April 9, 2024 • 29 mins
Private equity investment across the engineering and construction industry has vastly increased in recent years. In this episode, Consulting President Scott Winstead talks to Paul Giovannoni and Jayson Post about how private equity is reshaping the built environment and how FMI is working with investors.
Giovannoni's consulting practice mainly focuses on buy-side market studies and due diligence, while Post's work in investment banking helps private equity investors buy and sell assets. Learn more about the trends shaping the landscape for private equity and how FMI can help private equity firms make informed decisions and understand market nuances.
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
(00:00):
Welcome and thank you for listening to our latest episode on the growing influence of
(00:06):
private equity on the built environment.
I'm Scott Winstead, FMI Consulting President.
Once thought taboo, the construction industry and broader built environment has become an
attractive asset class for financial buyers and in particular private equity firms.
In this episode I have the privilege of sitting down with Paul Giovannoni and Jason Post, both
of whom play key leadership roles with an FMI and I work with private equity firms.
(00:30):
Paul Giovannoni is an FMI partner and the leader of our private equity consulting team,
which is purpose built to support private equity.
And Jason Post leads sponsor coverage at FMI, where he draws on nearly a decade of M&A and
capital markets advisory experience.
Among other things, we'll talk about the trends underpinning this activity, where we think
things are headed, and what private equity firms and potential sellers should consider
(00:52):
as part of their overall strategy.
Paul, Jason, welcome to the show and thank you for being here.
I'd love to start off with just a brief overview of your respective roles for context, just
so our audience has a sense of how you both engage with private equity and with broader
financial buyers.
Paul, why don't you get us started?
Sure.
So I'm a partner on the consulting side of our business and I lead a team of consultants
(01:13):
who primarily focus on buy side market studies and commercial diligence to support private
equity when they're investing in a specific asset.
Our team also does sell side market studies to support the sale, whether a privately held
asset or another private equity held asset, but primarily around market research type
(01:33):
activities.
We also do value creation work.
And for that, I'll be a liaison and bringing our other subject matter experts throughout
the consulting organization.
Great.
Thanks, Paul.
Jason, what about you?
As you mentioned, Scott, I lead our investment bank's financial sponsor coverage, which is
a big priority for the firm, given the massive increase in institutional capital we've seen
(01:54):
deployed into the built environment over the last several years.
So I spend all of my time focused exclusively on the private equity community.
My job is to manage and organize the firm's efforts around private equity as both buyers
and sellers of relevant assets.
What this looks like on a daily basis is somewhat twofold.
(02:16):
It's spending time externally with sponsors to learn about their investment strategy,
where their interest lies, and how we can be helpful in the portfolio.
Then it's also spending time internally with our bankers here to organize and craft our
strategy and direction as it relates to the sponsor community.
I'd love to kind of shift now and talk about just overall M&A activity.
(02:40):
And Jason, we'd love to start with you.
How would you characterize M&A activity overall this year?
Yeah, so this is a really interesting question, Scott.
And I think one that has a bit of a layered answer.
Overall, I'd say we're still seeing a slower deal environment due to many of the headlines
we've been reading about over the last year or so.
Things like higher interest rates, buyer slash seller, valuation gaps, uncertainty around
(03:03):
the direction of the economy.
And as it pertains to private equity specifically, these factors have certainly had a massive
impact.
They're putting strain on new investment cases, they're limiting available leverage,
they're delaying exits, and ultimately have made dealmaking and fundraising really difficult.
If you look at 2023, a deal volume was down about 60% and new fund closings down over
(03:27):
50%.
And so as we look to 24, I think these dynamics are improving, which has been evidenced by
a return of mega deals in Q1.
But I don't think it's quite been the onslaught that most expected.
That said, with rates stabilizing, a record of 1.2 trillion of dry powder, all of the
(03:49):
fundamentals point towards a return in activity.
And based on conversations I've had over the last several weeks, I think people are starting
to see more flow.
Now these are the general headlines, but I also want to take a minute to drill down a
bit further into what we're seeing at the lower end of the middle market and the built
environment specifically.
(04:09):
Because I think you start to see a somewhat different narrative here characterized by
more resilient demand.
I think all the factors impacting the broader markets still remain at play here and activity
is certainly down.
But there are fundamental differences around many of the assets we work with, things like
macro tailwinds, significant value creation opportunity, lower reliance on financial
(04:32):
engineering that have all supported both overall appetite and available dry powder in our end
of the market.
Sponsors are remaining prudent and selective, so deals are still harder to get done.
But it feels like the biggest limiting factor in our market has been supply of assets for
sale.
(04:52):
But seller sentiment has certainly improved, especially with founder and family owners.
And the PE exit pipeline, it will thaw eventually.
So I think we'll continue to see activity pick up.
That's great.
Thanks, Jason.
I appreciate that.
And you touched on a little bit about what you're seeing around sponsor coverage and
sponsor appetite in particular.
Paul, I'm curious how you would answer that same question just with respect to what you're
(05:15):
seeing.
I would echo what Jason said towards the end, really focused on the built environment.
We at this year have seen more activity in Q1 than we've ever seen.
And it's likely a combination of those macro trends that Jason mentioned, but also the
surge in interest in the built environment and the types of businesses within it.
(05:39):
I think the other thing where I've seen more significant amount of activity is related
to proprietary deals.
I would roughly estimate 80% of the work we've done this year have been proprietary deals
versus those out on the market.
And so it seems like private equity is becoming far more proactive versus reactive in chasing
(06:01):
assets in the market.
So far this year, it's been fantastic for the work we do.
We've done roughly twice the amount of work this year so far as we did last year.
