There’s a land rush in the HVAC industry. Private equity is buying companies left and right with multiples reaching levels that would have been considered insane a year ago. Extrapolating the possible outcomes of the acquisition spree lead to some unsettling scenarios for the future.
How Private Equity Works
Typically, private equity (PE) companies assemble a pool of money from large and institutional investors to buy companies. These are then, invested in, put together with other companies, and flipped a few years down the road. The funds that PE firms create typically have an expiration date, so there’s pressure to buy fast and towards the end of the fund’s life, to flip quickly.
The high multiples are not as unreasonable as they seem. If a PE firm can assemble a strong collection of contracting businesses and get any overhead reduction through shared costs, they will likely be able to flip this bigger entity to another PE firm for a 15X. "Presto changeo," the PE firm generates a 50% return or more if the fund utilizes leverage. For example, if half the funds used to buy the companies is debt, the return changes from 50% to 100%.
The next PE firm to take ownership can then add more companies and create an even bigger bundle. The bigger bundle gets flipped to a publicly traded company. The PE firm collects a 20X EBITDA and sells to a corporation with a price/earnings ratio of around 30. Instantly, the public company becomes much more valuable without even considering strategic fit
Why Sell Now?
Many contractors are jumping on the opportunity to cash out in 2021. If they are in a position to sell, there is not a lack of buyers. A contractor recently told me he had 60 companies sniffing at his business. That's right, he had 60!
Aside from the fact we are seeing record multiples, sales that occur after 2021 will be far less lucrative. The reason is it seems certain we are going to face higher capital gains taxes. Currently, long term capital gains stands at 20 percent, plus the 3.8 percent Obamacare surcharge. President Biden wants to tax capital gains at 39.6 percent.
Biden may not get the 39.6 percent rate. It all depends on how disciplined Senate Democrats will be. If they all fall into lockstep, they can do whatever they want as part of a budget reconciliation. Still, some analysts believe the final rate will fall into the 25 percent to 28 percent range, which is still too high.
Selling this year is no guarantee you will be taxed under the 20 percent rate. Congress has raised taxes retroactively several times in the past and the Supreme Court even upheld their right to do so. Given the radical nature of many of today’s elected representatives, anything is possible.
Golden Handcuffs
When a PE firm purchases a company, the owner is typically required to flip some percentage of his equity into the PE firm. This can range from 20 percent to 40 percent. It is the rare firm that doesn’t require something.
The PE firm seduces contractors with the promise of a “second bite of the apple” when the PE firm flips the bundle. This serves to keep the principal of the firm involved because he’s got a big financial stake in play. This will help prevent the talent exodus that occurred under consolidation in the 90s.
Where It Can Go Wrong
PE firms do not buy companies for the heck of it. They buy to build and exit. What they do is not easy. Picking up dozens of small businesses, evaluating them, negotiating with the owners, and performing due diligence one company at a time is a lot of work, but it is what these firms do.
Ultimately, there are two outcomes. The bundle can be taken public with an initial public offering and traded on one of the stock markets or it can be sold to a large public or private company. Think utilities. Think big boxes. Think of a company that sells stuff over the Internet.
Think it’s hard to attract technicians now? Imagine trying to compete with a mega company with an established training and development program, better pay, top shelf benefits, no weekends on-call, etc.
None of these entities are capable of building up the consolidated bundles that PE firms are assembling, but are certainly capable of buying the bundle. Think Internet sales are a problem today? Imagine what they could be under this scenario.
Think it’s hard to attract technicians now? Imagine trying to compete with a mega company with an established training and development program, better pay, top shelf benefits, no weekends on-call, etc. Think they will overlook your town? Nope, they are coming to small towns too.
Could this happen? Absolutely! Will it? Maybe. Consolidation failed. Maybe this will fail too. Running technicians is a lot harder than money guys think. By the time the public companies get involved, the original owners will have completely exited so the process and training programs will tell the tale.
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