Economic clouds put brakes on industry consolidation—for now

This year’s total consolidation will be in line with 2011, and 2013 will see a greater pace of activity.

By Mick Morrissey August 9, 2012

After two years of torrid consolidation among the Consulting-Specifying Engineer MEP Giants, the pace of merger and acquisition (M&A) activity among the leading providers of mechanical, electrical, plumbing (MEP), and fire protection engineering services slowed dramatically last year. In 2011, just 12 of the top firms were involved in a merger or acquisition. This was a dramatic departure from the frenzied pace in the prior 2 years when one-fifth of the industry leaders bought, sold, or merged. 

Why have the Giants eased off the gas pedal with respect to deals? How has industry consolidation changed over the past year? Is this slowdown likely to continue? And what does it mean for you? Read on to find out. Watch the video summary of the industry highlights.  

Economic mixed messages put the brakes on deal-making 

In speaking with many MEP firm owners and managers around the country, the almost unanimous consensus is that the first quarter of 2012 was markedly better business-wise than the same period in 2011. Indeed, many MEP firm managers say that 2011 overall appeared to be the year where the bottom of the economic cycle had been reached and that the “recovery” was taking hold.   

Given these somewhat positive conditions, one would assume that M&A would be on the increase in the industry too. M&A activity tends to rise and fall with economic activity. When the economy is growing, firms are stronger and generally more optimistic. There are relatively more buyers in the market and deal valuations are typically higher. On the flip side, during recessions firms are weaker and are more cautious. There are relatively fewer buyers in the market and deal valuations are typically lower. So with many member firms seeing better times in 2011 and the first quarter of 2012, it would be reasonable to assume that M&A activity would be increased too.

Well, the numbers tell a different story. In 2011, as we have seen, the pace of M&A among the MEP Giants slowed dramatically—down by 50% (despite an uptick in overall architecture, engineering, and construction (AEC) industry M&A activity for the year). This slowdown has spread beyond the MEP sector in 2012. Year-to-date 2012, the pace of deal-making among all AE firms is down 11% over 2011, with just 75 domestic deals completed by the beginning of June (Figure 1). This latter statistic mirrors the slower consolidation trend in the general economy. As of Jan. 20, 2012, some 220 deals had been announced in North America across all industries, compared with 396 at the same point in 2011, according to data from mergermarket—a decline of some 44%. And a recent PricewaterhouseCoopers study says the number of AEC industry deals was the lowest in 12 quarters, with deal values down more than 14%. 

It seems like over the past year and a half, the only constant in the news about the nation’s economic condition has been uncertainty. For every positive indicator that’s been announced, there has been a negative or concerning report that contradicts it. It appeared that unemployment was dropping and that we were out of the woods, but then the unemployment rate ticked upward. It seemed as if the Euro crisis had been dealt with, but then it roared back onto the front pages threatening to undermine the U.S. economic recovery. 

And even though the general national economic narrative has been one of slow economic recovery, there continues to be a deep sense of uncertainty and confusion that has put a damper on M&A activity in the MEP sector. 

How does this sense of uncertainty play out in less deal-making?  Our observations of and involvement in deals suggest that two primary reasons are in play as follows: 

  • First, buyers are still cautious about the overall economic outlook and are being ultra-rigorous in their due diligence. They are particularly vetting the quality of earnings and backlog as presented by potential sellers. If these items don’t pass muster, buyers are willing to punt on a deal, defer it, or present an overly conservative offer that gets turned down by the seller (see the next point). For example, we know of a firm on the East Coast that had strong profits through 2011, found a buyer at the end of the year, and was set to close the deal in early 2012. However, after its first quarter in 2011 went south quickly (the firm lost money every month), the buyer put the deal on ice. The erratic nature of business performance in 2012 is not conducive to deal-making—and there is a lot of volatility in earnings right now.
  • Second, since the beginning of 2012, sellers have been feeling more optimistic about their short-term outlook. They have been seeing more opportunities and hearing more good news from their clients and project owners. Their growing self-confidence is making them less likely to consider conservative offers from potential buyers (see the point above). We see this playing out across the country right now, and it perplexes many potential buyers. However, what we also are seeing is that this sense of confidence on the part of sellers is beginning to wane in the second quarter, based on weaker performance and worse or more confusing economic news. Some sellers are beginning to regret walking away from deals in 2011 and the first quarter of 2012. 

