Myths about Causes of Subcontractor Defaults

Subcontractors Default Primarily in Bad Economic Times

It may feel as if we are coming out of the "danger zone" as the economy starts to rebound from the impacts of the last couple of years, but—somewhat counterintuitively—the rebound or recovery period is typically the most active time for subcontractor defaults. Why is this?

Subcontractors are tough; they may survive a downturn by tightening their belts, drawing down their cash, and/or increasing their credit usage. When things start looking positive again, they may take on work that is oversized for their new cash position. Without sufficient cash to support the work, subcontractors are tremendously vulnerable to anything that impacts their cash flow, like another general contractor who pays slowly or materials cost escalation. Considering this, builders need to watch how the work they award to subcontractors fits with their present situation, not their historical capacity.

Once You Get Your Qualification Process Right, It Can Be Left Alone

Subcontractor qualification should be continuous to be truly useful, and your approach should evolve as needed. We are currently seeing defaults with builders who have never had any in the past. It's worth asking what has changed and make sure you address those changes.

For example, supply chain and cost escalation are increasing as drivers of defaults. Has your qualification approach been updated to add this topic? Discussions around those topics are incredibly important to have with your subcontractor partners right now.

Another data-driven addition could be adding quality questions to your standard questionnaire or meeting agenda when talking to potential subs. Quality is the main severity driver for defaults; if a default's cost breaches the level of two times the original subcontract, there is almost always a quality-related root cause. Does your prequalification address this proactively?

When a Default Occurs, the Subcontractor Qualification Probably Didn't Catch the Risk

There is a general impression that defaults occur when the subcontractor qualification effort missed areas of elevated risk. The much more painful truth is that, in over half of the defaults we've seen, red flags were raised but ignored or addressed with measures that didn't effectively mitigate the risks. An example is using joint checks when an operational risk—not a financial one—is in play. It is so painful when builders realize they could have potentially avoided the cost and headache of a default with closer attention to what their qualification process told them.

It is easy to be overconfident in the ability to work things out, and this may cloud the judgment of the team making award decisions. This is understandable; builders manage through challenges in construction every day. But when you have the opportunity to address any risk up front, take it.

Consider Safe Subcontractors You've Been Working with for Years

It's very easy to get comfortable with a subcontractor who is familiar and has done good work for you in the past. However, this can result in overlooking some serious risks. Why do we get too comfortable with some subcontractors? The following are two main factors.

• The age of the firm. A subcontractor you know and have been successful with in the past can lead to a level of comfort that is dangerous. We see defaults across all age bands, and our observations suggest that the likelihood of default may increase with the age of a firm. Issues around succession and industry changes may play into this phenomenon. Make sure your teams know that older firms aren't necessarily less risky and deserve just as much scrutiny for current capacity and ability as younger ones do.

• Relationships. No one would do this on purpose, but builders sometimes put their favorite subs out of business. In these situations, everyone starts out with good intentions. The subcontractor means to do the work profitably and well. The subcontract is awarded with full confidence, but sometimes the result is awful for everyone. Just because a subcontractor has done well on several million-dollar jobs does not mean they are equipped to take on a $2 million job. Your own financial calculations are the key to understanding the actual capacity of any subcontractor. Use them for familiar and unfamiliar entities alike.

Small Subcontracts Aren't All That Risky

It turns out, though, that our data suggest that the smaller the subcontract, the higher the cost of a default in relation to the original subcontract. The average multiplier on the smaller subcontracts is close to three times the original subcontract. This multiplier generally trends lower as the subcontract size increases. That means that a subcontract size that feels inconsequential from a default standpoint can have outsized effects. There really is no subcontract too small to cause headaches, disruption, and significant loss on a project, and the team making purchasing decisions needs to be aware of that.

Any Risk Mitigation Plan Will Do the Trick

Many times, we see risk mitigation plans in place for operational issues that are better suited to financial risks. If your qualification process identified an operational risk (workforce or quality concerns, for example), you should use an operation risk mitigation that addresses that risk. For workforce concerns, that might be production monitoring, or, for quality, it might be additional inspections, for example. These are not as simple to implement as financial measures might be, but if they best fit the risk, the work is worth it.

The Subcontractors Bear All the Cost Escalation Risk Due to Your Subcontract

Just like any activity on your project schedule has the potential to become a critical issue, so does escalation risk for any given sub. When cost escalation is likely, do not make exceptions to your financial qualification metrics; it's possible that an even more conservative approach is called for in this case. If subcontractors are not financially strong enough to bear the escalation, defaults can and do result.

Default Risk Comes Exclusively from Subcontractors

Your own project pursuit decisions have a strong influence on the likelihood of your subcontractors' success. As some markets grow and others shrink in response to economic forces, it is important that builders only make shifts in strategy very intentionally and work to understand the risks before diving into a new market segment, geography, or owner relationship. Each of those carries its own elevated risk, and the unknowns involved can lead to significant blind spots—which may evolve into decisions that lead to subcontractor struggles and ultimately defaults.

Conclusion

Since some of these ideas are contrary to what your teams may believe or have experienced, it's crucial that you spread the word. Think about it: do the right people in your organization have this information? If they do, it is far more likely their decisions will result in successful projects delivered as promised, with a minimum of painful subcontractor challenges.