The construction industry can offer private equity (PE) companies unique investment opportunities, whether that be residential, commercial, infrastructure, renewable energy generation or a myriad of other sub-sectors. While investment in this particular space is still small compared to the overall size of the PE sector, acquisition activity is noticeably on the rise.
Interest revolves around contractors
We’re seeing some aggressive growth strategies – as many as 40 to 60 acquisitions a year in some cases – when it comes to construction dealmaking, and that activity principally concentrates on contractors. PE firms are buying a contractor, specialty or otherwise, and then quickly adding on additional contractors to create a super-regional or national specialty contractor. For example, a Northeast-based HVAC contractor that employs several hundred workers across a region might buy other HVAC contractors in that same region, then progress to buying contractors in surrounding states, ultimately creating a rather large regional contractor.
Acquisitions over organic growth
What makes the construction space so appealing for investors? Two interesting scenarios can play out:
- Territory expansion: When a contractor makes the strategic decision to grow in a new territory, talent and relationships become critical, and those both take time to develop. Traditionally, a contractor may consider a local joint venture partner in a region that they want to establish a presence in. That approach is still common, but now that same firm has another option to expedite the process through direct acquisition.
- Jumbo growth. Acquisitions are a seamless way to grow a small company to a jumbo-size company rather than starting from scratch. This is playing out primarily in the commercial construction space. Sub-contractors tend to be small companies, but a bigger company with better work quality and safety controls is arguably better equipped to take on bigger, commercial projects. PE firms recognize this and see the market for larger subcontractors as largely untapped.
Two main risk concerns
Rapid growth is exciting for a PE firm and its investors but can result in several concerns from a risk perspective, namely:
- Quality of work. The biggest issue when it comes to quality of work are construction defects. That is, issues that could arise after a project has been completed, which are a result of poor design, materials or workmanship. Companies should have the right quality controls – from ensuring the correct use of materials or instituting an audit system to confirm work was done correctly before a company leaves a job site – so that larger issues like faulty electrical systems, leaky plumbing, roof cracks or worse don’t occur.
- Safety. Requiring steel-toed boots, hard hats, fall protection, heavy equipment protocols – these are basic safety measures. However, smaller, regional companies may not necessarily have or consistently enforce these controls. It’s imperative that the new parent company mandate safety measures and foster a safety culture in a way that retains employees so that job commitments can be met.
Risk retention will become standard
It’s important to look at future program structure as the deal pipeline in the construction sector grows. Most likely, at some point PE firms will have to take on a little insurance risk themselves. As they grow and losses become more predictable, carriers will likely want PE firms to take on more risk through a deductible. Posting collateral can be a bit of a surprise and concern, but risk retention may be an expectation to a certain point because there are few carriers who feel comfortable writing large, guaranteed cost deals. A good broker should educate and make sure PE firms are aware that the insurance program may need to change and risk retained as they outgrow guaranteed cost and execute a growth strategy.
Communication checklist for smooth deals
Very early on, PE firms should think about their communication plans to their carrier to ensure the carrier is comfortable underwriting the new, bigger company. Firms should even think more broadly about how the carrier can do some of the lifting to help integrate the expanding portfolio with risk control services or claims services. Not taking these steps can create big issues for firms and workers. We have seen some instances where claims come in and are denied because they are not covered by the policy – simply because the new carrier was not alerted to the acquisition.
Brokers and carriers can help pave the way for seamless deals by giving PE firms a checklist of information that is needed every time an acquisition is made. There are three main points to achieve with this checklist:
- Make sure the carrier is clear upfront that there is a growth strategy. If the carrier is in the dark about intended acquisitions, it can make arranging appropriate coverage after the fact unnecessarily difficult.
- Communicate if the growth strategy will change the type of work or the states in which a company is working. For example, certain states and cities have labor law risks that drastically change insurance needs. Alternatively, a company may have plans to expand from commercial into residential projects or add additional capabilities like plumbing or electrical work. These are all instances that could impact a carrier’s expectations of the risk they are underwriting and whether they even feel comfortable continuing a relationship. Proactively communicating about plans also helps carriers price out insurance ahead of time and gives firms a good idea of what growth costs could be from a risk and insurance lens.
- Explain how you will integrate safety and quality of work controls into the new acquisitions. If a firm is not sure about how to execute this, carriers that have strong risk control can help. Liberty Mutual has risk control professionals who can evaluate where risk gaps are and help bridge those gaps so newly acquired companies are poised for success.
We have seen a steep curve in deals in the construction space. No one wants insurance to hold up those deals, so with a little strategic foresight, planning and communication, growth can happen quickly and smoothly.
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