Kind of building on that answer.
Maybe Jason would start with you on this one as well.
So how would you describe the evolution of PE activity and the engineering construction
sector today versus even just five years ago?
(06:23):
We're definitely seeing more and more institutional dollars flowing into the ENC space and the
built environment more broadly.
I don't have specific numbers around investment dollars deployed today versus five years ago,
but I do know that despite the PE slowdown we saw in 2023, PE M&A made up around 50%
(06:43):
of total dealmaking within ENC, which is a record year and up from approximately 20%,
five years ago.
And look, I recognize that 2023 is a bit of a difficult comp just given how slow M&A
activity was.
But I think it's nonetheless a testament to how much more private equity interests we're
(07:04):
seeing in these sectors that were traditionally less of a focus for private institutional
capital.
I think we'll continue to see this trend evolve as investors seek to take advantage of the
value opportunity in these sectors.
But I think there's also something to be said for PE looking for sectors that historically
haven't been a focus, right?
(07:25):
Sectors where you still see relative value opportunities and significant meat on the
bone in terms of value creation.
Many areas of the built environment certainly fit that bill.
So just Paul, to build on that, you mentioned earlier the macro trend tailwinds that we're
seeing, I'm curious why at this stage the built environment is growing and attractive for PE.
(07:48):
So there's certainly a lot of macro trends driving PE interest in our space.
The first really being around the industrial revolution, there's certainly some money
flowing from the federal government when you think about all the semiconductor and battery
plants.
But it extends beyond that, general automotive, steel manufacturing, when we move to food
(08:10):
and beverage.
The whole industrial sector right now is extremely active.
And I'd even group into that data centers.
That has been a market where we've spent a lot of activity and time focusing in on the
drivers and the different niches within that market, the various stakeholders that play
(08:31):
in it.
We've also seen the install base of buildings dramatically increase over the last decade,
which of course increases the volume of activity that's needed related to maintenance and repair,
which of course is an attractive area for private equity.
We're also seeing a change in owner buying practices.
(08:52):
Now, when we think about maintenance and repair services, owners have learned their lessons
when it comes to deferring maintenance.
They're no longer willing to do that, even an economic downturn.
So we're seeing that driving more interest in the service and maintenance-based businesses.
Another focus area that's driven a significant amount of activity is around electrification.
(09:17):
And that extends to the service providers who are doing the actual work, both within
buildings and to the electric infrastructure.
But it also extends to manufacturers in the entire supply chain, from distributors to
transformer and switch gear manufacturers.
The industry is looking for a way to diversify from the large OEMs to a more stable supply
(09:41):
base.
And so we're seeing a tremendous volume of PE activity chasing the trends around electrification.
There's a whole host of others.
You can think of the infrastructure bills, things like that.
But there are certainly a lot of tailwinds in this industry, which help with that stereotype
of this industry being cyclical.
(10:01):
Yeah, I mean, you kind of touched on it.
But if you think about private equity and financial buyers invest in themes, right, and
the ones you mentioned, you've got infrastructure, you've got coastal erosion, you've got the
energy transition and decarbonization.
And the folks that are participants in the value chain of construction stand to solve
a lot of those issues or address a lot of those issues.
(10:22):
And so therefore making an attractive asset class.
And they are in what I'm seeing more and more of is a look towards the other stakeholders
in the supply chain.
So instead of just looking for the HVAC contractor, which is the tried and true P play.
(10:45):
Now they're looking for the specialized manufacturers or the sales rep agencies or distributors.
They're looking more broadly than just the service and maintenance side of that industry.
So you're exactly right.
They're following the themes and they're following the flow of the cash from those themes throughout
(11:06):
all the stakeholders.
And they're really finding the really nuanced participants servicing and benefiting from
those trends.
Jason, what would you add to that in terms of just some of the newer trends that we're
seeing beyond the HVAC roofing, building products, some of the traditional plays that
we've seen in the past?
A few areas that I've been hearing a lot more about recently are perimeter security and
(11:31):
access controls, i.e. fencing, gates, doors and any technology around that.
I always find it interesting kind of the fun names that private equity comes up with for
fairly simple businesses.
But another one is around kind of water infrastructure and wastewater treatment.
Everyone that I've spoken to seems to be looking for an asset in that space.
(11:57):
And then to Paul's point kind of things around infrastructure services, around the electrification
of the economy, et cetera.
And one other thing to kind of add to Paul's point around kind of the growing attractiveness
of the built environment to PE, I think some of it also rooted beyond some of the macro
tailwinds that we spoke about.
(12:18):
Some of it is also rooted in kind of the maturation of the private equity playbook and private
equities interest in kind of finding new sectors to deploy that playbook.
Sectors that still present some of the opportunities that maybe some of the more traditional focus
sectors of private equity historically have presented and ones where that opportunity
(12:44):
is still available.
Paul, how would you respond to the industry stereotype that construction is a cyclical
industry?
Well, there's certainly some cyclicality.
It's there is.
And it all depends on where you play and how you operate, whether you're exposed to it
(13:04):
or not.
If I think about the most extreme version of the cyclicality in our industry and look
at single family residential, new construction, it's very cyclical.
The spending can fall off a cliff at a drop of a dime.
It could happen very quickly.
And we saw that in 2020.
You saw new construction home starts stopped immediately.
(13:27):
They only take 40 to 50 days to build.
You can stop building them really quickly.
Horses, if we look at other parts of the industry, if we've go to the other extreme and think
about roofing, you know, call it 75 to 80 percent of the roofing industry is re-roof
and service and maintenance, which are non-deferable.
Your roof starts leaking at a data center.
