Lockton’s Deal Playbook is a collection of content on various topics related to M&A. Stay tuned for more selections from the playbook on lockton.com.
Surety underwriting is a complex, multi-layered process that entails an assessment of a company’s financial strength, capability, operational integrity, historical performance and resources to fulfill its contractual obligations. In addition to reviewing these factors at the time a surety bond is written, surety providers will monitor them on an ongoing basis to determine if any changes to existing surety terms might apply.
Should a company proactively address its surety program when there is a sale or acquisition on the horizon? Absolutely! Performing thoughtful due diligence on an existing program is essential to:
(1) Ensuring that appropriate capacity will remain available post-transaction to support the company’s business plan;
(2) Verifying that active bonds will not be adversely affected or interrupted by a transaction; and
(3) Avoiding post-closing surprises (for example, drastic changes in rates or collateral requirements).
What are surety bonds?
In essence, bonds are forms of guarantees. A surety provider guarantees that the company applying for a bond (the principal) will perform according to its contract with the obligee.
If a principal is unable to comply with the agreed-upon terms, the surety provider will assume the principal’s responsibility. This will be done in accordance with the terms of the contract and bond, to mitigate any loss and damage the obligee may suffer from the principal’s default.
Keep in mind that a bond is not an insurance policy. A principal is ultimately still liable for its obligations to the obligee, even if the surety is required to step in. That is why a surety provider will sometimes require collateral to support a principal’s obligation.
Who uses surety bonds?
Surety bonds come in many forms — performance, bid, customs, license and permit, just to name a few — and are utilized across a wide range of industries, including construction, transportation, and finance. Many public and private contracts, as well as federal and state requirements, may mandate surety bonds to support a company’s ongoing operations. Having adequate, cost-effective surety capacity in place is a vital part of the growth strategy for many businesses seeking to scale their operations.
How do mergers and acquisitions affect surety?
When a company is acquired, especially by a private equity firm, the transaction typically changes the composition of its balance sheet. A surety provider will, at a minimum, contemplate the amount of goodwill/intangible assets, debt leverage and liquidity on the post-acquisition balance sheet.
A provider will also perform a qualitative assessment of the buyer’s investment strategy and post-closing business plan to assess if and how any changes to the current surety terms may be required. Potential changes may affect the indemnity agreement, required collateral, rates for new bonds and/or other terms of the existing program. In some instances, the surety relationship may be terminated altogether, forcing a company to secure alternative providers.
Information required in due diligence and expected questions
Below are a few critical pieces of the puzzle that drive how a surety program might be impacted by a merger or acquisition:
The company’s proforma financials — in particular, its opening balance sheet.
Proposed transaction structure (stock, asset, carve-out, etc.), proforma ownership structure/legal structure chart (platform, bolt-on, etc.) and draft purchase agreement.
Who is the buyer and what is its investment philosophy?
Is there currently a parental guarantee that will go away at closing?
Current surety providers, indemnity agreements, active bonds and available capacity. Is collateral support required? If so, what are the amounts and forms of collateral?
Have there been any historical drawdowns?
The key to mitigating potentially adverse M&A scenarios — such as an unexpected collateral requirement that erodes a company’s borrowing capacity or significant premium rate increases that reduce its profitability — is to consult with a trusted broker early in the process.
Both the buyer and company need to be aware of any expected changes to surety program terms (for example, increases in rates or collateral requirements) and related action items (for example, replacing or amending bonds and/or indemnity agreements). Having a clear understanding of anticipated changes is important not only for financial projection and deal valuation purposes, but also to ensure that the company’s operations supported by the surety program can operate seamlessly through closing.
In addition to advising on the transactional topics above, a broker should help a company review its existing surety program for potential opportunities and room for improvement. For instance:
Are the current surety providers the best fit for the company’s operations?
Are the prevailing rates competitive?
Is there an opportunity to reduce collateral requirements?
Surety bonds are an integral part of many business operations across various industries in the U.S. A merger or acquisition may affect the terms of a company’s existing surety program, including premium rates, collateral requirements and/or bonding availability.
The key to mitigating unexpected outcomes and adverse financial impact is to engage with a trusted advisor early in the process. Lockton’s Transaction Advisory Practice and surety professionals are well-positioned to partner with a buyer and target company to provide pre-signing due diligence support and to execute on a post-closing strategy.