COVID-19 Impact on Specialty Trade Mergers & Acquisitions - Articles

Prior to March 2020, specialty trades, such as mechanical, electrical, plumbing, and HVAC, were the hottest verticals for mergers and acquisitions (M&A) in construction. When COVID-19 cases started spiking however, FMI saw about one-third of its contractor deals get paused, put on hold indefinitely, or cancelled as acquiring companies put pencils down on potential transactions. These concerns were chiefly due to buyers’ desires to protect their own balance sheets, trepidation over vulnerable end markets such as office and hospitality, and fear regarding the large unknown economic future of the country, not to mention the world. In the late summer/early fall however, FMI witnessed a marked sea change in transaction activity and interest from both buyers and sellers. As some of the early panic regarding the virus subsided, select buyers came back to the deal table, and sellers began calling FMI investment bankers to discuss exit strategies. While we are certainly not out of the woods yet, we are seeing green shoots of interest from sellers and ongoing shifts in deal structures, due diligence, and backlogs in this environment that will have meaningful impacts on acquisitions. This article will explore these M&A trends particularly as they relate to the specialty trades, which continues to be the market leader for M&A construction.

Buyers Are Still Buying

The first notable shift in the market environment was – unsurprisingly – created by the buyers. In March 2020, there was a clear subset of acquisitive contractors who put their ongoing or planned transactions on indefinite hold, particularly in end markets such as office, retail, amusement, and hospitality which are in the throes of combatting a substantial decline in backlogs. In the summer of 2020, most of these acquirers who hit the pause button on M&A were back in the market again, particularly among those specialty trade contractors with more resilient backlogs. In addition, buyers are witnessing another trend: companies and people migrating away from dense urban areas and natural disaster-prone regions, which are creating demands for housing and, to some extent, commercial development in select locations such as Colorado, Texas, Utah, and the Southeastern U.S.

Curious Sellers

Perhaps one of the more interesting developments in the M&A environment was from sellers. In August and September 2020, FMI was inundated with calls from prospective sellers seeking an education on the marketplace, valuations, and M&A processes. We attribute this to several factors. First, many business owners nearing retirement ages, battled-hardened by the Great Recession, are simply not wanting to navigate another downturn. Second, we see business owners looking to exit after back-to-back record-breaking years. We do however, caution these prospective owners to avoid trying to time the market as it can be exceptionally challenging – sophisticated acquirers are not “fooled” by the notion of continued record years and will be paying particular attention to works-in-progress (WIPs) and pipelines. Third, as construction cycles tend to lag GDP, we believe there still exists a fair degree of optimism from both buyers and sellers alike, but the great overhang of uncertainty for 2021 and 2022 could dampen these ambitions. Lastly, the prospect (prior to the election) of a “blue wave” spurred concerns about a higher tax environment, driving some sellers to the deal table.

Valuation Drivers

For those specialty trade contractors contemplating exits, what factors detract from value? First, there are factors that exist in contractionary and recessionary times which will always decrease valuation. A common example is lack of a robust succession plan. Some sellers embrace a myth that the buyer will simply walk in and replace the owners with new managers, but the buyers are busy running their own companies with their own management team, so having a strong employee organization chart is paramount. Another hurdle is unions; some acquirers for example, will not acquire union contractors and inherit the unfunded pension liabilities, making the pool of available buyers smaller. Lastly, the pandemic has caused margin pressure from increased competition and declines in backlog. This volatility and uncertainty have driven some buyers away from acquisitions which will create downward pressure on value.

On the flip side of the coin are value enhancers. Service-heavy, recurring revenue models, such as HVAC contractors who witness repeat business with maintenance contracts, can drive earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples well north of industry norms. For example, a project-based construction company may trade at 4-5x EBITDA, but a similar sized business in HVAC services may see double this multiple to 8-9x! Capabilities such as prefabrication, in-house design, building information modeling (BIM) solutions, and manufacturing prowess all drive trade margins and therefore value. Geography is also important – those subcontractors working in growing, populated regions such as Denver, Phoenix, Boise, and the Southeast can all expect a larger pool of suitors than those in sparsely populated areas.

What type of trade contractor you are matters a great deal as well. Some sectors, such as drywall, concrete, and masonry lack a deep pool of large acquirers which is important to drive acquisition demand. On the other hand, the mechanical and electrical sectors are populated with large, public companies such as EMCOR and Comfort Systems which use acquisitions as a key element of their growth strategies. At the top end of the market, HVAC services command not only interest from strategic acquirers, but also private equity firms which have been extremely busy rolling up this fragmented sector.

So Where are the Bargains?

What has the pandemic done to valuations? Surprisingly, not much. With companies working through robust backlogs, both buyers and sellers are still experiencing attractive financial performance on existing jobs. Opportunistic buyers waiting for a downturn in valuation multiples have been disappointed as sellers have not yet conceded a willingness to trade for less. This of course may change, particularly as we get into a period of potential greater pipeline softness in 2021 and 2022. In December 2019 for example, comparable public mechanical, electrical, and plumbing (MEP) companies were trading at 7.3x enterprise value divided by forward EBITDA. This multiple dipped to 5.6x in March 2020, but as of November 2020, these multiples were largely unchanged at 7.1x. In fact, for the construction and engineering industry as a whole (both domestic and international public companies), this multiple increased from 6.4x in December 2019 to 6.8x in November 2020. It is important to note that the multiples below reflect those of large, publicly traded companies, and so appropriate discounts should be applied if used for smaller, privately held companies.

Our Crystal Ball

Based on conversations with contractor management teams, we expect that 2021 will see an increase of deal activity over 2020, particularly due to the “lost quarter” when M&A transactions were on hold. We expect to see deal announcements in mechanical and electrical trades where there continues to exist robust interest from large, privately and publicly held companies. In addition, we anticipate a few announcements from industrial mechanical contractors with heavy exposure to oil and gas seeking to diversify into other end markets such as food and beverage and pharmaceutical. Lastly, we expect to see continued consolidation for HVAC service companies, particularly those providing air filtration and refrigeration solutions that cater to demand for cleaner air and cold food storage.

On the bear side, we expect M&A activity among trades with exposure to retail, office, hospitality, transportation, amusement, and multi-family to be dormant. While we expect there will be interest from large mechanicals and electricals to acquire attractive targets, we expect valuation to remain a hurdle for closings. For example, there is a lot of interest in acquiring pandemic-friendly electrical and HVAC contractors that service data centers, pharmaceuticals, warehouses, and distribution centers, but why will the sellers be willing to trade at market or lower values when they are in the midst of record-setting demand?

All in all, the M&A market for construction is doing far better than we had anticipated at the outset of the pandemic. It is our hope that vaccines and treatments continue to show positive progress through clinical trials. No matter who is in the White House, the one outcome we can count on is less uncertainty (even though it may take time to officially resolve any dispute) which always bodes well for both the economy, demand for new construction, and – consequently – M&As.