(13:48):
You have to fix it or in a school.
And so there's extremes on both sides, but within the middle, the cyclicality is limited.
And if you focus on the areas that are non-cyclical, that have solid funding sources, which have
a long duration of project activity.
(14:10):
If you think about the institutional segments of healthcare and education or even any kind
of government spending, those are fairly stable, whether we're in a poor economic condition
or not.
We're seeing that right now with multi-families starting to pull back, but education and healthcare
are still growing.
And if we take that just down from the segment level to the service types, we move from new
(14:34):
construction, which can be cyclical, to repair and retrofit and even better to service and
maintenance, that cyclicality completely drops off.
So there is that stereotype and there is truth to it, like there is with most stereotypes,
but there are so many pockets of non-cyclical activity in this space.
(14:55):
It draws in those private equity buyers who are concerned about it.
And it creates opportunity for those that want to buy in a slower period and bet on the
upside, which we're starting to see a little bit of that right now as well.
Yeah, it's interesting as you talk about it.
I think it pays to scratch a couple of layers beneath the surface.
You think about it.
The office, traditional office market, has historically been somewhat cyclical, but if
(15:19):
you break it down into its sub-component parts, data centers right now are technically
classified as an office property.
Now, data centers, it's an arms race right now in spending.
I mean, it's just go, go, go.
Don't see much of an end in sight, but the broader commercial office sector isn't faring
so well right now.
(15:39):
Well, that is certainly accurate.
And even more interesting point we're thinking about office.
So office, new construction office, think buildings, towers, it's been decimated.
Right now you're not seeing a lot of new construction.
But if you focus on the sub-segment of office TI, tenant improvement work, that is actually
(16:02):
an area of growth.
And what we have found through recessions is that office TI is very counter cyclical
because as tenants vacate properties, the landlords and building owners are looking
to spruce them up in either providing incentives through leases or sprucing them off themselves
(16:22):
and spending money on that tenant improvement.
So as the market softens, tenants move from office building to office building.
And with that comes tenant improvement dollars.
I think office construction in New York or new construction is down 10 to 15%, maybe
even more than that, where tenant improvement in class A in trophy space is up almost double
(16:45):
digits right now.
So it's a tale of two different worlds, but it's all office.
Yeah.
We both heard Jay Bowman in our shop use the phrase, bulls and bears coexist at all times.
And I think that's a good example of it, right?
I think it's also important to note that many founders of these businesses have actually
built them in a way that the business is inherently more cyclical.
(17:06):
As a founder, the big projects that are largely associated with cyclicality are typically higher
margin, potentially easier to plan for, easier to manage labor around, then kind of the consistent
small ticket maintenance and repair work.
And it's not that that work isn't there.
It's that some previous owners haven't prioritized it as much.
(17:28):
So this actually presents a really big opportunity for many private equity buyers because if
you shift that mix to more repair and maintenance, you not only reduce the overall cyclicality
of the business, but you also likely drive some multiple expansion as well.
Building on that answer with respect to cyclicality, I'd love your take, Paul, on how private
(17:50):
equity should think about fragmentation in the industry.
How fragmented the industry is, and then also how abundant private ownership is and the
lack of institutional capital.
So it provides an opportunity for lower middle market private equity firms to be that first
(18:11):
money in.
And there's a significant amount of upside opportunity to really create change within
these businesses and create value.
I think their private equity is finding that combination of that fragmentation and the
high volume of private ownership creates a significant amount of opportunity that just
(18:33):
doesn't exist in other markets.
And I think the other thing that we haven't touched on is just the significant amount
that construction activity as a whole, and I'm including new construction, I'm including
repair and retrofit and service and maintenance makes up of overall GDP and what a significant
(18:56):
driver construction is of the economy and the volume of dollars being spent.
When you loop together that combination of the volume of money spent in this industry
combined with its fragmentation as well as the private ownership of most of the businesses,
I think it's somewhere north of 90% of the businesses are privately owned, it creates
(19:21):
a very attractive market to start pursuing for acquisitions.
Maybe to build off of that, Paul, would love your perspective on some other things that
we see that are sort of inherent to the industry and what makes it unique relative to ownership
of some of these firms.
(19:42):
What is it about the construction industry and the broader built environment that's unique
from a private equity perspective?
Well, I think what is unique about this industry is just how fundamental it is to the economic
well-being and growth of this country.
I'm just looking at a brief statistic, but if we think about the growth in GDP last year,
(20:08):
construction was about 15% of that growth.
All construction makes up about 8% of GDP a year in and of itself.
But when you think about all the other facets of our economy and our daily lives, construction
is at the heart of all of that.
And I think when you take that and how critical it is to the world we live in, and then you
(20:34):
layer on top of that the high level of fragmentation, which brings about significant opportunity
for roll-up, as well as the high volume 90 plus percent of these businesses in this industry
being privately held and the opportunity to be that first capital in, it makes for a wonderful
(20:56):
combination to add value and to really sophisticate and professionalize these organizations.
And if you think about roofing, right, roofing has been in the private equity playbook for
at least a decade, if not two, if you go all the way back to Tecta early 2000s, there are
(21:18):
still thousands upon thousands, if not hundreds of thousands of roofing firms that are still
privately held across the US that private equity is starting to invest in.
And so the opportunities abound for investments and value creation in this industry.
(21:41):
There's so much meat on the bone in terms of value creation with these businesses.
And I think that private equity has kind of not necessarily woken up to it as much as
it is, sees that the days of kind of just sitting on an investment, growing top line
a bit, and then the multiple kind of expanding on its own, just given the massive growth
(22:03):
in demand from PE, those days are kind of over.
