Keep Your Corporate Strategy in Mind
One of the reasons companies lose sight of their strategy when they start to think about acquisitions is that growth by acquiring a company is so much more dramatic and sudden than organic growth. Twenty years ago, it was the norm in the industry to assign an estimator or project team to a new geography or type of project. After a successful bid or sales effort, a project was obtained, the organization was built and a new initiative was started. This process was notably slow and sometimes expensive.
Since then, acquisition has become the preferred alternative to organic growth. However, firms often tend to start their discussions with the acquisition criteria for expansion or the companies that are available and fail to adequately analyze what they want to accomplish with an acquisition. They also fail to discuss the impact the acquisition will have on both organizations and the implications of the acquisition for ownership and management succession. The acquisition becomes the strategy, whereas the original strategy was to enter a new market or to grow.
Planning an acquisition should begin with a discussion of corporate strategy in which other tactics to achieve corporate goals are considered and, if appropriate, rejected. Time frame considerations often lead companies to determine that a strategy calls for acquisition. Once you determine that the strategy calls for acquisition, the acquisition process itself must be planned and periodically monitored for its fit with the overall strategy within your company’s mission.
Planning for Acquisitions
Contracting is a tough business, as most businesses are; however, there are some fundamental characteristics of construction companies to consider when the idea of growth by acquisition is on the table. Here are a few observations from FMI Corporation’s mergers and acquisitions work with contractors:
- Contracting is fragmented for a reason. Some of the factors include:
- Geography — The ability to travel is limited for most contractors.
- Lack of economies of scale — Contractors don’t necessarily gain efficiencies or buying power with size.
- Propensity of the business of larger firms to unravel — As contractors grow, they sometimes lose focus and discipline at the project level.
A construction company is principally a group of people who know how to procure, perform and get paid for construction services. Take a few top people out of most construction companies and the company loses focus quickly. Key people can lose motivation, go to competitors or even start new competitors. So the phrase, “Our people are our key assets,” is particularly true for construction companies.
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Market opportunities come in waves. Five years is an eternity in the contracting business when it comes to planning. It is not so much that the technology changes, it’s because what is built does. Construction may grow overall with gross domestic product, but within the market for construction, sectors are going up and down, sometimes radically. Therefore, a contractor cannot rely on the work it does today to grow consistently.
- Contractors don’t do very well in downturns. Construction suffered severe downturns in the early 1980s as interest rates soared and in the early 1990s in the wake of the savings and loan crisis. These downturns bankrupted many developers and contractors.
Perhaps the current downturn will be less onerous for contractors, but generally a lot of contractors do not do well in a downturn. In fact, one sign of a savvy contractor is the ability to get small when economic conditions call for it.
Other considerations for contractors in downturns include:
- Falling backlogs cause contractors to reduce margins.
- Contractors may lay off people needed in an upturn.
- Banks and bonding companies periodically embrace — then later turn away from — the industry.
Fundamentals of Acquiring a Construction Firm
While acquiring a contractor may provide great strategic opportunity, be aware that there are perils to be avoided. We recommend you carefully consider these fundamentals before tendering an offer:
- Acquiring a company often destroys some of its value. An acquisition changes almost everything about a company unless you never plan to integrate the companies. However, there is really no such thing as not integrating. Owners change, incentives change and top management usually changes. For better or worse, the whole corporate culture will likely change.
We mentioned above the importance of key people in determining value; it’s not surprising that much of the value of a construction company may be in its culture. Think of the values that may be gained and lost when integrating the acquisition.
- Cash flow is king, but the balance sheet matters in contracting. A construction firm must be able to bond and bank.
A number of the consolidators in recent history have proven that bad things happen if you do not have a strong balance sheet when the tide of fortune turns against you. The reliance of cash flow on people issues, the uncertainty of the length of the construction economic waves and the potentially destructive impact of the very act of acquisition tempers reliability of the discounted cash flow method for valuation.
- A construction company is usually worth more to the seller than to the buyer. Sellers understand the risk profile of the company better than the buyer does because they have “lived the company.” From the buyer’s perspective, the very act of acquiring the company can destroy value. Therefore, there must be motivation by the buyer or seller to bridge the value gap.
- An acquisition in construction is more like a marriage than an investment. There are no good hostile takeovers in contracting. Financial analysis is meaningless without a cultural fit and consideration for compatibility and retention of the organization. Divorce is never pretty in construction.
Acquisitions do not fail because a buyer pays 10% or even 20% too much. They fail because of people issues such as poor integration or poor cultural fit. The more you study the financials of an organization, the fuzzier financial projections for the future become.
Ultimately, an acquisition’s success depends on the acquirer’s ability to maintain and enhance the organization’s ability to procure, perform and get paid for construction services.
