Rebuttal: Contracting Business Private Equity Rant
Updated: Feb 17
In its March 2022 issue, Contracting Business included an article in its Rant section entitle “Why HVAC Private Equity Will Crash and Burn.” The article was written by a long-time industry veteran and current President of Service Nation, Matt Michel. The article comes down hard on private equity investment in the HVAC industry and while history does point to potential for failure, the article jumped to some conclusions that need a closer examination.
Let’s focus on an important underlying premises of the article. Michel writes “There are too many players chasing too few contractors. Not all of them are major players, but 20 is too many. Ten is too many. Either P.E. firms will target outside of residential service and replacement market as consolidators did in the 1990s, and start buying weaker companies; or some, followed by others, will start to abandon the industry.” The article references residential consolidation, but the overall critiques are common for both commercial and residential private equity investment so we will focus on both.
This scarcity premise is an important one as it strikes the core of the private equity playbook. While scale isn’t the only value consolidators provide, it is a major aspect of their investment strategy. So, are there in fact too many consolidation efforts chasing too few contractors? My answer to that question is A) It’s a big marketplace, and B) It’s quality over quantity that matters, and C) Owners can hedge their bets.
A. It’s a Big Marketplace
According to US Census data, there are 103,359 HVAC and plumbing contractors in the US. The census doesn’t’ break out plumbing separately but let’s assume two thirds of those are HVAC contractors. That’s 69,250 HVAC contractors.
The census does break down contractors by number of employees. Private equity firms tend to buy companies in the 20 employees to 250 employees size range which brings us to a total of 10,965 HVAC and Plumbing contractors and two-thirds of that is 7,314 HVAC contractors. That’s a lot of contractors for private equity consolidators to purchase but to be fair, there are also a lot of consolidators competing to make acquisitions. IEI Advisors is tracking 70 of them with about half of them on the commercial side and the rest residentially focused.
A consolidator would likely see their efforts as quite successful if they were able to purchase 20 to 30 contractors and for our example, we’ll use the higher number. With 70 consolidators purchasing 30 companies each, that would be 2,100 contractors being acquired or 29% of the market. That’s a significant chunk of the market but far from indicating that there aren’t enough potential acquisitions to fuel consolidation.
B. It’s Quality Over Quantity That Matters
To an extent these numbers address the scarcity premise but there are certainly gaps in the analysis. It’s difficult to say how many quality contractors make up the marketplace or how many of those businesses may be available for purchase by consolidators. So that begs the question, what is the fallout IF consolidators run out of quality contractors to purchase? Will they in fact crash and burn?
The short answer is maybe. The potential failure point for consolidators isn’t in how many contractors they can purchase but their discipline in purchasing quality contractors. To his credit, Matt Michel references the importance of quality but then quickly leaps to the assumption that all consolidators will be undisciplined in their approach and will buy “weaker companies.”
Given the number of acquisition headlines in the past few years, one could assume that consolidators currently have low standards for quality or that it will trend that direction soon. My experience as a broker leads me to believe that isn’t necessarily the case. I am frequently in contact with consolidators about HVAC companies for sale only to hear a response along the lines of “that business doesn’t meet our criteria” or “it’s not in line with our current strategy.”
So, what will become of a disciplined consolidator IF there ends up being a lack of quality companies to buy? A crash and burn scenario seems unlikely. It’s far more likely that the private equity firm will simply wind up exiting their investment by selling to another consolidator or another large company. As the old saying goes, “there will always be a market for quality.” But there’s also another old saying, “history tends to repeat itself” which just might be the case for undisciplined consolidators repeating the crash and burn scenario.
C. Hedging Your Bets
Owners considering a sale during this consolidation wave may find it hard to fully trust that consolidation is going to deliver on all of it’s promises. That’s perfectly reasonable and the good news is, owners can leverage the consolidation wave without betting the farm on it.
1. Get multiple offers. The big benefit of consolidation for owners considering a sale is that there are way more buyers than sellers in the market today. It creates competition for business sales which gives owners options of who to sell to while also driving up valuations. In today’s market, quality HVAC companies that are properly marketed may get upward of 10 offers. Even if you are not sure you want to sell to a consolidator, you can leverage their offers to negotiate with the type of buyer you do think is the best fit for you and your team.
2. Negotiate for cash up front. A consolidator will likely want you to rollover some portion of your sale price into equity in their larger consolidation company. They do this to ensure owners still have some skin in the game and are motivated to work with all the other partner companies for the benefit of the overall consolidation effort. This isn’t necessarily a bad deal for owners as this rollover equity can certainly grow in value to potentially yield a significant return. That having been said, it’s riskier than cash-in-hand. Owners with any amount of skepticism about the consolidation effort being successful should negotiate for most or all the purchase price in cash. In this sellers’ market, it’s a concession that many buyers may accommodate.
3. Verify the consolidators track record. For consolidators that have been growing their HVAC business for some time, owners can request to see their financials to understand how profitable the venture has been. Owners can also request to speak with some of the companies the consolidator has already purchased and particularly owners that sold a few years ago. This can really help owners get a glimpse of their future with the company from the firsthand experience of another owner. This step is particularly important if an owner plans to sell to a consolidator and work with them for several years. For a consolidator that may be new to the HVAC game, owners can ask to speak with owners of companies they’ve partnered with in other industries. A good private equity firm should have a strong track record across industries of growing companies and treating owners fairly.
By applying these hedging strategies, owners can determine if a consolidation acquirer is the right fit for them. It certainly isn’t for everyone, but if the price, terms, and track record all line up, consolidation can be an attractive option for owners to consider.
* A shorter version of this article (without section C) was published online by Contracting Business Magazine on April 4th, 2022 and was also included in the June print edition of Contracting Business Magazine.