Now the investments that sponsors are making are going to really focus around these value
creation levers.
I mean, if you look at what has been driving the returns for private equity over the last
10 years, over 50% of that is related to multiple expansion.
(22:24):
And there are certainly pockets within the built environment where, you know, that multiple
expansion opportunity is still there.
But the shift has really got to be to focusing more on value creation.
Historically, the top line has been driven the other 50%, but margin improvement has
been around 1% of the value creation.
(22:45):
And that definitely varies when you know, depending on which end of the market you're
looking at and which GPs, but as a whole, private equity is starting to turn its head
towards, we really need to find opportunities where we can truly create value.
And maybe that is through things like inorganic M&A, but I think it's still a lot of, to
(23:06):
Paul's points around kind of professionalization and really rolling up your sleeves and actually
driving improvement in the business itself.
So, Paul, what would you add to that?
When you look at any of the articles written about the current state of private equity,
that's one of the key themes you've seen over the last six to 12 months is that private
(23:31):
equity to create the value that's possible has to go back to old school private equity
ways.
Truly rolling up your sleeves, like Jason said, and doing core business fundamental improvements
to drive that value.
It's no longer a mathematical equation and moving numbers around and financial jiu-jitsu
(23:58):
to create that value.
It really is about improving these businesses.
And going back to my comments around just how private this is, it's founder owned.
A lot of these founders have made the decision, do I invest in the company or do I buy a new
boat?
And now with private equity, you have the ability in the capital to make these improvements
(24:22):
and really drive these businesses upward.
And there's a significant volume of that opportunity in this industry, which I think
is wonderful.
And I think it creates that opportunity for private equity.
And I think they're starting to see it.
What are some examples, Paul, what you're seeing and some of the work that your team
does with clients, rolling up your sleeves and really building tangible value?
(24:43):
Well, there's the obvious of bringing in a full suite of professional managers, truly
professionalizing functions like HR and business development, putting in all of the tools necessary
to really drive the operations side of the business.
(25:05):
But then it's also figuring out ways to improve the lives of the employees, which of course
is going to drive significant value.
This is a people business.
And so you see a tremendous investment in the people.
And I'm not talking about managers, I'm talking about field labor, superintendents, project
(25:25):
managers, improvement of their benefits, of their skills, of their compensation.
And then there's a diversification.
It's about finding areas that have higher margins, less cyclicality, improving the overall
dynamics of the world that the business works in.
Creating that diversity that just makes an overall better business, both for the owners,
(25:49):
as well as the people that work there.
Well, from a founder perspective, we will often see how a lot of the decisions, if not all
the really important ones flow through the singular individual and the founder.
And to really scale and to grow and to build, you've got to build a leadership team that's
capable of stepping in and making some of those decisions.
And if the founder is still calling all the shots, that's a problem.
(26:12):
We talked about stereotypes and the stereotype of the cyclicality of our industry.
I think the one stereotype that also lingers is the stereotype of private equity in the
construction industry and a mismatch of cultures.
And it's a stereotype that goes the other way, where the owners of businesses within
(26:36):
the built environment see private equity as a dirty word.
And I can speak from firsthand experience that the majority of the private equity firms
that I work with really have blue collar roots.
They care about improving these businesses.
They care about the making an even better environment for the workers.
(26:58):
They care about continuing the legacy of the founder.
And so I think there's a stereotype to overcome with just what it means to bring private equity
into this space.
Again, I can speak firsthand that I have worked with amazing private equity firms that really
want to roll out their sleeves and understand this industry and improve it.
(27:19):
And that's exciting that it's going to improve the lives of the members of this industry.
Historically, private equity has been thought of as kind of this Wall Street business model.
That definitely still exists.
I mean, if you look at the top managers, I mean, those firms still have major Wall Street
roots, but private equity has grown so much in the last 10 years.
(27:40):
There's this whole end of the market.
And I think specifically, when you look at the lower middle market, a lot of the firms
active in that area, as Paul mentioned, have blue collar roots and really don't necessarily
have that same buttoned up Wall Street feel that a lot of the top managers do.
And I think that also is a point of we've been hearing a lot about how the inflow into
(28:03):
private equity funds from investors is kind of concentrating at the top managers.
That's going to continue.
But I do think there's something to be said about lower middle market firms always kind
of having a leg up in terms of being buyers of the assets in the lower middle market versus
a mega fund that launches a lower middle market strategy to Paul's point around the
(28:27):
fact that those smaller funds are likely going to have that kind of more blue collar roots.
It's going to be a more material investment for them versus a lower middle market fund
within this massive 100, 200, $300 billion overall platform.
Jason, it reminds me of a conversation we had with the private equity firm where the
(28:50):
founder had left a larger firm, larger private equity firm, because he wanted to work with
smaller businesses and he wanted to be able to roll up his sleeves and work right next
to those owners and be a true partner.
That's what excited him.
And that's what I think is fantastic.
When we think about the lower middle market, we think about our industry.
(29:11):
Most private equity funds in that space want to be just that a partner.
They don't want to take over.
They want to improve and they want to build a legacy on the improvements that they contributed
to those firms, which aligns really well culturally.
In my experience, works very well.
Welcome and thank you for listening to our latest episode on the growing influence of
(00:06):
private equity on the built environment.
I'm Scott Winstead, FMI Consulting President.
Once thought taboo, the construction industry and broader built environment has become an
attractive asset class for financial buyers and in particular private equity firms.
In this episode I have the privilege of sitting down with Paul Giovannoni and Jason Post, both
of whom play key leadership roles with an FMI and I work with private equity firms.
