Construction as a target sector for SF

May 21, 2020

by a searcher from SKEMA Business School in Dubai - United Arab Emirates

Hi, I wanted your thoughts on the construction sector as a target industry for a search fund. I don't often see this sector as a target industry, and I was wondering why?

From my perspective, it is a large, fragmented, and growing industry, and while cyclical, some niche subindustries can be considered resilient. I am thinking of the roofing contractors, the framing contractors, the road-building contractors. Most of them enjoy margins above 15% and have excellent growth prospects. There are also very few technological obsolescences and plenty of targets in the size range.

Any thoughts?

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Reply by a searcher
in Portland, OR, USA

I had a deal in the construction sector that started moving forward but failed early-on. The company was a niche sub-contractor that served residential, commercial, and municipal projects in a rural but wealthy/touristy area. Their books seemed well kept for a small (>$1.5M EBITDA, fewer than 50 FT employees) construction company. Many of the employees had been with the company for 10+ years with the skilled foremen averaging roughly 25yrs. The asking price and multiple were low; it became apparent why. The cyclicality of construction hit the company hard in 2019 and EBITDA dropped from '18 to '19 by ~40%. Weather, project financing, plan changes, etc... all accounted for the sudden drop according to the owners. I was able to go back in their records and analyze cycles like the '08.- '12 construction slowdown. It was a boom or bust business. The company's EBITDA fluctuated far too much to be a sound acquisition model, at least with my debt to equity ratio. The lenders I approached were not interested in the deal, especially with the heavy leverage I would have needed to acquire the company.

That said, roofing seems like a great niche within the construction industry to target, and you have a growth strategy. Search Fund Accelerator had one of their searchers acquire Legacy Roofing in Akron, Ohio not long ago. I assume the acquisition was put through a lot of scrutiny by the accelerator board, so it shows you there are companies out there in construction that are good targets.

Reply by a searcher
from SKEMA Business School in Dubai - United Arab Emirates

Thanks for your feedback. Those are excellent points. I quite like the roofing niche as it offers less cyclical patterns than classic builders, particularly in regions climatically more exposed. To extend the conversation, I believe that you can still improve the margin of most of the mid players with few of the following initiatives:
1) more systematic control of each project: a lot of the company I saw between US$5m and US$30m revenue are still tracking their costs and WIP on a yellow pad.
2) I agree with Jason that labor and materials are the main costs. I guess by internalizing some of the production, particularly on metal roofing, you can save one or two bp of gross margin.
3) Increase services to increase your recurring clients and improve your working capital structure. Few small roofers are offering services such as roof asset management services or solar micro-grid network management. Not only you invoice on service, but you preempt bid competition when they need installation or reroofing.4) Lastly, I agree with Jason on the cost per unit. It will not change as you grow because you won't get economies of scale on labor and material. I, however, feel that your overheads won't grow as fast as your top line. So I believe you can expect some EBITDA margin improvement as you increase revenue.

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