Qualified Opinion: Trends Shaping Construction and Engineering M&A

Qualified Opinion: Trends Shaping Construction and Engineering M&A

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This article was written by Middle Market Growth magazine, the official publication of the Association for Corporate Growth, and includes a print magazine, website, weekly e-newsletter and daily newsfeed.

Stout Managing Director Jim Owen recently corresponded with Katie Mulligan, Editor-in-Chief of Middle Market Growth magazine, for a Q&A about trends impacting M&A involving construction and engineering businesses.

Katie Mulligan: What are the long-term trends driving investment in the construction and engineering sector?

Jim Owen: There are many trends affecting private equity (PE) investment in the sector, but three in particular have converged to ratchet up interest: aging infrastructure, the challenges of climate change and increasing regulation.

Much of the installed infrastructure in the U.S. is nearing the end of its useful life. Utilities, transportation and power generation in particular have saddled public and private owners with maintenance and upgrade costs that often exceed replacement costs. Not only are these aging assets more vulnerable to severe weather events, which have become more damaging and frequent, but their replacements must be more resilient to these threats. Resilient infrastructure requires specialized planning, engineering, construction and maintenance for new builds and existing or modified infrastructure. All of this is being governed by more stringent regulations and requirements for preventive maintenance, inspection and integrity services.

Mulligan: Where are the greatest opportunities for PE investors in this space?

Owen: The current market dynamics have not gone unnoticed. We’ve seen the creation of specialized groups to offer early planning and consulting services to owners of assets being retrofitted or built for long-term sustainability and resilience. Specialized inspection firms are incorporating new technology — from drones to robotics to remote-operated vehicles — to gain efficiencies and improve safety.

Every expanded service can create a recurring revenue stream via long-term contracts and master services agreements, and provide a rich data stream that must be captured, interpreted and stored.

PE firms are focused on businesses that can evolve, adapt and grow within this dynamic environment, placing particular emphasis on the people: from senior management to department heads, project management and technology departments.

Mulligan: Describe deal volume and valuations in the construction and engineering sector.

Owen: Although 2019 started slowly, volume has increased since March, led by factors including strong credit markets, strategic acquirers seeking growth and diversification, and private equity sellers taking advantage of high valuations.

The credit markets underpin valuation, and while initial leverage reads don’t always lead to over-leveraging at closing, they provide a lift in valuations for PE buyers. Non-bank debt, seller financing and other structuring remain widely available.

Margin pressure in many traditional construction segments, as well as labor shortages and a battle for talent, is driving acquisition demand among both domestic and international strategic buyers.

We are seeing valuations for attractive firms running one to two turns higher than historical averages, while valuations for very desirable assets, such as engineering, consulting, inspection and testing firms, are approaching double digits. Plus, the time from launching a sale process to closing has shrunk considerably. Not all sellers want to go through a broad sale process, so good firms can still be acquired at reasonable multiples.

Mulligan: How should construction businesses prepare for an economic downturn?

Owen: The construction sector tends to lag an economic slowdown due to the long-term nature of projects and the fact that most large owners have multi-year capital expenditure plans. Still, examining firms that fared better in the last downturn offers key insights.

The kiss of death for an engineering or construction firm is leverage. Interest expense squeezes cash flows and heavy leverage limits the flexibility to grow ahead of a slowdown and to survive (or flourish) during a downturn.

Diversification across end markets, geographies, customers and projects can soften the blow in any one area, since not all facets tend to slow at  the same time. The West Coast, Gulf region and Northeast, which are seeing demographic-driven spending growth, should fare better than average. Government spending can increase to spur job growth, and a balanced blend of recurring revenue from maintenance and inspection work can offset declines in new-build and capital expenditures.

Lastly, having a strong management team in place, along with solid systems and procedures, will drive success even if the overall economy slows. 

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