(00:30):
Paul Giovannoni is an FMI partner and the leader of our private equity consulting team,
which is purpose built to support private equity.
And Jason Post leads sponsor coverage at FMI, where he draws on nearly a decade of M&A and
capital markets advisory experience.
Among other things, we'll talk about the trends underpinning this activity, where we think
things are headed, and what private equity firms and potential sellers should consider
(00:52):
as part of their overall strategy.
Paul, Jason, welcome to the show and thank you for being here.
I'd love to start off with just a brief overview of your respective roles for context, just
so our audience has a sense of how you both engage with private equity and with broader
financial buyers.
Paul, why don't you get us started?
Sure.
So I'm a partner on the consulting side of our business and I lead a team of consultants
(01:13):
who primarily focus on buy side market studies and commercial diligence to support private
equity when they're investing in a specific asset.
Our team also does sell side market studies to support the sale, whether a privately held
asset or another private equity held asset, but primarily around market research type
(01:33):
activities.
We also do value creation work.
And for that, I'll be a liaison and bringing our other subject matter experts throughout
the consulting organization.
Great.
Thanks, Paul.
Jason, what about you?
As you mentioned, Scott, I lead our investment bank's financial sponsor coverage, which is
a big priority for the firm, given the massive increase in institutional capital we've seen
(01:54):
deployed into the built environment over the last several years.
So I spend all of my time focused exclusively on the private equity community.
My job is to manage and organize the firm's efforts around private equity as both buyers
and sellers of relevant assets.
What this looks like on a daily basis is somewhat twofold.
(02:16):
It's spending time externally with sponsors to learn about their investment strategy,
where their interest lies, and how we can be helpful in the portfolio.
Then it's also spending time internally with our bankers here to organize and craft our
strategy and direction as it relates to the sponsor community.
I'd love to kind of shift now and talk about just overall M&A activity.
(02:40):
And Jason, we'd love to start with you.
How would you characterize M&A activity overall this year?
Yeah, so this is a really interesting question, Scott.
And I think one that has a bit of a layered answer.
Overall, I'd say we're still seeing a slower deal environment due to many of the headlines
we've been reading about over the last year or so.
Things like higher interest rates, buyer slash seller, valuation gaps, uncertainty around
(03:03):
the direction of the economy.
And as it pertains to private equity specifically, these factors have certainly had a massive
impact.
They're putting strain on new investment cases, they're limiting available leverage,
they're delaying exits, and ultimately have made dealmaking and fundraising really difficult.
If you look at 2023, a deal volume was down about 60% and new fund closings down over
(03:27):
50%.
And so as we look to 24, I think these dynamics are improving, which has been evidenced by
a return of mega deals in Q1.
But I don't think it's quite been the onslaught that most expected.
That said, with rates stabilizing, a record of 1.2 trillion of dry powder, all of the
(03:49):
fundamentals point towards a return in activity.
And based on conversations I've had over the last several weeks, I think people are starting
to see more flow.
Now these are the general headlines, but I also want to take a minute to drill down a
bit further into what we're seeing at the lower end of the middle market and the built
environment specifically.
(04:09):
Because I think you start to see a somewhat different narrative here characterized by
more resilient demand.
I think all the factors impacting the broader markets still remain at play here and activity
is certainly down.
But there are fundamental differences around many of the assets we work with, things like
macro tailwinds, significant value creation opportunity, lower reliance on financial
(04:32):
engineering that have all supported both overall appetite and available dry powder in our end
of the market.
Sponsors are remaining prudent and selective, so deals are still harder to get done.
But it feels like the biggest limiting factor in our market has been supply of assets for
sale.
(04:52):
But seller sentiment has certainly improved, especially with founder and family owners.
And the PE exit pipeline, it will thaw eventually.
So I think we'll continue to see activity pick up.
That's great.
Thanks, Jason.
I appreciate that.
And you touched on a little bit about what you're seeing around sponsor coverage and
sponsor appetite in particular.
Paul, I'm curious how you would answer that same question just with respect to what you're
(05:15):
seeing.
I would echo what Jason said towards the end, really focused on the built environment.
We at this year have seen more activity in Q1 than we've ever seen.
And it's likely a combination of those macro trends that Jason mentioned, but also the
surge in interest in the built environment and the types of businesses within it.
(05:39):
I think the other thing where I've seen more significant amount of activity is related
to proprietary deals.
I would roughly estimate 80% of the work we've done this year have been proprietary deals
versus those out on the market.
And so it seems like private equity is becoming far more proactive versus reactive in chasing
(06:01):
assets in the market.
So far this year, it's been fantastic for the work we do.
We've done roughly twice the amount of work this year so far as we did last year.
Kind of building on that answer.
Maybe Jason would start with you on this one as well.
So how would you describe the evolution of PE activity and the engineering construction
sector today versus even just five years ago?
(06:23):
We're definitely seeing more and more institutional dollars flowing into the ENC space and the
built environment more broadly.
I don't have specific numbers around investment dollars deployed today versus five years ago,
but I do know that despite the PE slowdown we saw in 2023, PE M&A made up around 50%
(06:43):
of total dealmaking within ENC, which is a record year and up from approximately 20%,
five years ago.
And look, I recognize that 2023 is a bit of a difficult comp just given how slow M&A
activity was.
But I think it's nonetheless a testament to how much more private equity interests we're
(07:04):
seeing in these sectors that were traditionally less of a focus for private institutional
capital.
I think we'll continue to see this trend evolve as investors seek to take advantage of the
value opportunity in these sectors.
But I think there's also something to be said for PE looking for sectors that historically
haven't been a focus, right?
