Private equity is leading a new round of consolidation. The last round didn’t end particularly well. Will this be déjà vu all over again? Here are a few reasons why private equity will fail.
The P.E. Structure
First, it is helpful to understand how private equity is structured. To generalize and oversimplify, private equity (P.E.) funds feature a general partner and a collection of limited partners who invest and loan money to the fund. Because P.E. funds typically use as much debt as possible and the general partner is responsible for the debt, a high value is placed on acquiring businesses that can generate immediate cash flow.
Accordingly, P.E. funds do not as a rule, seek poor performing businesses that can be turned around. They seek good companies that are generating healthy levels of earnings before interest, taxes, depreciation, and amortization (EBITDA) to help pay down the debt. They are also focused on the residential and light commercial service and replacement segment of the industry.
Too Many, Too Few
HVAC private equity is doomed to crash and burn. There are too many players chasing too few contractors. Nearly 20 private equity funds are targeting 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, start buying weaker companies, or some, followed by others will start to abandon the industry. The first two scenarios are recipes for failure. Given the lemming-like way P.E. firms followed each other into the industry, the exodus of a few might start a race for the exit among the rest.
Who knows? Some attrition may help the more serious players. They believe that they can take a collection of companies from across the country or a region and get greater organic performance from them than they will deliver independently. They can possibly succeed if they can come up with a game changing approach to sales and marketing (until it is quickly copied), bringing in more revenue. The consolidators of the 1990s couldn’t.
There is also the belief that the buying power of a group of companies will far exceed their buying power separately. Gains here will be marginal at best. Good companies already buy well, and if they are in a buying group, they buy even better. Plus, contractors exhibit loyalty to certain brands and/or suppliers. Even when a manufacturer owned a consolidator, they didn’t unify purchases under one of the manufacturer’s brands or a private label. They couldn’t do it. Neither could the other 1990s consolidators.
Shared Services Potential
There is potential for shared services. Marketing could be shared, except that HVAC is fundamentally a neighborhood business. If nationwide sales, marketing, and branding were the answer, Sears would be the industry’s dominant force. Human resources and accounting could be shared, except it’s hard to see much savings in the way of efficiencies, but easy to see the creation of a slow and cumbersome corporate bureaucracy. Again, the consolidators of the 1990s weren’t able to achieve much efficiency in the way of shared services.
In all likelihood, the private equity fund managers are going to be disappointed that they can’t make one plus one equal three, and often end up with less than two. Generally, the goal is to flip the consolidated businesses in three to five years for three to five times the investments made in purchasing and trying to merge them.
This doesn’t even factor in the shipment cliff. Private equity saw industry performance in 2020 as proof of the resilience of HVAC. But 15 years earlier was the previous record year for shipments and industry shipments contracted 40 percent over the following four years. Enough replacements were deferred from 2020 into 2021 to keep the replacement market contraction from arriving on schedule, but it is still looming. Contractors working their tails off can grow in a down cycle. How hard will contractors who sold their businesses work? What will private equity do if sales drop or are flat?
Say the contractor does not participate in an equity roll into the consolidated company and thus, doesn’t stay on as an employee. As soon as his non-compete expires, he can become a well-funded competitor reacquiring his old customers and favored employees. Private equity can’t stop this from happening and neither could the 1990s consolidators.
It’s déjà vu all over again.
Matt Michel is President of Service Nation Inc. and the 35th person to be inducted into the Contracting Business Hall of Fame.