Addressing questions about the impact of COVID-19 through the lens of the Great Recession.
The financial advisory team at Zweig Group has been gently pelted with questions from across the AEC industry over the last months regarding how the COVID-19 crisis compares and contrasts to the Great Recession.
Even during the previous heights of AEC profitability and demand for services leading up to the last recession, the lowest-ranked reason for acquiring a firm – consistently – was adding staff. During those simpler times, we didn’t suffer the chronic shortage of talent in the AEC industry like we are facing today, or, at least, it wasn’t a primary driver for inorganic growth. In fact, the talent shortage didn’t start to become reflected in our data until 2016 as a driver of acquisitions.
Fast forward, and the equation has completely shifted. The demographics entering COVID-19 will not have changed at its conclusion: 80 percent of AEC firm ownership is held by individuals age 50 or older, and the average age of a land surveyor is 60. There are several statistics about fewer graduates exiting A/E college programs that point to a continued limit of supply of talent over at least the medium term based on evolving visa limitations, curriculum challenges, and other topics best addressed at the higher education level. Without drawing a conclusion, suffice it to say that there is reason to be concerned that we may see another gap in our businesses at the entry level. While understandable that entry-level talent today isn’t a top concern, leaders are making decisions that will inevitably result in perpetuating the very same hole that – just a mere two months ago – certain CEOs I know by name swore never, ever to repeat: and in 10 years, please don’t be surprised that deciding not to hire out of the Class of 2020 causes a missing gap of 10-year experienced project managers. There ought to be other conversations around the scarcity of staff related to career development and training, as well as technology investments, but those are for another article. Once we see an increase in demand for services or at least a semblance of stability, the question that will be in front of us is how much talent will remain in our firms, and where does that place staff in the ranking of reasons to purchase a company?
This gap at the middle tier of companies across the nation will likely influence ownership transition options in the next 10 years, or potentially – here’s my optimism – we may finally see AEC firms warming up to the concept of transitioning small percentages of ownership to people in their 40s. It seems – to me – that if you are deemed old enough to run for president of the United States, you might just have what it takes to buy 2 percent of your 30-person engineering firm.
Another contrast between the M&A world of late 2019 and the recession is the negotiation parameters around purchase price. Using 10 years of median data from 2005 to 2015, the average purchase price that firms expected to receive for their firm was exactly 70 percent of net service revenue; compared to an actual price paid average of 53 percent over the same 10-year period. Revenue has fallen so far to the wayside in negotiations over the last 12 months that I almost pine for a conversation about free cash flow, working capital, and – how could I forget – liquidity ratios (the “three sisters” of underwriting). In 2005, our Valuation Survey provided a median value of 4.49x EBITDA when the valuation was conducted for the express purpose of a potential or actual sale or merger; the upper quartile was 5.70x. In 2011, the median was 4.24x and the upper quartile was 5.2x. The record backlog and confidence in outlook meant that we were hearing ranges as high as 7.5x for middle market AEC transactions until very recently.
I think that the focus on EBITDA may give way somewhat to a return to top-line revenue based net service revenue as a “governor” of the purchase price and we could see a return down to a limit of approximately 100 percent of net service revenue, which would align with our data trends and historic market highs and lows.
The stability of future revenue and ability to draw upon the existing client base will become an opportunity as profit decreases and as backlog is seen as more erratic, meaning the opportunity is for a buyer to “out manage” the sell-side owners by adding processes and efficiencies. Last year, we saw plenty of firms with 30 percent profit margins on the market – a business model based on acquiring firms achieving additional symbioses with that kind of profit margin wasn’t logical, so the goal of acquirers was to preserve the highly profitable operations by supporting revenue growth. The conversation has started to shift again, and I think during this interim period, at least, before the bounce-back that many folks much smarter than I am predict, we might hear net service revenue boundary conditions dusted off and put back into offers in the near term.
This article does not purport to due justice to the myriad ways COVID-19 has changed the way we negotiate. The disruption extends from the courting process to the cost of capital to integration planning to kids shrieking in the background during an intense negotiation session. It’s a reality both surreal and fundamentally human. This is an odd time to take on the risk of the market by buying or selling – tell me what you’re seeing!
Jamie Claire Kiser is managing principal and director of advisory services at Zweig Group. Contact her at jkiser@zweiggroup.com.
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