Editor's Note: This is the second of three articles by PCE Investment Bankers, LLC. on the subject of liquidity. To read the previous article, click here. To read the next article in the series, click here.
In the first installment of this series on liquidity strategies, we explored the merits of "internal" approaches which typically consist of selling to family, senior managers or to the tax-advantaged Employee Stock Ownership Plan (ESOP).
Generally speaking, these internal approaches appeal to those who prioritize culture preservation, favorable tax treatment, independence and/or the perpetuation of family ownership.
While the values above may be accommodated in an external approach, the following goals play more prominently:
- Maximize cash at closing of the transaction
- Minimize personal exposure to bonding indemnification and/or bank debt and guarantees
- Reduce or eliminate work responsibilities and time in the office
External liquidity strategies generally include the sale of the business to one of following three categories of buyers:
- Strategic, often a competitor
- Financial, or private equity groups (PEG)
- Public markets, or an initial public offering (IPO)
Initial Public Offerings
Particularly since the passage of the Sarbanes-Oxley Act in 2002, the high and rising cost of being public can only be justified by the largest of companies with aggressive growth plans. What makes the publicly traded approach work is for professional investors (hedge, mutual, pension funds) to purchase blocks of stock. Such investors want to put significant amounts of money (millions of dollars) to work and yet not own a significant percentage of the stock (preferably less than 1 percent). This math suggests a minimum market capitalization of $500 million to $1.0 billion. The cyclical nature of the construction industry also tilts against being public, leaving only the largest and most diversified contractors to be good candidates for initial public offerings.
Strategic buyers are the most likely to pay a premium for construction companies given the synergies that the combination of the companies generates. Whether public or private, the strategic buyer may be a direct competitor currently operating in the same line of business or a company working in a related or adjacent business.
Strategic buyers often choose acquisitions as their preferred method of growth rather than risking the investment and the time delay inherent in organic strategies. Public companies are rewarded for growth and have continual pressure from investors to produce it. If a public company can make an acquisition at a lower multiple than its stock currently trades, it is immediately rewarded with stock price appreciation.
Public companies can make acquisitions using their stock as currency or pay with cash. Several factors go into the decision to use stock or cash:
- The current stock value
- The size of the transaction
- Availability of cash or ability to borrow money
- Valuation of the target company
Today, many public construction companies are holding historically high amounts of cash on their balance sheets and are likely to pay more cash than stock when making acquisitions. In underperforming markets, large public companies aggressively seek to gain market share. The investment thesis for these companies is that they will be able to expand geographically, or enter into new industry niches, while valuations are lower and can emerge as dominant competitors when the market recovers.
Several public companies were active acquirers in 2008 and into the first quarter of 2009.
While transactions in the public market get the most attention, the majority of transactions are executed by privately held companies in the middle market and out of the public eye. In today's environment, many companies are seeking a stronger partner as they try to weather a slowing commercial construction market. Conversely, companies that have enjoyed success over the past few years and have retained
earnings inside the company are trying to expand market share, similar to the strategies of the publicly traded companies. A typical acquisition by a private company is completed mostly with cash going to the selling shareholder. However, it is common for the selling shareholder to receive an ownership interest in the acquiring company and to continue to be responsible for directing their geographic region or industry niche post transaction. This is especially true when the selling shareholder desires to continue to work post transaction.
The current market is an opportune time to for stronger contractors to take over weaker competitors or for two similarly sized companies to take advantage of operating efficiencies and to combine and make one, stronger company.
PEGs, or financial buyers, have raised money for the specific purpose of buying operating companies. Over the past several years, they have played an increasingly important role in mergers and acquisitions, raising more than $250 billion in each of the past three years. For every dollar PEGs raise, they add an additional $3 in debt, increasing their purchasing power into the trillions of dollars.
The managers of the PEGs are financially savvy but operationally challenged. They look to buy industry expertise in the management team of the first company they purchase in a specific sector. This company becomes their "platform" investment, meaning they can build upon its business practices, industry knowledge and relationships.
The financial buyer now becomes a quasi-strategic buyer with a growth strategy of pumping additional capital into the platform and buying other companies ("add on") in related fields or adjacent geographies. A great example of this is Long Point Capital's acquisition of Cumming Construction Management, Inc., in December of 2006. Long Point had an interest in the sector and used this "platform" to make two add-on acquisitions in 2008; Construction Controls Group in February and Southern Management Group in August.
There are several advantages in selling to the financial buyer:
- They don't want to run the business and will not tinker with operations so long as its performing
- They offer a significant "sweat equity" stake (typically 10 percent) in the company to senior management
- Bank debt is not guaranteed and bonding is not personally indemnified
There are, however, also several challenges:
- Financial buyers are challenged to pay the premium prices some strategic buyers may be willing to offer, particularly in today's credit challenged markets.
- If bonding requirements are significant, the financial buyer will need to establish a cash reserve or line of credit in the company to overcome the absence of personal guarantees and indemnity.
- Bonding capacity along with the cyclicality of the industry has kept private equity from being as prominent a player in the construction sector, in spite of what their purchasing power would suggest.
The construction industry has experienced an influx of foreign buyers over the past several years. Many of the world's largest construction companies (i.e., Balfour Beatty, Bovis Lend Lease and Skanska) are based overseas. With the Bush administration's weak dollar policy, foreign exchange rated facilitated international mergers and acquisitions (M&A) activity and allowed foreign buyers to use strong foreign currency to acquire domestic construction companies. The best example of this may be Balfour Beatty's acquisition of Centex Construction's commercial group in March of 2007. The purchase price was more than $400 million dollars, but significantly less expensive for Balfour Beatty when considering the exchange rates at the time. This combined with the fact that the U.S. market was booming made it a very attractive place for foreign operators to make acquisitions.
Several of the prominent foreign operators have purchased their American platform and now have domestic operating companies. With the dollar gaining some strength, it can be expensive for these companies to return these U.S. earnings to their foreign owners. Therefore we expect foreign buyers to remain a force in the market as they use money earned domestically to expand their presence in the United States.
While we expect 2009 and 2010 to be a challenging market for the construction industry, we anticipate an active M&A environment. Many companies will take advantage of the slower market to consolidate market share, expand geographically or to enter into new lines of business. The current market conditions allow the acquiring company to purchase businesses at attractive valuations and to seize market share.
1 - Market data a sampling of public construction and engineering companies. Composite made up of URS Corp. (NYSE:URS), AECOM Technology Corporation (NYSE:ACM), Shaw Group, Inc. (NYSE:SGR), Granite Construction, Inc. (NYSE:GVA), Tetra Tech, Inc. (NasdaqGS:TTEK), Perini Corp. (NYSE:PCR), Michael Baker Corp. (AMEX:BKR), Sterling Construction Co., Inc. (NasqaqGS:STRL) and Hill International, Inc. (NYSE:HIL).
Construction Business Owner, March 2009