We have been discussing the difference between cyclical risk factors that lurk inside disorderly markets and trends that permanently change the nature of construction business risk. Consolidation is a trend characterized by the amalgamation of smaller organizations into larger ones, resulting in fewer but more powerful industry participants. Consolidation usually signifies that an industry is in a mature phase of its life cycle. In a September 18, 2000, ENR article I predicted a 20% reduction in construction firms by 2020, (which has occurred) and continuing in the direction of 25% (the definition of industry consolidation). When large construction companies grow at a rate faster than the remaining firms in the industry, it is at the expense of the midsize and smaller organizations who are left with a diminished portion of the market.

External Forces

Construction Industry consolidation, like most other trends, is caused by external forces altering the industry’s structure and accelerating its evolution. This short list of external factors will be familiar to most contractors:

1. Increasing project size and complexity
2. Increases in size of buyers of construction services
3. Increasing sophistication of buyers
4. Increasing demands in speed of performance
5. Continuing growth of multi-national companies
6. Growth of global capital surplus
7. Worsening skilled labor shortage
8. Increased role of costly technology.
9. Continuing cultural revolution
10. Reduction in family succession
11. Growing impact of Inheritance tax

Internal Factors

• An internal factor driving construction industry consolidation is the limited access to adequate growth capital available to small and medium sized companies.
• Most American industries grow internally. After a company has established its product and identified its market, it grows by responding to demand and producing more products more efficiently. If the demand growth spurt exceeds its internal capabilities, it sells pieces of its current capability on public stock markets and uses that capital to expand its internal capability and grow.
• Construction does not grow internally. It doesn’t produce established products more efficiently to grow but rather must go out in the market and find new business. This is external growth and, as I have said so often over the years, every time a contractor starts a new project it’s like starting a new business. Every new project, which is the only source of ongoing business for contractors, requires new employees, new geography, new design specifications, new owner, new payment systems, new legal entanglements, and new capital requirements.
• For reasons we will discuss next week, construction has almost never accessed public stock markets for growth capital. It is a capital-intensive industry internally funded by retained earnings while suffering from limited access to expansion capital provided by public markets.

Construction Capital

Accountants, bankers, and sureties think in terms of capital, but contractors rarely use the term. However, contractors are keenly aware of how much cash they have on hand; the cash flow from ongoing jobs; available lines of credit; their current bonding capacity. We tend to think in terms of “cash flow” and how much financial “go power” we have left in the tank. Let’s look at the classes of capital available to small to medium sized contractors and evaluate their power to fuel a construction company’s ongoing external growth.

1. Owner’s equity - This is usually the paltry sum the original founder put in decades ago to get started. Often it isn’t even cash but rather as little as a used pickup truck, some tools, and a week’s wages. This continues to be the equity profile of the startup construction company even into the 21st century.
2. Retained earnings - Back in the mid-twentieth century, retained earnings were the main source of construction company capital. Those were the “good old days” when contractors worked with 10% to 15% and sometimes 20% or more profit margins and grew slowly, usually taking one or two additional jobs at a time in their local market while being careful to get paid on time. Because the growth rate was limited to available capital produced by ongoing job profitability, growth was “self-limiting” by the amount of current earnings retained on the balance sheet.
3. Working capital lines of credit - Bank lending is not equitybut, it is capital. Neighborhood banks vary in their eagerness to lend to local contractors that have proven they are profitable and have retained an adequate amount of past profit to fund new work.
4. Asset Lending - Heavy equipment, rolling stock, and other fixed asset expenditures are usually financed through asset-based borrowing.
5. Bonding - Bonding capacity is an important source of capital although it is rarely seen as such. All public and many private owners will only employ contractors who qualify for payment and performance bonds, and some contractors will only employ subs who they can bond around. Most banks will only lend to contractors who have adequate bonding capacity.

Consolidation

The big get bigger and the small get less work over time and sometimes depart the scene. This is a trend not a short-term anomaly. If you’re a small to medium sized contractor who intends to stay in business for a while, learning to manage capital is critical to your success. Watch this space for some useful capital management tips you may have ignored in the past.