Demand for specialty engineering services is attracting strong interest from private equity firms. Funds are attracted to the industry, in part, because of the consistent drivers of demand. Strict building codes require regular renovations and upgrades to fire systems, which create a steady stream of revenue for the companies that serve these needs. Meanwhile, property owners are increasingly investing in technology that can improve energy efficiency.
In an effort to capitalize on the opportunity, Detroit-based Huron Capital Partners has taken a buy-and-build approach, investing in smaller companies within specialty niches. But investors need to be aware of the challenges in this fragmented market. Watch our video.
Full transcript below:
Huron Capital takes advantage of investments in the fragmented specialty services market
Sean Roberts: Huron Capital is a lower middle-market private equity firm. We were founded in 1999, and we've now raised $1.7 billion through six private equity funds, and we focus on three different sectors. The first is consumer products and services, second is specialty manufacturing, and lastly, is business services.
Michele McHale: We are one of the largest accounting tax consulting and wealth management firms in the country. We serve over 400 private equity funds. We have worked with Huron Capital for over 10 years in a variety of industries, one of which is engineering services. We are seeing an incredible amount of deal activity in this sector, and this could range from regular engineering services to fire and life safety.
Upgrades and retrofitting existing buildings are really driving activity in the market, not just new building. The U.S. is flush with residential and commercial buildings, and owners of these buildings are really incentivized to keep their occupancy rates up by adding new lifestyle conveniences to the buildings that are really attractive to tenants.
Sean Roberts: Commercial buildings are getting more and more connected, the internet of things. That's providing a lot of demand for property owners to want to automate their buildings in order to monitor their energy usage, make sure that the building is wired for all the latest in fire detection and safety. That trend is just on the cusp of becoming mainstream, and I think what we're seeing, and our companies are benefiting from this, is that, as property owners are looking to make investments in their buildings they're making sure that they're connected.
So what we look for are sectors within that broader engineering services market where it's highly fragmented and we can go look to build a large organization through a buy-and-build strategy by acquiring several small companies that have a specialty in that niche.
There a couple of big challenges in this industry. The first one is, highly competitive, lots of people want to buy the leaders in these industries. And the second one is that it's highly fragmented. There are lots of great small companies out there, but it creates a challenge in that you have to go find them, you have to convince the owner to do a transaction with you, you have to make sure that there's a mutual interest in joining your organization. So you got to spend a lot of time out on the road, having meetings with those business owners.
Michele McHale: One key challenge that we see is on the accounting side. We often see companies that are not recognizing revenue in compliance with GAAP. This can cause some challenges as you're trying to evaluate the company. These owners typically tend to think in terms of cash, so they're not really thinking about when they actually earn the revenue under GAAP. That is important to a PE firm as they're looking at investing in this company because they really need to understand what this company would look like under GAAP.
Another challenge can be the integration of system and processes. You're combining a lot of companies together under a buy-and-build strategy, and they're typically all operating on different systems and have different operating principles and strategies. So combining all of these together under one platform can be a major challenge.
Sean Roberts: Building a relationship with the owner of the business, that's probably the key when you're executing one of these buy and build strategies is, you've got to have the right people on our team who can connect with the business owner to make sure that that relationship gets off on a good start. People and culture make all the difference. When you're combining a professional services organization with another one, they have to get the people and culture part of it right or things can go poorly.
Michele McHale: Since labor is the number-one cost driver in this industry, it is important for companies where there's some seasonality, that they're able to flex their labor force. Backlog is important in this industry as well as typically this is a significant portion of what our clients are buying. So analyzing backlog to make sure it's comparable with historical levels to support the future growth of the company, as well as looking at the project mix and the expected margins in the backlog, is really important as well.
Sean Roberts: There's a lot of activity, the larger companies in the space, which is clearly what we're trying to build, that have got all the right characteristics, whether it's high margins, consistent growth, both organically and through acquisition, those businesses tend to trade at high valuations. And I think what you're seeing throughout the M&A markets today are a lot of competition. Bigger private equity firms coming into the lower middle market. There's lots of capital out there looking to do deals. So for those attractive businesses you're getting a lot of interest and the valuations are getting high.
I think the thing that's really interesting about being in the lower middle market is, you see tons of variety. We're trying to find acquisition targets and strike deals with small companies that are owned by a founder, and there's lots of personalities out there, there's lots of fun stories about the meetings that we've had with these different business owners over the years. And that's what really keeps it interesting and makes you want to wake up and find your next deal is that variety.