(07:25):
Sectors where you still see relative value opportunities and significant meat on the
bone in terms of value creation.
Many areas of the built environment certainly fit that bill.
So just Paul, to build on that, you mentioned earlier the macro trend tailwinds that we're
seeing, I'm curious why at this stage the built environment is growing and attractive for PE.
(07:48):
So there's certainly a lot of macro trends driving PE interest in our space.
The first really being around the industrial revolution, there's certainly some money
flowing from the federal government when you think about all the semiconductor and battery
plants.
But it extends beyond that, general automotive, steel manufacturing, when we move to food
(08:10):
and beverage.
The whole industrial sector right now is extremely active.
And I'd even group into that data centers.
That has been a market where we've spent a lot of activity and time focusing in on the
drivers and the different niches within that market, the various stakeholders that play
(08:31):
in it.
We've also seen the install base of buildings dramatically increase over the last decade,
which of course increases the volume of activity that's needed related to maintenance and repair,
which of course is an attractive area for private equity.
We're also seeing a change in owner buying practices.
(08:52):
Now, when we think about maintenance and repair services, owners have learned their lessons
when it comes to deferring maintenance.
They're no longer willing to do that, even an economic downturn.
So we're seeing that driving more interest in the service and maintenance-based businesses.
Another focus area that's driven a significant amount of activity is around electrification.
(09:17):
And that extends to the service providers who are doing the actual work, both within
buildings and to the electric infrastructure.
But it also extends to manufacturers in the entire supply chain, from distributors to
transformer and switch gear manufacturers.
The industry is looking for a way to diversify from the large OEMs to a more stable supply
(09:41):
base.
And so we're seeing a tremendous volume of PE activity chasing the trends around electrification.
There's a whole host of others.
You can think of the infrastructure bills, things like that.
But there are certainly a lot of tailwinds in this industry, which help with that stereotype
of this industry being cyclical.
(10:01):
Yeah, I mean, you kind of touched on it.
But if you think about private equity and financial buyers invest in themes, right, and
the ones you mentioned, you've got infrastructure, you've got coastal erosion, you've got the
energy transition and decarbonization.
And the folks that are participants in the value chain of construction stand to solve
a lot of those issues or address a lot of those issues.
(10:22):
And so therefore making an attractive asset class.
And they are in what I'm seeing more and more of is a look towards the other stakeholders
in the supply chain.
So instead of just looking for the HVAC contractor, which is the tried and true P play.
(10:45):
Now they're looking for the specialized manufacturers or the sales rep agencies or distributors.
They're looking more broadly than just the service and maintenance side of that industry.
So you're exactly right.
They're following the themes and they're following the flow of the cash from those themes throughout
(11:06):
all the stakeholders.
And they're really finding the really nuanced participants servicing and benefiting from
those trends.
Jason, what would you add to that in terms of just some of the newer trends that we're
seeing beyond the HVAC roofing, building products, some of the traditional plays that
we've seen in the past?
A few areas that I've been hearing a lot more about recently are perimeter security and
(11:31):
access controls, i.e. fencing, gates, doors and any technology around that.
I always find it interesting kind of the fun names that private equity comes up with for
fairly simple businesses.
But another one is around kind of water infrastructure and wastewater treatment.
Everyone that I've spoken to seems to be looking for an asset in that space.
(11:57):
And then to Paul's point kind of things around infrastructure services, around the electrification
of the economy, et cetera.
And one other thing to kind of add to Paul's point around kind of the growing attractiveness
of the built environment to PE, I think some of it also rooted beyond some of the macro
tailwinds that we spoke about.
(12:18):
Some of it is also rooted in kind of the maturation of the private equity playbook and private
equities interest in kind of finding new sectors to deploy that playbook.
Sectors that still present some of the opportunities that maybe some of the more traditional focus
sectors of private equity historically have presented and ones where that opportunity
(12:44):
is still available.
Paul, how would you respond to the industry stereotype that construction is a cyclical
industry?
Well, there's certainly some cyclicality.
It's there is.
And it all depends on where you play and how you operate, whether you're exposed to it
(13:04):
or not.
If I think about the most extreme version of the cyclicality in our industry and look
at single family residential, new construction, it's very cyclical.
The spending can fall off a cliff at a drop of a dime.
It could happen very quickly.
And we saw that in 2020.
You saw new construction home starts stopped immediately.
(13:27):
They only take 40 to 50 days to build.
You can stop building them really quickly.
Horses, if we look at other parts of the industry, if we've go to the other extreme and think
about roofing, you know, call it 75 to 80 percent of the roofing industry is re-roof
and service and maintenance, which are non-deferable.
Your roof starts leaking at a data center.
(13:48):
You have to fix it or in a school.
And so there's extremes on both sides, but within the middle, the cyclicality is limited.
And if you focus on the areas that are non-cyclical, that have solid funding sources, which have
a long duration of project activity.
(14:10):
If you think about the institutional segments of healthcare and education or even any kind
of government spending, those are fairly stable, whether we're in a poor economic condition
or not.
We're seeing that right now with multi-families starting to pull back, but education and healthcare
are still growing.
And if we take that just down from the segment level to the service types, we move from new
(14:34):
construction, which can be cyclical, to repair and retrofit and even better to service and
maintenance, that cyclicality completely drops off.
So there is that stereotype and there is truth to it, like there is with most stereotypes,
but there are so many pockets of non-cyclical activity in this space.
(14:55):
It draws in those private equity buyers who are concerned about it.
And it creates opportunity for those that want to buy in a slower period and bet on the
upside, which we're starting to see a little bit of that right now as well.
