Who are these private equity extraterrestrials, what do they want, and how long will they be here?
Private equity interest and activity in the AEC industry has been ramping up exponentially in the past several years, and it’s caught everyone’s attention. However, I think its presence still feels a bit alien to many people living in the AEC world. Running with that theme, I think it’s appropriate for every one of the AEC world’s inhabitants to ask three questions: who are these private equity extraterrestrials; what do they want; and how long will they be here?
Who are they? In the simplest terms, private equity is a form of private financing that is separate from the public markets. Private equity firms pool large amounts of capital from what are called limited partners, with the intention of investing it into promising ventures and distributing a healthy return back to its limited partners at a later date. These pools of money are called private equity “funds.” The most common holding period in a private equity fund is 10 years, though this can vary depending on the firm. A private equity firm’s limited partners are often, but not exclusively, pension funds, wealthy families or individuals, and companies with a lot of cash on-hand. Some of the most common types and strategies of funds are as follows:
- Buyout funds. These take a controlling interest in an operating company or business, the platform company, and provide support (financial, strategic, or both) to the company’s management team to increase its value. The most common holding period for a platform company is five to seven years.
- Venture capital funds. These funds specialize in making minority investments in fast-growing companies or startups.
- Fund of funds. Some larger private equity firms will have funds that are dedicated to investing in other successful and well managed funds that need additional capital.
What do they want? The short and honest answer is a return, though I don’t think that this must come with the negative connotations that some in the AEC industry put around it. Some have a predisposition that a private equity firms’ intentions are to buy a controlling interest in firms, strip the operations and staff to its bare bones to maximize their bottom line, and then sell off their withered and beaten remains at the end of the holding period. This really isn’t true in a people-focused service industry such as AEC. Private equity firms that are looking to enter our industry are focused on buying companies, but they invest in management teams. Having said that, they do need the firm to maintain a healthy level of profitability so they can provide strong returns to their limited partners, otherwise the limited partners will choose to invest their money elsewhere when their investment period comes to an end. Private equity firms measure the success of their funds using metrics called a Multiple of Invested Capital and an Internal Rate of Return. The higher the firm’s MOIC and/or IRR, the less trouble they’ll have when requesting additional capital from new or existing limited partners to start their next fund. Circling back to the original point – in a service industry such as ours, private equity firms need the portfolio company’s staff to remain not only intact, but determined and happy as well. This is necessary so their quality of work may remain high, and they may continue to grow. Ultimately, private equity firms want to help their portfolio companies thrive and grow.
How long will they be here? Likely for a while, which may be a benefit to our industry and its stakeholders. Private equity firms are home to some of the savviest investing minds out there, and they are here for a reason. They see a massive potential for growth in the industry as the United States’ infrastructure has been deemed improvable, and our government has taken notice and recently passed the record-breaking infrastructure bill. On top of the opportunistic state of our industry, there are also moderately low barriers to entry in terms of price as firms in our industry trade for relatively low multiples compared to other industries’ firms. However, as discussed in my previous article, the increase in buyer demand in our space will likely cause the multiples to increase over time if the supply is unable to keep up. In the end, private equity interest in our space means that the outlook for our industry is strong, and multiples are likely to continue moving upward. The hope is that they stay for a while.
Hopefully this deepened your understanding of why and how our newfound private equity allies are showing us interest lately. If you have any questions about anything mentioned in the article, please reach out.
Andy Chavez, CM&AA is a senior analyst within Zweig Group’s advisory services group. Contact him at achavez@zweiggroup.com.
