Source: XL Group Insurance, Construction Insider, January 2013
By: Jason LaMonica, Vice President/Profit Center Head, Construction Performance Risk
One of the biggest inherent risks General Contractors and Construction Managers face as they build projects is the risk of a subcontractor default. A failure of a sub to perform can add cost, delay a job, and cause reputational damage for a contractor and owner. While not all defaults are preventable, sound prequalification and management practices can greatly reduce the risk of default and mitigate the severity of those that do happen.
First and foremost, selecting the right sub for the work gives you the best chance for success. Selection involves prescreening subcontractors across a wide variety of criteria. Here are some key areas to consider and address when selecting subcontractors:
Financial Review
Subcontractor Insolvency is far and away the biggest cause of default. Getting timely, audited financial statements from your subs and using standard objective metrics to evaluate them is the cornerstone of any subcontractor review process, especially in this challenged economy. Consider who does the evaluation at your firm; are they qualified? Is it done consistently across your organization? Is the data collected and evaluated in aggregate?
There are many areas of a subcontractor’s balance sheet that are important to review, such as Net Asset Value, Quick Ratio, Current Ratio and Return on Equity. All are important, but consider paying extra attention to Days of Cash. Available cash means a sub has enough reserve on hand to handle the unforeseen. Without adequate cash, one slow paying owner or general contractor on another job can cause your sub to become insolvent, regardless of that sub being treated fairly and paid appropriately on your job. CFMA (www.cfma.org) has some good resources on how to evaluate subcontractor financial statements that expand upon this subject.
Capability and Experience
Does the sub have experience with jobs of a similar size and scope? For example, if the largest subcontract a sub has ever done is $1,000,000, asking that sub to perform on a $5,000,000 subcontract is likely beyond his/her capability. Similarly, asking an ornamental metal sub to do structural steel work, even if the subcontract is smaller than their typical job size, is likely not a wise decision. Finally, locale matters. Subs working in an unfamiliar geography do not know the labor force, local laws and common practices. These are all things that can lead to performance issues.
Historical Performance
How well do you know this sub? If you’ve worked with him/her before, how did it go? Is this information shared from one project team to another? If you don’t know the sub, who do you know that does? Consider using internal and external reference checks to ensure you are not going into a subcontract blindly. Work only with subs that have performed well for you or for trusted peers.
Centralization vs. Decentralization
Whether your qualification process is done centrally for your whole company or in the field by many different project teams, consistency is the key. For centralized teams, ensure the team is qualified, empowered and used consistently. Make their involvement mandatory to ensure field compliance. For decentralized companies, see that the project teams receive adequate training on expectations and
procedures, and consider an internal audit process to ensure compliance to your corporate standards.
Aggregation Exposure
Qualification is an inexact science. Even the best qualification processes will not prevent all defaults from happening. Thus, it’s important to consider limitations on exposure on any one job (Single job limits) and any one subcontractor across all jobs (aggregate limits). How much can you afford to lose on any one job? How much of a hit can you take across your enterprise if a subcontractor becomes
insolvent and causes losses to multiple jobs? By limiting your exposure commensurate with the outputs of your qualification process, you can minimize your exposure to loss.
Bond-ability Letters
Surety underwriters do a great job, but they have a singular focus: making sure they write bonds in a way that will be profitable. That does not always tell you whether or not your sub can perform. A bond-ability letter from the sub’s surety is at most a secondary check against the financial viability of
the sub. Even then, that check can be misleading; the surety most likely has an indemnity agreement from the sub, and in many cases collateral. As a GC or CM, you will not have access to the same.
“Continuous,” not “Pre” Qualification
Subcontractor qualification is not a onetime event. It must be done continuously to be valuable. A review on a subcontractor that is a year old is not worth much; things change too fast. Continually updating your reviews will provide more accurate and current information. However, doing reviews too often become burdensome and difficult to achieve. Reviewing pre-award is good, but pre-bid is better – there is little sense in wasting your time or your subs’ time bidding if they will not qualify to do the work. Also, consider refreshing all reviews at least annually, and more often for critical scopes, new subs or any scopes you identify that have a heightened level of risk.
Despite the best qualification processes, there will inevitably be times when you are forced to use a sub that does not meet your minimum requirements. This can be driven by a directive from an owner, MBE/DBE requirements or a host of other reasons. Does this mean you should pass on bidding the job? Not necessarily. Situations such as these represent a heightened level of risk, and should be met with a heightened level of planning and management to mitigate that risk. Consider using a formal risk mitigation planning process to document the deficiencies you found in the qualification process and set up specific action plans to address them. This could include setting up joint checking, more frequent meetings/reviews with the sub, mentoring programs or any other means at your disposal to help the sub perform. After all, money is far better spent preventing defaults than curing them.
The net result of your subcontractor qualification process is that it should improve your sub selection, be documentable, and should help focus your risk mitigation plans in the right area. In short, it should put you in the best possible position to deliver your project on time and on budget.