Executive Corner: Five Takeaways on 2018 A/E M&A Activity
With a backdrop of solid macroeconomic growth, strong financial performance and robust backlogs—yet facing the tightest labor markets in a generation—A/E owners and executives are understandably wrapping up 2018 in a cautiously optimistic mood. And while there are certainly market sectors and states facing more headwinds than others, the year can best be described as “a rising tide lifting all boats” for the industry. However, a mature economic and design/construction cycle now is exhibiting mixed signals on its future direction, and leaders are anxious on the impact of rising interest rates, higher material prices and lingering trade battles. These factors undoubtedly will test an industry still familiar with the painful depths of the last recession.
And yet there are hopeful reasons to be optimistic for A/E firms, at least in the short-run. Wide-sweeping tax reform passed at the end of 2017 is set to dramatically reduce marginal tax rates for A/E firms. For owners and companies, this has the potential to unlock vast amounts of capital to be steered toward future organic growth, capital expenditures, higher compensation, acquisitions and internal transitions.
In addition, the exciting convergence of design and technology, along with endless project demands for modernizing 21st century infrastructure and buildings, means a reshaping of our country’s physical landscape in dramatic ways. Finally, succession planning has been in full swing the last two years, and we’re witnessing a number of talented, fresh-faced CEOs and presidents taking the reins, many with bold new ideas on leadership and strategic growth.
Overall, the 2018 M&A market for A/E and environmental firms is the strongest we’ve seen this decade. By our tabulations, it will go down as a banner year, with the number of transactions projected up 25 percent over 2017. Numbers like these are consistent with mature macroeconomic and industry cycles we’re now witnessing. Despite continued unevenness in the energy/oil and gas sector, we’re seeing robust volumes across all other geographies, disciplines (architecture, engineering, environmental consulting) and client/market sectors.
Key A/E M&A takeaways for 2018 include the following:
1. It’s been a big year for small deals. Almost 75 percent of industry transactions this year involved a selling firm with less than 50 employees—the highest percentage this decade. In addition, after several years of notable mega-mergers, 2018 was relatively quiet, evidenced by the small number of ENR 500 firms that sold. Mid-size strategic buyers—those generally with $25-$250 million in revenue and often seeking niche targets—have been on the front lines of M&A activity all year, and we expect that to continue.
2. The Baby Boomers continue to check out. From conversations with A/E owners assessing their exit strategies, we’re seeing the second half of the Baby Boomer generation (those born in the late 1950s and early 1960s) indicating that now is the optimal time to sell and join forces with a larger parent. They’ve successfully navigated their companies back to sustained profitability and seen their personal fortunes stabilize with improvements in the housing and stock markets. They offer that while eager and talented, their younger staff members increasingly don’t have the means or desire to become owners, making internal transfers difficult. The valuation multiples are there, and many don’t want to make the mistakes of the prior cycle by missing out if/when a downturn materializes. In addition, many feel the relentless competitive and consolidation forces shaping the industry toward larger scale, deeper resources and a full-service mentality.
3. Private equity is quietly transforming the A/E industry. During the 2000s, we witnessed the global “invasion” of Canadian, Australian and European design and consulting firms. They steadily entered the United States through M&A and changed the competitive landscape with new names and an international mindset. Today, it’s the private equity and financial investors who are acquiring and recapitalizing our industry’s most venerable organizations. In fact, there are now more than 30 A/E and environmental firms partially owned by financial sponsors, and the list is growing. In 2018, we saw companies such as Kleinfelder, All4 and Montrose Environmental take on private equity; while others such as SLR Consulting, Apex Companies, CHA and CLEAResult swapped one investor group for another. These “platform” investments also have been responsible for the heightened levels of transaction activity, enthusiastically acquiring other niche firms for growth and scale. Traditional A/E strategic buyers now have to compete with these groups, who often bring higher valuations, enhanced liquidity and a story of aggressive upside growth potential.
4. Integration risks rise in a mature-cycle stage. Bringing together two disparate A/E firms with differences in project management, business development, design acumen, size and culture always is a fragile exercise. But it’s even more challenging when the economy is running at full capacity. Disgruntled staff members unhappy with a buyer’s new bonus plan, benefits, roles, communication or operating practices have no shortage of career options and competitor opportunities to pursue. Buyers, along with the seller’s ownership team, have to work extra hard to convey the benefits of a merger, reassure nervous employees, and tout “business as usual” to prevent disruptions and defections.
5. Talent shortages are here to stay and will further drive M&A. If there was a mantra that defined 2018 for A/E firms, it’s “We’re Hiring.” Conversations with CEOs, human resource directors and recruiters all share the vexing inability to find the quality and number of professionals to keep up with current project opportunities. Whether it’s biologists, interior designers, surveyors, carpenters, electrical engineers or bridge inspectors, the acute labor shortage has impacted all professions in every part of the country and is constraining the growth and health of our industry. Companies continue to compete for a finite talent pool alongside energy companies, developers, government agencies and tech firms, and a fundamental shift in A/E recruiting and retention tactics is required. As a result, the “buy vs. build” strategic growth assessment will continue to shift toward mass-talent aggregations and acquisitions