Yeah, it's interesting as you talk about it.
I think it pays to scratch a couple of layers beneath the surface.
You think about it.
The office, traditional office market, has historically been somewhat cyclical, but if
(15:19):
you break it down into its sub-component parts, data centers right now are technically
classified as an office property.
Now, data centers, it's an arms race right now in spending.
I mean, it's just go, go, go.
Don't see much of an end in sight, but the broader commercial office sector isn't faring
so well right now.
(15:39):
Well, that is certainly accurate.
And even more interesting point we're thinking about office.
So office, new construction office, think buildings, towers, it's been decimated.
Right now you're not seeing a lot of new construction.
But if you focus on the sub-segment of office TI, tenant improvement work, that is actually
(16:02):
an area of growth.
And what we have found through recessions is that office TI is very counter cyclical
because as tenants vacate properties, the landlords and building owners are looking
to spruce them up in either providing incentives through leases or sprucing them off themselves
(16:22):
and spending money on that tenant improvement.
So as the market softens, tenants move from office building to office building.
And with that comes tenant improvement dollars.
I think office construction in New York or new construction is down 10 to 15%, maybe
even more than that, where tenant improvement in class A in trophy space is up almost double
(16:45):
digits right now.
So it's a tale of two different worlds, but it's all office.
Yeah.
We both heard Jay Bowman in our shop use the phrase, bulls and bears coexist at all times.
And I think that's a good example of it, right?
I think it's also important to note that many founders of these businesses have actually
built them in a way that the business is inherently more cyclical.
(17:06):
As a founder, the big projects that are largely associated with cyclicality are typically higher
margin, potentially easier to plan for, easier to manage labor around, then kind of the consistent
small ticket maintenance and repair work.
And it's not that that work isn't there.
It's that some previous owners haven't prioritized it as much.
(17:28):
So this actually presents a really big opportunity for many private equity buyers because if
you shift that mix to more repair and maintenance, you not only reduce the overall cyclicality
of the business, but you also likely drive some multiple expansion as well.
Building on that answer with respect to cyclicality, I'd love your take, Paul, on how private
(17:50):
equity should think about fragmentation in the industry.
How fragmented the industry is, and then also how abundant private ownership is and the
lack of institutional capital.
So it provides an opportunity for lower middle market private equity firms to be that first
(18:11):
money in.
And there's a significant amount of upside opportunity to really create change within
these businesses and create value.
I think their private equity is finding that combination of that fragmentation and the
high volume of private ownership creates a significant amount of opportunity that just
(18:33):
doesn't exist in other markets.
And I think the other thing that we haven't touched on is just the significant amount
that construction activity as a whole, and I'm including new construction, I'm including
repair and retrofit and service and maintenance makes up of overall GDP and what a significant
(18:56):
driver construction is of the economy and the volume of dollars being spent.
When you loop together that combination of the volume of money spent in this industry
combined with its fragmentation as well as the private ownership of most of the businesses,
I think it's somewhere north of 90% of the businesses are privately owned, it creates
(19:21):
a very attractive market to start pursuing for acquisitions.
Maybe to build off of that, Paul, would love your perspective on some other things that
we see that are sort of inherent to the industry and what makes it unique relative to ownership
of some of these firms.
(19:42):
What is it about the construction industry and the broader built environment that's unique
from a private equity perspective?
Well, I think what is unique about this industry is just how fundamental it is to the economic
well-being and growth of this country.
I'm just looking at a brief statistic, but if we think about the growth in GDP last year,
(20:08):
construction was about 15% of that growth.
All construction makes up about 8% of GDP a year in and of itself.
But when you think about all the other facets of our economy and our daily lives, construction
is at the heart of all of that.
And I think when you take that and how critical it is to the world we live in, and then you
(20:34):
layer on top of that the high level of fragmentation, which brings about significant opportunity
for roll-up, as well as the high volume 90 plus percent of these businesses in this industry
being privately held and the opportunity to be that first capital in, it makes for a wonderful
(20:56):
combination to add value and to really sophisticate and professionalize these organizations.
And if you think about roofing, right, roofing has been in the private equity playbook for
at least a decade, if not two, if you go all the way back to Tecta early 2000s, there are
(21:18):
still thousands upon thousands, if not hundreds of thousands of roofing firms that are still
privately held across the US that private equity is starting to invest in.
And so the opportunities abound for investments and value creation in this industry.
(21:41):
There's so much meat on the bone in terms of value creation with these businesses.
And I think that private equity has kind of not necessarily woken up to it as much as
it is, sees that the days of kind of just sitting on an investment, growing top line
a bit, and then the multiple kind of expanding on its own, just given the massive growth
(22:03):
in demand from PE, those days are kind of over.
Now the investments that sponsors are making are going to really focus around these value
creation levers.
I mean, if you look at what has been driving the returns for private equity over the last
10 years, over 50% of that is related to multiple expansion.
(22:24):
And there are certainly pockets within the built environment where, you know, that multiple
expansion opportunity is still there.
But the shift has really got to be to focusing more on value creation.
Historically, the top line has been driven the other 50%, but margin improvement has
been around 1% of the value creation.
(22:45):
And that definitely varies when you know, depending on which end of the market you're
looking at and which GPs, but as a whole, private equity is starting to turn its head
towards, we really need to find opportunities where we can truly create value.
And maybe that is through things like inorganic M&A, but I think it's still a lot of, to
(23:06):
Paul's points around kind of professionalization and really rolling up your sleeves and actually
driving improvement in the business itself.
So, Paul, what would you add to that?