The Basics of a Successful Acquisition
If you are certain that acquisition is the move to make to implement your growth strategy, the following fundamentals will improve your chances of success.
- Don’t outrun your people and don’t assume the acquired troops will follow. It is easy to become enamored with marketing strategies, operational efficiencies and financial potential. However, strategies fail without people to execute them. Plan according to your organization’s ability to get the troops aligned behind the strategy.
- Formulate an operating strategy to develop key people. This will support organic growth and provide leaders for acquired companies to bring them into your culture. It is important to remember to develop leaders, not just managers. There is a difference between management and leadership. Managers implement plans and direct people. Leaders drive the organization and set direction for the business. You need both, but leaders are often forgotten in development efforts.
Leaders can be developed and it is best if they are developed internally. Leaders are hard to hire without upsetting the organization. Make leadership development part of your long-term plan for growth and ultimately the continuity of the firm (whether it’s sold to employees or to a third-party buyer).
- Don’t outrun your balance sheet. Financial advisors often counsel aggressive growth or distribution of earnings. Construction is a cyclical business, and markets can turn quickly. Bad jobs happen even to the best of contractors. History tells us that banks and bonding companies are not very forgiving when times get tough. In the recessions of the early 1980s and early 1990s, it was the contractors with perseverance and a solid balance sheet that emerged stronger.
A bit of a Depression mentality helps in construction. Anyone who has spent time with a parent or grandparent who lived through the Great Depression should understand a certain way of thinking that says — no matter how good things get, you should be prepared if things get really bad. Boomers and Generation Xers are less likely to think this way.
In construction, markets can turn sharply, a job can be a disaster, people can be lost and lawsuits can defy comprehension. If your fortunes turn, a strong balance sheet is a good thing to have when those you have counted on are less than supportive. Never make a bet you can’t cover.
- Forecasting beyond five years is based on your confidence in dealing with a changing market. Be realistic when making projections beyond five years. By years four or five, the buyer will have far more impact on the success of the operations than the seller will. Cash flow and earnings are the basis of valuation, but the reality in construction is that after you make the acquisition, your culture will change the acquired company’s culture, some people will be lost and markets will change. Thus, cash flow in the short term will be driven largely by what you buy. Over time, however, your responsibility for cash flow will increase for better or worse.
If you are going to forecast beyond five years, you are really basing it on what you do to the company to make it successful in five years. A lot of buyers five years into an acquisition wonder what they were thinking when they started, because their initial vision was so different from the world they now face.
- Analyze the waves. Buyers often look at companies as financial machines that generate cash flows for which they pay a fair value. Underpinning that assumption is another assumption — the market that generates the cash flow will be there as long as the cash flow model projects. The reality in construction is that most market sectors go through peaks and valleys of activity and that good margins draw competition. Successful companies are able to move with the markets.
- Have a strategy to deal with the change you will inflict on the company. You will change the company you acquire, and some of the change will likely be destructive. Think this through realistically and develop action plans to make the best of it. You need to perform an organizational analysis before you close, and you should take it to some depth before you value the company.
This organizational work will lead directly into your integration plan. The seller, and as much of the organization as the seller will let you work with, should be involved in developing the integration plan. This involvement should enable you to surface as many of the problems you will face in the acquisition as you can.
As we discussed earlier, the very act of acquiring the company will often destroy value. Your goal is to minimize the destruction and set the stage for building future value.
- Look for companies with similar cultures. We recently met with a potential buyer and seller and noted that, after the buyer finished the acquiring company’s presentation, the potential seller said, “You sound like us describing our approach to the business.” That type of cultural similarity is important in acquisitions. Changing culture is risky and hard to do.
- Focus early on culture and motivation, but don’t procrastinate on value and structure. You can spend a lot of time getting to know an acquisition candidate, and that should be the initial focus. However, if the seller is not motivated or is unrealistic on value, cultural fit will not get a deal done. Don’t rush to numerical analysis. Instead, begin a discussion of value and structure after determining basic fit.
Don't Ignore the Fundamentals of Contracting in Making Your Acquisition
Acquisitions are fun, challenging, potentially profitable — and potentially a mistake. Don’t ignore the fundamentals of contracting in making your acquisition. Take the time to get to know the seller and to know yourself. Resist the temptation to get lost in the numbers and confront the people issues. Remember that acquisitions are a means to fulfilling strategy and that letting the acquisition itself become the strategy is a mistake, usually an expensive one.
Stuart Phoenix is a principal with FMI Corporation’s Investment Banking Group who assists general contractors, specialty contractors, construction materials producers and design firms in the areas of mergers, acquisitions and ownership transfer. He can be reached at 919-787-8400 or sphoenix@fminet.com.
©2002 FMI Corporation.This article originally appeared in the May 2002 issue of FMI Management Letter. Used by permission of FMI Corporation.
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