion of any of the standard covenants and conditions for contractors: a. b. c. d. e.
no additional lenders full subordination of related party debt loss or reduction in bonding capacity cross-default and cross-collateralization key person life insurance, disability insurance, or CVLI equal to the total credit exposure f. no change in ownership or management g. no sale or purchase of assets that exceeds 25% of total credit exposure. h. no change in auditing firm or bonding company i. current ratio > 1.00 j. NWC > 0 k. TNW > 0 l. senior debt/capital funds < 4.0 13. Nonstandard loan documentation used to close loan. 14. Use of attorney unapproved by bank for preparing documents or closing loans for contractors.
Lender
Credit Officer
Date
Date
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A Written Policy for Lending to Contractors
Exhibit 2 15__ 1521 1522 1531 1541 1542
SIC Codes for Contractors
Building construction and operative builders general contractors (GC) - single family homes GC— residential buildings, other than single family operative builders GC —industrial buildings and warehouses GC —nonresidential buildings other than industrial buildings and warehouses
16__ Heavy construction 1611 GC—highway and street construction, except elevated highways 1622 bridge, tunnel and elevated highway construction 1623 water, sewer, pipeline, communication, and powerline construction 1629 heavy construction, not elsewhere classified (NEC) 17__ construction —special trade contractors 1711 plumbing, heating (except electric), and air conditioning
12
1721 1731 1741 1742 1743 1751 1752 1761 1771 1781 1791 1793 1794 1795 1796 1799
The Journal of Lending & Credit Risk Management January 1999
painting, paper hanging and decorating electrical work masonry, stone setting, and other stonework plastering, drywall, acoustical, and insulation work terrazzo, tile, marble and mosaic work carpentry floor laying and other floor work NEC roofing, siding, and sheet metal work concrete work water well drilling structural steel erection glass and glazing work excavating and foundation work wrecking and demolition work installation or erection of building equipment, NEC special trade contractors, NEC