The Domino Effect
Four trends that will play out over the next five years and then converge in a domino effect to remake the A/E industry.
I just got back from speaking at the invitation-only Lockton International General Counsel Forum at The Yale Club of New York. It’s always a wonderful event that brings together the legal eagles from 55+ (which coincidentally is the age range box I check on surveys these days) of the industry’s largest firms.
This year the forum returned in person, and the general counsels relished the opportunity to get together. As Karen Erger, Senior Vice President and Director of Practice Management for Lockton, put it: “Our general counsels took full advantage of the forum’s opportunities to glean ideas, intel, and inspiration from each other and our speakers on how to lead their firms forward in our radically transforming industry.”
I had the privilege of sharing with them our perspective on four trends that will play out over the next five years and then converge in a domino effect to remake the industry. And it all starts with disruptive technologies…
Disruptive technologies: Around the industry, individual firms will continue to invest record amounts of treasure, time, and talent to harness the potential of AI, machine learning, digitization, and in-the-field robotics to improve enterprise-wide performance and profit. Most of these discrete firm initiatives will fail to reach market or realize only marginal impact if they do. (Pro tip: Before you invest yet another million dollars in the “digital triplet” idea from your next-generation leaders, get yourself a copy of The Innovator’s Dilemma.) However, over the next five years the sum total of these collective efforts—in concert with the introduction of external disruptive technologies by VC-backed groups and industry vendors—will forever alter the industry’s pricing, service, delivery, and operations models. The mainstream of these disruptive technologies will trigger a domino effect of change in the industry as we now know it.
Consolidation: The industry will see massive consolidation over the next five years. We’re forecasting that about 3,100 firms—or close to 10% of the industry—will be absorbed by the end of 2026. This forecast factors in both (a) rising interest rates (which will turn the heat down on 2022’s torrid year-to-date increase of 30% to somewhere closer to 20%) and (b) a recession in or around 2023. This five-year shakeout will be driven by a combination of industry fundamentals and stimulus from the Infrastructure Investment and Jobs Act. Domino effect? Consolidation will begin a steady decline after 2026 as firms choose to invest their capital in disruptive technologies that allow them to be more profitable, improve performance, and scale faster than acquisitions of non-tech-enabled AE and environmental services firms.
Recapitalization and revaluation: Private equity will continue to supplant employee ownership over the next five years. Ninety percent of the ENR Top 500 Design Firms that are choosing to sell or recapitalize are selecting a private-equity option when they do. By the end of 2026, better than one-third of the ENR Top 100 Design Firms will be backed by private equity. Of the 3,100 firms that will sell over the next five years, 1,100 of them will be to a private-equity investor or operating firm. As a result, M&A valuations will continue to increase over the next five years. Upper-quartile M&A multiples will hover in and around the mid-teens on trailing 12 months EBITDA. Median multiples will linger just shy of 10x. Lower-quartile multiples will remain flat south of 5x. Domino effect? Overall valuations will begin to decline after 2026 as strategic and portfolio acquirers focus more on disruptive technology investments rather than acquiring traditional AE and environmental consulting firms. Those AE firms that successfully integrate disruptive tech into their businesses will see their values hold if not increase. However, the bottom will fall out for the median and lower-quartile firms as buyer demand will disappear.
Labor’s half decade in the sun: Gone are the pre-pandemic days of annual raises of between 4% and 5%. In 2022, we’re expecting to see a step-function jump in labor costs of about 10% as firms compete for talent like never before. Even with a recession next year, it’s going to be a hyper-competitive market in our industry for talent over the next half decade, and we expect annual labor cost increases between 7% and 10%. Firms are going to continue to throw out long-standing compensation practices and pay scales in order to onboard and retain the talent needed to meet record demand for services. We expect that super-generous loyalty bonuses, immediate (knee-jerk?) counteroffers, more frequent base comp adjustments, more creative benefits, and infinite workplace flexibility (“tell me how and when you’d like to work”) will be the norm to keep talent in place. Signing bonuses—at all levels—will be standard to bring talent on board. (Remember the days of unpaid interns?) Labor cost increases will put tremendous pressures on the industry’s bottom line and will contribute to the demise of weaker players. From a compensation perspective, this will be an awesome five years to be a design or environmental firm employee. Domino effect? Once disruptive technologies are mainstreamed, the balance of power will shift back to investors and management. When they tell you “technology is not about replacing people,” they are telling the truth—if by the truth they mean “technology is all about replacing people.”
Morrissey Goodale is a CFE Media and Technology content partner.
Original content can be found at Morrissey Goodale.