How to Profit From the HVAC Industry’s New Wave of Consolidation
Today, consolidation is driven by private equity
It’s back. Consolidation is once again impacting the HVAC industry but, this time, with a difference. In the 1990s, consolidation was driven by publicly traded ventures. Today, it’s private equity, and that might mean an exit opportunity for you.
CONSOLIDATION IN THE 1990S
In the 1990s, consolidation swept across the HVAC industry. Contractors were rolled up into large publicly traded companies like American Residential Services, Group Maintenance America Corp., Service Experts, and the utility-owned Blue Dot.
Consolidation in the ’90s was a Wall Street play. The focus was short term. Each quarter needed to show progressive growth in revenue and profit. With multiple consolidators combing the industry for acquisitions, valuations soared. But there was a catch. Contractors sold their companies for cash and stock, or simply for stock in the consolidator. All was well as long as stock prices escalated.
Desperate to show the quarterly growth that analysts demanded, the consolidators began to overlook culture and fit. If a company was in the black and willing to sell, one consolidator or another would buy it. Residential service and replacement companies were combined with new construction, commercial, even heavy commercial and specialties — like companies that focused on computer room HVAC.
On paper, consolidation made lots of sense in terms of buying power, shared overhead, etc. Whether because of poor fit, a clash of cultures, a loss of local company leadership, or other reasons, it all began to come apart. Instead of consolidation causing one plus one to add up to three, it came out as one. The stock lost value, and the contractors who hung on to the stock saw their wealth evaporate.
Some contractors bought their old companies for pennies on the dollar and tried to restore them. Others started over. The consolidators that didn’t fail became hollow shells of what they were in their prime and have been sold, resold, and resold again.
THE RISE OF PE
In response to the tech bubble crash and several high-profile scandals like Enron and WorldCom, Congress passed the Sarbanes-Oxley (SOX) Act to make business more transparent.
While there is some debate about the benefits and necessity of SOX, it is clear that the number of initial public offerings (IPOs) each year declined by half after SOX.
Capital flows where it is welcome, and the costs and burdens of SOX pushed capital from public to private markets. This is evident in the reduction of IPOs and the increase in private equity (PE) firms, which have jumped from less than 1,500 firms in 2000 to more than 4,000 today.
PE firms manage funds that contain investments by institutional investors, pension funds, university endowments, high-wealth trusts, and wealthy individuals. Each fund has certain investment parameters and exists for a set period (e.g., four to six years).
PE firms are under a lot of pressure to find sound investments because of a fund’s time constraints. However, there is a big difference between the time constraints imposed on private equity and the pressure for a publicly traded company to show stellar performance each quarter.
PE AND HVAC
Over the past couple of years, private equity discovered HVAC. Contracting companies are believed to be relatively recession resistant because heating and air conditioning is a necessity. Well-run contracting companies also generate attractive returns. Moreover, the multiples or prices paid for contracting companies are attractive vis-à-vis multiples in other industries.
The PE firms interested in HVAC do not appear likely to replicate the mistakes of the consolidators and may realize the paper promise of consolidation. By and large, they are seeking companies with a management team in place and/or an owner who wants to continue to operate the business. They want strong local brands and are inclined to leave them in place.
While the multiples paid by PE firms are less than the consolidation era, they are mostly cash. There might be earn-outs, notes, and equity rollovers to keep the owner involved and interested, but the majority of the transaction is generally cash. With a trillion dollars of dry powder on the sidelines, private equity has a lot of cash to throw around.
The goal of a PE firm is to assemble a group of companies and grow total earnings before interest, taxes, depreciation, and amortization (EBITDA). Once a trigger point is reached (e.g., $50 million EBITDA), they flip the entity to another PE fund or a public company. A PE firm might buy a group of contracting companies for 4.5 multiples of EBITDA, grow margins somewhat, and sell a $50 million combined EBITDA business for a 10 to 15 multiple.
If a public company is the buyer and trading at a price/earnings ratio of 20 (the current average for the S&P 500), the deal instantly boosts share prices by 33 to 100 percent more than the price paid by the consolidated entity.
PREPARING YOUR COMPANY
If you have any plans for an exit over the next five years, prepare your company now. Clean up your financials. Implement defined business processes. Develop a management team. Create an employee recruiting and training system. Build your brand. Enhance subscription revenue with service agreements and the connected home. These steps will maximize your multiple and attractiveness.
For help preparing your business for a maximum exit, consider joining the Service Nation Alliance.Call 877-262-3341 to learn about the free, no-strings Success Day seminars to learn how to enhance profitability while preparing for an exit.
Publication date: 3/4/2019