M&A Deal Structuring: Using the PE Playbook to Your Advantage

The AEC industry is filled with firm managers who are risk-averse. It’s an industry built upon the necessity of reliability, permanence, and zero failure. The structures and systems that firms design and build must stand the test of time. This mantra was driven into me at Georgia Tech when my professor announced to the class it was his “duty” to ensure that no substandard students pass his class, lest he or someone in his family drive over an unsafe bridge we designed.

Designers look for ways to ensure the performance of their designs and mitigate their risks. So, it is no surprise that when I look at M&A deals in the AEC space, I see similar conservatism reflected in their structure. The desire to remove risk is often associated with eschewing debt and using only cash to fund acquisitions. While it may be less risky in some respects, it is also costly and can drive down shareholder returns. One alternative is to take a play out of the private equity playbook.

Leveraging Debt, the Private Equity Way

Many AEC firms entering the M&A market observe how private equity-backed firms achieve growth more rapidly through acquisitions. These PE-backed firms use debt as a force multiplier to grow beyond their investors’ equity and boost returns.

Private equity is not a new concept. Large “buyout funds” have been around since the 1980s, employing leveraged buyouts (LBOs) for decades with much success. The key to the PE success formula is using debt to lower the cost of capital and drive investor returns. An LBO is similar to buying a house in the United States. Let’s use a hypothetical home purchase to illustrate how debt can increase your returns.

• You buy a house for $1 million with a down payment of $200,000 and a loan of $800,000.
• Just after closing, you get an unsolicited offer to buy the house for $1,200,000.
• In this instance, the value of the home increased by 20%, but your return on equity is 200% (you put down $200,000 and walked away with $400,000).

This example is overly simplistic and not likely to occur, but the fundamentals are the same. Shareholder returns are driven by the amount of money invested, not by the increase in value. Adding debt to an acquisition reduces the equity invested and can increase returns, provided the investment can service the debt. Firms that utilize debt in their acquisition structures increase their returns and maintain cash for other purposes.

Debt < Equity

Interest rates are much higher now than they were just a few years ago, as the Federal Reserve Board has increased the Federal Funds rate to battle inflation. You may wonder why someone would advocate for using debt when it is relatively expensive. While debt is more expensive than it once was, it is still much cheaper than the cost of equity, which is essentially defined as an equity investor’s required return.

The cost of equity for most privately held AEC firms exceeds 20% and, in some cases, will exceed 25%. That means that when valuing your firm, your cash flow is discounted over 20% to come up with your firm’s value. When comparing “expensive” debt at 8% to the cost of equity, you can see that debt is still very much cheaper than equity.

Debt has other benefits; interest payments are expensed and, therefore, reduce tax liabilities. The caveat to the tax benefit is that as debt matures, the debt payments will become heavier on the principal, which receives no tax benefit. The cash flow impact of the debt payment remains the same, but your tax bill will increase as you will expense less interest through the life of the loan. As interest rates come down, debt taken out today will have the opportunity to be refinanced later, taking advantage of capital markets to continuously drive down a firm’s cost of capital and boost shareholder returns.

Marrying Debt + Structure

There are two components to crafting an offer to purchase a company: value and structure. The value represents what the company is worth, while the structure outlines how the buyer will pay this value to the seller. The structure can significantly impact the return for the buyer. An experienced advisor can play a crucial role in this process, helping firms increase shareholder returns.

Debt is an important factor if M&A is in your future. A manageable amount of debt can be beneficial, but too much can lead to serious consequences. Strategic debt management can significantly bolster your M&A success; though, choosing the optimal amount of debt to meet your goals best can be challenging.

Next Steps

No matter which approaches a firm takes as it considers M&A deal structuring, it is a complex situation. If you are interested in having a conversation about how to maximize deal structure, including how to choose the appropriate types and amounts of debt to meet your acquisition needs, reach out SN.

For more insights and to join the conversation, listen in on AEC Unscripted M&A Edition. In this episode, Ira and Jeff explore the typical investment model, how to position your firm for PE (platform vs. add-on strategy), and the key benefits and considerations. Learn how to leverage PE to access capital, strategic expertise, and achieve your growth goals. Tune in and learn how one of the most seasoned AE private equity investors approaches deals.