When you look at any of the articles written about the current state of private equity,
that's one of the key themes you've seen over the last six to 12 months is that private
(23:31):
equity to create the value that's possible has to go back to old school private equity
ways.
Truly rolling up your sleeves, like Jason said, and doing core business fundamental improvements
to drive that value.
It's no longer a mathematical equation and moving numbers around and financial jiu-jitsu
(23:58):
to create that value.
It really is about improving these businesses.
And going back to my comments around just how private this is, it's founder owned.
A lot of these founders have made the decision, do I invest in the company or do I buy a new
boat?
And now with private equity, you have the ability in the capital to make these improvements
(24:22):
and really drive these businesses upward.
And there's a significant volume of that opportunity in this industry, which I think
is wonderful.
And I think it creates that opportunity for private equity.
And I think they're starting to see it.
What are some examples, Paul, what you're seeing and some of the work that your team
does with clients, rolling up your sleeves and really building tangible value?
(24:43):
Well, there's the obvious of bringing in a full suite of professional managers, truly
professionalizing functions like HR and business development, putting in all of the tools necessary
to really drive the operations side of the business.
(25:05):
But then it's also figuring out ways to improve the lives of the employees, which of course
is going to drive significant value.
This is a people business.
And so you see a tremendous investment in the people.
And I'm not talking about managers, I'm talking about field labor, superintendents, project
(25:25):
managers, improvement of their benefits, of their skills, of their compensation.
And then there's a diversification.
It's about finding areas that have higher margins, less cyclicality, improving the overall
dynamics of the world that the business works in.
Creating that diversity that just makes an overall better business, both for the owners,
(25:49):
as well as the people that work there.
Well, from a founder perspective, we will often see how a lot of the decisions, if not all
the really important ones flow through the singular individual and the founder.
And to really scale and to grow and to build, you've got to build a leadership team that's
capable of stepping in and making some of those decisions.
And if the founder is still calling all the shots, that's a problem.
(26:12):
We talked about stereotypes and the stereotype of the cyclicality of our industry.
I think the one stereotype that also lingers is the stereotype of private equity in the
construction industry and a mismatch of cultures.
And it's a stereotype that goes the other way, where the owners of businesses within
(26:36):
the built environment see private equity as a dirty word.
And I can speak from firsthand experience that the majority of the private equity firms
that I work with really have blue collar roots.
They care about improving these businesses.
They care about the making an even better environment for the workers.
(26:58):
They care about continuing the legacy of the founder.
And so I think there's a stereotype to overcome with just what it means to bring private equity
into this space.
Again, I can speak firsthand that I have worked with amazing private equity firms that really
want to roll out their sleeves and understand this industry and improve it.
(27:19):
And that's exciting that it's going to improve the lives of the members of this industry.
Historically, private equity has been thought of as kind of this Wall Street business model.
That definitely still exists.
I mean, if you look at the top managers, I mean, those firms still have major Wall Street
roots, but private equity has grown so much in the last 10 years.
(27:40):
There's this whole end of the market.
And I think specifically, when you look at the lower middle market, a lot of the firms
active in that area, as Paul mentioned, have blue collar roots and really don't necessarily
have that same buttoned up Wall Street feel that a lot of the top managers do.
And I think that also is a point of we've been hearing a lot about how the inflow into
(28:03):
private equity funds from investors is kind of concentrating at the top managers.
That's going to continue.
But I do think there's something to be said about lower middle market firms always kind
of having a leg up in terms of being buyers of the assets in the lower middle market versus
a mega fund that launches a lower middle market strategy to Paul's point around the
(28:27):
fact that those smaller funds are likely going to have that kind of more blue collar roots.
It's going to be a more material investment for them versus a lower middle market fund
within this massive 100, 200, $300 billion overall platform.
Jason, it reminds me of a conversation we had with the private equity firm where the
(28:50):
founder had left a larger firm, larger private equity firm, because he wanted to work with
smaller businesses and he wanted to be able to roll up his sleeves and work right next
to those owners and be a true partner.
That's what excited him.
And that's what I think is fantastic.
When we think about the lower middle market, we think about our industry.
(29:11):
Most private equity funds in that space want to be just that a partner.
They don't want to take over.
They want to improve and they want to build a legacy on the improvements that they contributed
to those firms, which aligns really well culturally.
In my experience, works very well.
Popular Podcasts
Dateline NBC
Current and classic episodes, featuring compelling true-crime mysteries, powerful documentaries and in-depth investigations. Follow now to get the latest episodes of Dateline NBC completely free, or subscribe to Dateline Premium for ad-free listening and exclusive bonus content: DatelinePremium.com
Amy Robach & T.J. Holmes present: Aubrey O’Day, Covering the Diddy Trial
Introducing… Aubrey O’Day Diddy’s former protege, television personality, platinum selling music artist, Danity Kane alum Aubrey O’Day joins veteran journalists Amy Robach and TJ Holmes to provide a unique perspective on the trial that has captivated the attention of the nation. Join them throughout the trial as they discuss, debate, and dissect every detail, every aspect of the proceedings. Aubrey will offer her opinions and expertise, as only she is qualified to do given her first-hand knowledge. From her days on Making the Band, as she emerged as the breakout star, the truth of the situation would be the opposite of the glitz and glamour. Listen throughout every minute of the trial, for this exclusive coverage. Amy Robach and TJ Holmes present Aubrey O’Day, Covering the Diddy Trial, an iHeartRadio podcast.
Stuff You Should Know
If you've ever wanted to know about champagne, satanism, the Stonewall Uprising, chaos theory, LSD, El Nino, true crime and Rosa Parks, then look no further. Josh and Chuck have you covered.