Private equity challenges in the short- and long-term
Morrissey Goodale reports 36% of all A/E industry transactions this year have involved private equity and recapitalization of the industry by PE has been steadily crowding out capitalization by employee-owners.
36% of all A/E industry transactions this year have involved private equity (PE). That’s 120 out of 336 deals for those of you who like numbers instead of percentages. Over the past decade, recapitalization of the industry by PE (never to be confused with Professional Engineer) has been steadily crowding out capitalization by employee-owners. (1) “Why is this PE recapitalization happening to our industry now?” and (2) “Where does this all end?” Morrissey Goodale tries to answer both of them here.
There are three answers to the “Why”: First, it’s not just happening in the A/E industry (we’re not that special). PE’s influence in the U.S. has been growing rapidly over the last decade plus—and has become pervasive in almost every industry. Per McKinsey, PE’s net asset value has grown more than sevenfold since 2002, twice as fast as global public equities. And consider the growth in U.S. PE-backed companies, which numbered around 4,000 in 2006 and rose by 106% to about 8,000 in 2017. Meanwhile, U.S. publicly traded firms fell by 16% from 5,100 to 4,300.
And there’s no slowdown in sight: PE has played an important—some might say outsized—role in reshaping the U.S. economy after recent economic crises. Indeed, there was a dramatic rise in PE involvement in the economy after the Great Recession when bank lending became subject to tighter regulations. And the coronavirus pandemic has set the stage for even greater growth. Deloitte predicts that Assets Under Management (AUM) by PE could total $5.8 trillion (with a “T”) by 2025, up 28% from $4.5 trillion at the end of 2019.
Infrastructure writ large is attractive to PE: This is the second reason why the A/E industry is seeing such an influx of PE investment. Infrastructure is an attractive investment vehicle for private investors with the promise of stable, long-term cash flows. The Public-Private Partnership (PPP) infrastructure model has worked well outside of the United States, and there is clearly a need for private investment in U.S. infrastructure—the public sector cannot fund it all. PE firms are active in the water and transportation infrastructure sectors domestically, and private investors are looking for more opportunities to directly participate in U.S. infrastructure projects. Also, in this socially conscious day and age, infrastructure is a great way for private investors to boost their ESG scores.
But, like a relationship status on Facebook—it’s complicated: The PPP model for infrastructure has and continues to face challenges here in the U.S. Private-sector participation is still minimal compared to the needs and the potential market. And PE players are concerned that the Biden administration’s $1 trillion infrastructure proposal doesn’t do enough to make it attractive for them to jump in.
Which is why the A/E industry is so attractive to PE: We provide the ideal investment vehicle to participate indirectly in the infrastructure space. We are the perfect adjacent investment. Design and environmental firms provide PE investors with an “asset-light” way to exploit opportunities in the infrastructure sector.
Endemic industry performance and structural features: This is the third reason why the A/E industry is seeing so much PE investment. Most firms in the industry never reach their potentials in terms of ROI, ROE, and ROA. This is largely due to (a) sub-optimal business management practices on the part of the architects, engineers, and scientists who lead the firms and (b) a lack of accountability for performance. (We are an industry run by very smart professionals who for the most part are not business savvy and fail to hold those around them to task.) This tendency to underperform makes design and environmental firms very attractive investments for PE sponsors. These investors bring both business acumen and access to cheaper capital via debt to the acquired firm. Combined, these features dramatically improve ROI, ROE, and ROA.
And then, of course, bigger is better: The PE model is based on the simple fact that scale in a professional services firm translates to higher value. PE firms invest in a design or environmental firm at a certain size at a specific multiple of EBITDA, and then they exit their investment (typically after about five years) having grown the firm to a larger size (with improved bottom-line performance along the way) at a higher multiple. At our Texas M&A Symposium last month we showed how the median EBITDA multiple for A/E and environmental firms between $25 million and $100 million in gross revenue is 5.1x while that for firms over $500 million is 10.4x. Buy low, sell high—usually to another PE firm. Our highly fragmented industry of over 40,000 firms—all of which are facing leadership and ownership challenges—is ripe for consolidation by PE.
So, where does this all end? In the long term, for a variety of socio-economic and demographic reasons, we’re headed inevitably to an industry that is majority PE-owned and minority employee-owned. Already, 15% of the ENR Top 100 is PE-backed. While the economy is strong, the PE model works well—just like any other capital model. The question becomes what happens when we hit the next economic recession or crisis. How will this new cohort of debt-burdened A/E and environmental firms fare when the industry faces headwinds instead of the tailwinds we’ve had for the past decade?
Industry savior or destroyer? There’s plenty of data that show that in the larger economy, PE-backed firms were able to navigate the Great Recession more successfully than firms with other capital models. So, I’m less concerned about the resilience of this new capital model in our industry. Rather, I see the risk in the capabilities of the leadership teams guiding these firms through the next recession or economic crisis. The opening pitch by most PE investors when they meet an A/E firm management team is usually: “We don’t know how to run a design firm—you do. We just want to partner with you to help you achieve your vision.” Come the next crisis, the PE investors better hope that the management teams actually do know how to navigate successfully through the storm.