At long last, private equity (PE) has turned its attention to the construction industry. It makes sense with a demographic of aging owners, industry challenges solved by consolidation, and high-demand sectors (specifically healthcare and technology) – all of which appeal to PE firms on the hunt for opportunity. As sales take off and private equity funds seek out their pick of the proverbial litter, sellers need to know how to translate years of hard work into financial figures that speak to those on the other end of the negotiating table.
It’s crucial for industry leaders to understand, internalize and speak to the criteria private equity firms use to choose acquisition targets. Achieving the financial standing that makes a construction business an appealing acquisition target will serve its owners regardless of their interest in a deal. Strong financial statements can attract buyers while improving access to bonding, financing and business opportunities.
There are a few key principles to follow to earn the financial performance of your construction business the highest possible marks from a firm.
1. Anticipate and Answer Scrutiny
The due diligence process is rigorous. Private equity firms may be relatively new to the construction industry, but they’re old hands at identifying red flags. Construction businesses need to have strong financial processes in place so they aren’t rushing to organize financial details, finalize contracts or uncover employee data with a deal on the line. Skeletons are often uncovered in due diligence and that’s a top cause of deals that fall through. In addition, mad scrambles to clean up known but unaddressed issues can result in missed details – like unresolved union agreements or contract disputes – that can have a detrimental impact on valuations and credibility. This is why sophisticated financial practices should be in place as early as possible.
2. Ease Integration Fears
While a sale may feel like the end of your journey as an owner, it is just the beginning of life for a new entity. Demonstrating that your business has up-to-date technology, well-trained internal teams, and a demonstrable commitment to best practices across departments will ease one of any buyer’s top concerns: integration. If you reinforce a commitment to professionalism in the dealmaking process by producing information timely, answering questions openly, and sharing details about your capabilities, buyers will see a smoother road ahead of them post-close. And the peace of mind that inspires often earns a premium on your valuation.
3. Enhance the Quality of Your Quality of Earnings Report (QoE)
QoEs make or break deals in any industry. For construction and others that rely on project-based financing, they can be particularly revealing. In our day-to-day work advising construction firms, we routinely uncover larger, unexplainable swings in monthly profits, volatility in general and administrative expenses, inconsistent estimates and cut-offs, and other potential red flags.
There is no shortcut to sophisticated financial practices, just as there is no substitute for reliable figures. Prioritize getting a robust, reliable monthly view of financials. That’s essential whether you’re pursuing a sale or just want to understand your business’ financial performance. Here are a few real-world examples of misclassified or misallocated costs that can compromise valuations:
- Charging equipment purchases to job costs, decreasing project margins and EBITDA.
- Repeated overestimates of remaining costs, suppressing revenue on a percent-complete basis. Chart out misestimated projects and you’ll see a sawtooth pattern that can scare potential buyers.
- Non-business expenses. Operating accounts stuffed with owner-related expenses add overhead and understate EBITDA.
- Unbilled work. Work on properties owned by related entities without billing or intercompany recognition understates revenue and margin and misstates the cost basis of the other companies.
For middle-market businesses, these may look like familiar missteps. Usually, they’re born out of a practical need rather than malfeasance and there are accordingly straightforward ways to protect valuations by remediating them.
- Reconstruct monthly financials and work-in-progress reports (WIPs). Perform monthly tie-outs of assets and liabilities, retention, over and under billings, and WIP to the general ledger. Ensure percent-of-completion revenue recognition aligns with on-site progress and change orders.
- Optimize fixed asset and equipment policies. Create a fixed asset register, establish charge rates for equipment, and reclassify equipment purchases (for example, moving them from job costs to fixed assets). Recording equipment as a fixed asset enables depreciation benefits while reporting profitability accurately.
- Clean up expenses. Enforce policies and controls that route non-operating expenses appropriately and document add-backs with supported evidence.
- Establish governance. Billing protocols and intercompany agreements should cover all work and historical periods should be adjusted, with supporting documentation, to reflect cost transfers and associated revenue.
- Generate disciplined forecasts. Develop a process for the monthly close calendar that features sign-offs on changes and a WIP that explains variance. In addition, build a dashboard to track KPIs like margin fade/gain, under and over billings, retention, and backlogs.
Everyone makes mistakes. When those mistakes show up on QoE or elsewhere in the due diligence process, there are reliable ways to fix them.
The benefit of preparation is clear: increased credibility with buyers and realize higher valuations. With multiples in the sector as high as 5-to-10 time EBITDA, the upfront investment necessary to optimize financial practices and refine your operations can prove transformative when all is said and done. That’s true whether your exit strategy centers on a sale or succession.
Craft A Plan, Move Forward
View your financial practices as an opportunity to generate value and you’ll always be in a great position to align your valuation expectations with the markets. With every detail documented, communicating the effort you’ve poured into your business will be as easy as pointing to the page. One final important tip for owners that may be too preoccupied to consider their own position post-close. Don’t diminish the value of your deal by failing to meet with experts ahead of time to anticipate the hidden fees (legal, tax, etc.). After all, due diligence isn’t just for PE firms.
