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How private capital can help AEC firms with growth and ownership transition

Private capital is a potentially viable solution for many common challenges relating to growth and ownership transition in the AEC industry.

Neil Churman
07/13/2017

Even today, the mention of private equity often conjures images of the corporate raiders of the 1980s - titans of Wall Street acquiring companies through hostile takeovers and using copious amounts of high-yield debt to do it. Phrases like "slash and burn" and "strip and sell the assets" came to be synonymous with the leveraged buyouts of that era. When it comes to the architecture, engineering, and environmental consulting (AEC) industry though, a very different story has emerged.

At the most basic level, AEC firms (and more broadly, professional services firms) are different in that, the most important assets , the people,  go home at the end of the day. From the perspective of a private capital partner (such as private equity investors, mezzanine lenders, and other types of alternative lenders and investors), many of the same concepts that drive strong firm performance are the factors that make for good investments in the AEC space. Building a profitable and defensible market position, developing a strong leadership team, hiring and motivating talented staff, managing risk, and providing superior client service are all fundamental to success, whether or not a financial partner is involved. Private capital is a potentially viable solution for many common challenges relating to growth and ownership transition in the AEC industry.

Summary of notable private capital transactions in the AEC industry. Data Source: Capital IQRecent private capital involvement in the AEC industry

Over the last few years, private capital has played a prominent role in the AEC industry, ranging from mega-deals involving global firms to smaller transactions with local or regional players. Among the most notable large transactions were Apollo Group's investment in Ch2M, OMERS Private Equity's transaction with ERM, and New Mountain Capital's deal to take TRC private. All of these deals involved national or global AEC firms and private equity funds with billions of dollars under management. By contrast, there have also been quite a few transactions involving smaller, more specialized firms with smaller private equity groups that focus on working with service businesses. Keystone Capital has been involved in four industry deals in recent years including pipeline engineering firm Eagleton Engineering (acquired by Jacobs in 2014), building envelope consultant Vidaris (acquired by Cortec Group, another private equity investor, in 2015), and current investments in specialized healthcare architecture firm Environments for Health, and transportation CM/CI specialist Target Engineering Group.

Other notable private equity groups with past or current investments in the AEC industry include Long Point Capital (EYP, CHA, Cumming Group) and Bernhard Capital Partners (ATC Group Services, Wink Engineering, The MCC Group), among a group of others who have looked to the AEC industry as an attractive opportunity.

An overview of some of the types and sources of debt and equity financing that may be available to AEC firms. Courtesy: 7 Mile AdvisorsTypes of private capital providers

There is a broad range of ways a company can be capitalized, whether with equity or debt, and a mix of both will invariably be most efficient in terms of cost of capital. AEC firms have traditionally been financed by paid-in-capital from the founders/owners and ongoing retained earnings on the equity side and a senior bank loan or credit facility on the debt side. However, there is a wide spectrum of capital solutions in between that may make sense in the right situations as firms aim to grow or transition their ownership. Moreover, there are numerous private equity groups and lenders, many highlight specialized in terms of their industry focus and transaction type, that can provide capital to industry firms.

Why look to private capital?

As AEC industry firms evolve, they may find themselves boxed in by their existing capital structure. For firms pursuing growth opportunities, whether organically or through acquisition, may not have adequate cash on the balance sheet to pursue these opportunities. Since most engineers have limited hard assets, bank debt is generally extended either as a function of the firm's cash flows or against its accounts receivable. Moreover, traditional banks are relatively conservative in the amount of capital they are willing to lend. For an AEC firm seeking to raise capital for growth or acquisitions, a mezzanine loan may prove to be a viable solution.

Mezzanine debt is "junior" or "second lien," meaning in the event of a liquidation, they are paid after the senior lender, usually a traditional bank. While a mezzanine lender is willing to extend beyond what a traditional bank might be willing to offer, it usually comes at a higher coupon rate with potential warrants to compensate for the higher risk they are taking. While the "sticker price" of such a loan may be more expensive, for firms that seek transformative growth opportunities, the benefits may significantly outweigh the costs.

The other vehicle for firms chasing market opportunities is growth equity. This may come in the form of a majority or minority investment from a private equity group. Private equity groups seek to generate returns by helping companies grow revenues while simultaneously improving the bottom line. They add value by providing capital and know-how to make add-on acquisitions, provide managerial expertise in improving operations and back office systems, and can make connections with other strategic partners that bring value. The takeaway for AEC firms is that the expertise and industry experience a private equity group brings to the table is just as important as the capital they provide.

Another common circumstance where private capital proves ideal for AEC firms is in transitioning ownership. When an owner or group of owners is eyeing retirement, it's often difficult for them to transfer ownership internally to the next generation of staff who may not have the capital, desire, or experience to take the reins. At the same time, owners may not be interested in pursuing a sale to a strategic buyer (another AEC firm). In this situation, private capital may be able to provide the means to allow the departing shareholders to unlock the equity value they've built in their firms, while maintaining a meaningful stake for those key staff that do wish to continue on. Moreover, those staff may have the opportunity for their remaining share of the firm to grow in value, as a financial partner helps to fuel growth.

Ultimately, the specific situation, goals, preferences, timelines, and risk tolerances among AEC firm owners will drive whether, and what type of, capital is most effective for their firm's circumstances. Knowing that there are a wide range of alternatives available can enable AEC firms to better plan, prepare, and seize market opportunities.

Neil Churman, 7 Mile Advisors, director. This article originally appeared on 7 Mile Advisors' blog. 7 Mile Advisors is a CFE Media content partner. Edited by Hannah Cox, content specialist, CFE Media, hcox(at)cfemedia.com.

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