Published April 16, 2022 by Craig Arends of CliftonLarsonAllen
By: Jeff Servais
2021 was a great year for construction sector M&A. Passage of the IIJA will mean a significant increase in highway and street funding, which will support continued M&A activity. While the infrastructure bill presents many opportunities, we are also faced with the reality that we don’t have enough skilled laborers needed for production.
Companies will need to evaluate resources and figure out their right approach moving forward. At CLA we see significant opportunities and challenges that the construction sector will face in the coming years, and these will need to be address in order to navigate them to succeed.
Areas such as residential service and specialty construction are particularly hot. Here are a handful of key construction deal issues that you should consider when evaluating an opportunity in these segments –
Revenue Recognition
GAAP requires revenue associated with long-term contracts to be recognized as performance obligations are met. Many construction companies use the percentage-of-completion method, which bases revenue recognition on management estimates. It is critical to understand management’s historical estimating ability and how that impacts the historical financials. It is also crucial to understand how the current open job estimates compare to the historical closed job estimates, flagging a potential future fade in profitability. Many smaller businesses do not properly utilize percentage of completion accounting; therefore, this is a key item to address early in the diligence process.
Working Capital and Indebtedness
Treatment of under billings and overbillings can vary according to the Company’s billing practices. If the Company is overbilled and presents negative working capital on a cash-free debt-free basis, a buyer may want to consider overbillings to be treated as indebtedness. If this is part of the Company’s normal cash conversion cycle, a seller may be able to argue that overbillings are a part of net working capital. These different approaches can significantly impact the net purchase price.
Unions
If the Company’s labor force includes union employees, it’s important to understand new management’s intention going forward. Is the union still a good fit? If not, what are the consequences for leaving the union? Is the union underfunded and how will that impact the business going forward? How will an underfunded liability impact valuation, if at all?
Captives
Many construction companies invest in captive insurance for reduced premiums and tax benefits, but is it truly a good fit post close? How have the dividends or profits impacted the business? What is the expected go-forward impact? It is important to understand the Company’s role and performance within the captive to analyze potential exposure going forward.
Minority, Disability, or Women Owned Businesses
Will an acquisition impact a company’s minority, disability, or women-owned business designation? It’s important to consult with legal counsel early on when investing in one of these companies to try to understand scope of exposure. Buyers should be sure to understand the EBITDA impact of contracts won due to these designations and if similar post close wins are sustainable.
Craig Arends is a principal with CLA and is the managing principal of CLA’s private equity practice. He can be reached at Craig.Arends@claconnect.com or 612.397.3180.
Jeff Servais is a principal in charge of the Transaction Services practice for CliftonLarsonAllen LLP in the Midwest region. He can be reached at Jeff.Servais@claconnect.com or 972.383.7713.