These mismatched expectations and outlooks on the part of potential buyers and sellers are directly derived from the general lack of clarity and uncertainty about the nature of the current economic recovery. Both camps recognize the recovery is occurring, but one—the buyers—is more skeptical than the other about its pace and associated risks. Hence the overall slowdown in deals.

The story behind the slowdown 

The M&A activity of the MEP Giants has tended to be a leading indicator of overall AEC M&A activity in recent years. And the slowdown seen among the Giants in 2011 is playing out in different ways in the larger AEC space in 2012. 

With the immediate economic picture so murky, M&A remains largely a defensive game rather than an offensive one—with just 57% of domestic deals occurring across state lines (Figure 2). Prior to the “Great Recession,” between two-thirds and three-quarters of deals occurred across state lines, reflecting the fact that acquisitions were being used as a growth strategy by acquirers. However, since 2008, interstate M&A activity has continued to bump along at a much lower percentage, between 55% and 57%, a reflection of a greater number of same-state firms defensively merging to protect their home territory.

In perhaps the most interesting trend in AEC firm mergers as a result of an uncertain domestic economic environment, a greater number of U.S. firms are making acquisitions overseas where they see more project opportunities. Through the beginning of June 2012, 10 U.S. design firms made international acquisitions (Figure 3). That’s double the number of deals involving an overseas buyer of a U.S. firm in 2011. It’s also a distinct departure from the pattern that we have seen in the past. 

From 2007 (and before) through 2010, the pattern of international cross-border AE firm M&A activity was pretty much the same every year, with a greater number of firms from overseas acquiring U.S. firms. Prior to the financial crisis (2007 through 2008) this pattern was supported by a relatively cheap dollar compared to other currencies, making U.S assets (including design firms) also relatively inexpensive for overseas buyers. Immediately after the financial crisis in the midst of the recession and early stages of economic recovery (2009 and 2010), overseas buyers took advantage of a U.S. market in flux to establish or increase their position in the buildings and infrastructure sectors through acquisitions of leading consulting engineering and EA firms.   

Underpinning the net inflow of acquisitions into the U.S. over this period was the view of many overseas buyers that the long-term trends and outlook for the U.S. infrastructure market continue to make it very attractive. They saw—beyond the recession—the significant unmet demand for infrastructure improvements and they anticipated (and still do) that within the next decade the U.S. will find a public-private funding “fix” to meet that demand. They want part of that action and have been using acquisitions to establish themselves in the market in anticipation of it occurring.

But 2011 saw a change in this pattern when the deal flow in and out of the U.S. reached equilibrium with 19 deals involving a U.S firm acquiring overseas matching the same number of deals involving a U.S firm sale to a firm headquartered outside of the U.S. 

And year-to-date 2012, there is a distinctly different pattern in play, with U.S. firms being dramatically more active in acquiring overseas. Some examples of 2012 Giants who have acquired outside of the U.S. this year include AECOM Technology Corp. (Los Angeles) acquiring 160-person environmental and engineering consultancy Capital Engineering Corp. (Taipei, Taiwan, Republic of China), SSOE Group (Toledo, Ohio) acquiring design and construction management firm NKS Design Technologies (Mumbai, India), URS Corp. (San Francisco) acquiring oil and gas industry construction services provider Flint Energy Services (Calgary, Alberta), and CDM Smith (Cambridge, Mass.) acquiring INGESAM (Cali, Colombia). 

Is this slowdown a break in the battle or something more long-term and permanent? Our work and research would suggest that the gap between buyers’ and sellers’ perspectives is beginning to narrow. And while we expect that this year’s total consolidation will be in line with last year’s, we fully expect 2013 to see a greater pace of activity. The challenges for smaller firms—hyper-competition, leadership and ownership transition, and the continued growth of alternative delivery projects—will result in many of them having no other choice but to sell to survive and thrive.

Morrissey is managing principal of Morrissey Goodale LLC, a management consulting and research firm based in Newton, Mass., with offices in Phoenix and Denver, that serves the AEC industry exclusively. An engineer by training, Morrissey has assisted numerous MEP firms in the areas of strategy development and implementation, leadership development and transition, technical and professional talent recruitment, ownership transition, and mergers and acquisitions. Watch the video from Morrissey Goodale.